So, what exactly is yield farming? Begin with this. It earns passive interest on your crypto holdings, typically at rates significantly greater than a savings account.
Then proceed to this. It’s dangerous. The larger the return, like with any other investment, the higher the risk. Bank savings accounts now earn a fraction of one percent APY (annual percentage yield) or APR (annual percentage rate), with the distinction being that APY reinvests earnings for compound interest. Farming incentives start at a few percent and can reach hundreds of percent.
You can make even more by lending your crypto assets to a decentralized finance, or DeFi, enterprise. However, even with exorbitant interest rates, with yield farming you need money to generate money and the ability to let it sit for long periods of time.
Aave is one of the larger DeFi financing schemes, with $24.4 billion committed. On December 13, it offered 2.87 percent APY on USD Coin and 5.44 percent APY on Binance USD, both stablecoins, but only 0.01 percent APY on Ethereum. However, the Curve DAO token offered 12.15 percent.
You lend funds to more obscure DeFi projects for a higher payout, with the higher returns coming from the more obscure projects. As a result, the risk of hackers, fraud, and outright “rug pulls” – the originator of a project stealing all the funds — is significantly higher than with proven DeFi lending protocols like Curve, Yearn, or Aave.
What are you up to?
Let’s take a step back and examine how DeFi projects function. Lending protocols are one of the most common types of DeFi projects. They work as follows: Person A deposits crypto — typically dollar-pegged stablecoins — in a liquidity pool on a DApp, which person B borrows and repays with interest. (This is also known as liquidity farming.)
Funds are staked or locked into smart contracts, which manage the liquidity pools on which DeFi lending algorithms rely. These are essentially money that have been pooled and from which borrowers can borrow. Pool participants receive a percentage of the interest earned based on the amount they have locked. The rules of the pools can become complicated, so make sure you understand what you’re getting into.
Among the many snags is that some initiatives give rewards in the form of their own tokens. This has a lot of possible advantages and disadvantages. For one thing, you are essentially investing in that token in the hope that it will rise in value. It also provides access to tokens that are difficult to obtain because they are from a fresh project with limited supply. As a result, they are quite volatile.
In June, billionaire investor and crypto enthusiast Mark Cuban tweeted that he’d lost a significant amount of money when Titan, an obscure DeFi token he owned, fell, plunging from around $60 to virtually $0.
Another issue that arises from the mix of yield farming and crypto volatility is what is known as “permanent loss.” While stalled crypto is trapped in a liquidity pool, its value might increase and fall, resulting in momentary profits or losses — sometimes scary ones — on paper. However, if you withdraw your cryptocurrency from a pool at the incorrect time, your losses are irreversible.
When you reinvest these reward tokens into other liquidity pools, you receive various tokens, which is where yield farming gets truly complicated — and best left to investors who are skilled and versed in the workings of DeFi. It is possible to construct complex investment chains.