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What Is Yield Farming?

September 21, 2021

4m

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The previous lesson described the inner workings of liquidity mining, a popular method of using existing crypto assets to earn more crypto by providing liquidity to decentralized exchanges. Aside from liquidity mining, DeFi also offers another yield product: yield farming.

Yield farming arrived alongside governance models during summer 2020. As more developers focused on expanding DEXs and improving their level of decentralization by delegating the decision-making process to the community, a unique yield product was born. Yield farming is essentially the same as liquidity mining, with the core difference being that farmers additionally earn LP or governance tokens.

What is Yield Farming?

Each decentralized DeFi project has a unique governance model. The utility of that model is derived from the use of governance tokens. A person who provides liquidity to a DEX with a governance model not only earns fees but governance tokens as well.

Alternatively, the protocol will grant LP tokens - a token representing a user’s share in the liquidity pool. LP tokens are ERC-20 tokens and are held in the wallet of the contributor, which means that they can be actively used on other DeFi protocols. The end result is that one can maximize his profits by farming existing crypto assets and farming new LP tokens as well.

Another major point that must be noted is that yield farmers behave aggressively in the crypto market. To earn the best rewards and stay competitive they are forced to constantly chase liquidity pools with the highest APY rate.

This fervorous activity led to the creation of yield farming aggregators, protocols that allow farmers to participate in the best LPs all from one spot. A notable example of a yield farming aggregator is Yearn Finance, the popular DEX built by famous DeFi developer, Andre Cronje.

Similar to liquidity mining, yield farmers also suffer impermanent loss - the difference being that the risk is far higher if farmers decide to farm LP tokens as well.

A Step-by-Step Guide to Yield Farming

A simpler way of understanding yield farming and its increased complexity is via a step-by-step guide. We have used MetaMask as an example so make sure to read our How to use MetaMask guide if you need help. Here are the eleven steps that you must take to farm:

  1. Buy BTC, ETH, USDT, USDC, or DAI. These are the most universally accepted cryptocurrencies for generating yield on most DeFi protocols. Note that you'll need to buy some ETH no matter what to use as gas, which we'll explain later.
  2. Download the MetaMask Wallet browser extension. After installing, create a wallet and securely backup your keys and seed phrase.
  1. MetaMask wallets hold ERC-20 tokens — tokens issued on the Ethereum blockchain. As it so happens, most DeFi platforms are built on Ethereum too. So, you should have no problem sending the currencies from step one to your MetaMask, with the exception of Bitcoin. If you want to use Bitcoin on the Ethereum blockchain and hold it in your MetaMask, you'll need to wrap it first using the Ren Bridge to create wBTC, or buy wBTC on an exchange.
  1. Once your ERC-20 tokens are safely inside your MetaMask wallet, you're ready to start interacting with DeFi platforms and begin the never-ending fun of yield farming.
  1. For simplicity's sake, we recommend learning yield farming using Compound Finance. Compound started the yield farming craze and is, in many ways, the most beginner-friendly DeFi platform. Head over to Compound, then click the App button in the upper right-hand corner.
  1. After clicking App, you'll be asked to connect your wallet. Click the MetaMask option, then sign in to your MetaMask.
  1. Select the asset you want to supply from the Supply side of the landing page. Choose the amount you want to provide, then click supply. Note that there are two APY figures shown — supply APY and distribution APY. The former is paid in-kind (same as the deposited asset), the latter is paid in COMP. This means you're earning two forms of APY for one deposit.
  1. MetaMask will ask you to confirm two transactions. The first is to interact with the Compound smart contract, the second is to confirm the transaction. Both will cost gas paid in ETH, which is why we noted in step one to keep ETH in your wallet regardless of your chosen supply asset.
  1. After the transactions confirm, the Compound app will notify you that all is well, and you'll see your balance column populate with the amount you supplied. To the left of balance is the APY / Earned column, which displays both your APY rate and how much you've earned.
  1. At the top of the Compound page is a Net APY gauge to help you keep track of your total APY earned between both supply APY and distribution APY rates.
  1. To increase your yield farm potential, you can now borrow against your supplied assets to earn even more distribution APY (paid in COMP) while lending those assets back to Compound or another platform DeFi platform like Aave, Yearn Finance, or Curve Finance.

Conclusion

Yield farming is practically the same deal as liquidity mining. However, there are a few key differences that might pose a deal breaker when deciding between the two. To summarize:

  • Yield farming is competitive.
  • Yield farming offers better rewards.
  • Yield farming protocols distribute, alongside fee rewards, LP tokens or governance tokens as well.
  • If LP tokens are farmed, IL risk rates increase.

Based on their difficulty, we recommend the following yield farming protocols.

Easy mode:

  • Compound Finance
  • Maker DAO
  • Aave

Intermediate:

  • Uniswap
  • SushiSwap
  • Synthetix
  • Curve Finance
  • Yearn Finance
  • Badger DAO
  • Cream Finance
  • Harvest Finance
  • Balancer

Expert mode:

  • Alpha Homora
  • Mirror Protocol
  • Metastable
  • Loopring
  • dYdX

More Lessons in

A Beginner’s Guide to Decentralized Finance (DeFi)