What is yield farming?

A Guide to Yield Farming
Today’s post is about yield farming, one of the most important concepts in DeFi.

Until about three years ago, you could not do very much with crypto other than HODL it or trade it. People from traditional finance often pointed out that unlike shares (which offered dividends), crypto gave no return. The only strategy was either to HODL and hope the price went up or else to trade on centralized exchanges.

This lack of opportunity meant that if you bought 1 ETH in January, you had exactly 1 ETH at the end of the year. The dollar value may have increased, but there was no way to increase the ETH you held.

The difference between now and then is that there are ways to turn your cryptocurrency into even more cryptocurrency. In other words, you can derive a yield from it. The term ‘yield farming’ simply means creating strategies for maximising yield and moving your cryptocurrency around to get the best rates. Think of it like an interest rate, but for crypto.

Most DeFi takes place on Ethereum (although other chains such as BSC and Avalanche are becoming more popular because of Ethereum’s high gas fees). DeFi Pulse and DappRadar rank the different DeFi platforms by popularity. Even in the current bear market, the TVL (total value locked) in DeFi is tens of billions of dollars.

How do you get yield from your crypto?

The most common ways to get yield are lending or staking. If you visit two of the best-known DeFi platforms, Aave and Compound, you will see lists of tokens that can be deposited for other people to borrow, along with their APY.

APY stands for Annual Percentage Yield. This means the yield you would receive if you lent your tokens to the platform for an entire year and you received interest that was compounded. (This means when the interest you have earned is added to the amount you originally deposited, so that you earn interest on the interest!) 

So, what happens to your tokens once you have deposited them in the pool? The answer is that they are lent out as collateralized loans.

Collateralized loans are a big part of DeFi. Borrowers can deposit collateral in one token and then borrow another token, to make the most of shifting exchange rates between the two tokens. To mitigate risk for lenders, borrowers must always deposit more collateral than the sum they are borrowing – and they may be liquidated and lose funds if the value of their loan becomes too big a proportion of their collateral.

When you add your tokens to a lending pool, it is important to be aware that there is no centralized intermediary validating the financial circumstances of borrowers. Unlike a bank or a fintech company, a DeFi platform is simply a set of smart contracts on the blockchain. DeFi smart contracts are programmed to take certain actions in response to events such as changes in price. This means that if people who have borrowed from the pool where you have staked your funds are liquidated, you may also lose a proportion of what you have staked.

How to get yield from liquidity pools on DEXs

Depositing pairs of tokens on a decentralized exchange is another way to earn yield. This is more risky than simply depositing a single token on a lending protocol because you run the risk of suffering impermanent loss as the token exchange rate goes up or down.

For more about impermanent loss, Binance Academy has a good explanation here.

Decentralized exchange liquidity pools are simply a smart contract that is programmed to allow anyone with a crypto wallet to swap one token for another and to adjust the price according to the ratio of tokens in the pool – in other words, an automated market maker. 

The most popular DEXs are UniSwap, SushiSwap and PancakeSwap (the latter is on BSC). All DEXs carry an inherent risk because funds are not insured and are dependent on the contract code not being vulnerable to hacks. However, some liquidity pools are less risky than others. The riskier a pool and the more volatile an asset, the higher the yield normally is. Some pools on PancakeSwap offer APY well in excess of 100% to reflect this risk.

What is liquidity mining?

In the case of Aave and Compound, investors who stake their tokens receive AAVE and COMP tokens as a reward, in addition to the interest they earn. However, smart investors do not simply receive these tokens and leave them in a wallet – they gain even more yield by staking these reward tokens.

Similarly, investors who receive NFTs in return for depositing tokens in liquidity pools can stake these and receive even greater rewards.

Protocols themselves may also issue additional rewards for holding their tokens and committing them to a liquidity pool. So in this case, an investor may receive two types of reward for depositing their tokens in a pool:

  • A share of the transaction fees every time someone makes a trade in the pool
  • Yield on the liquidity pool NFT when it is staked

Yield farming and tax

Successful yield farmers will often change their positions frequently in order to maximise yield. Where one type of yield is stacked on top of another and where APY is constantly changing, it can be challenging to calculate the tax you owe. 

This is where Skytale’s integration with QuickBooks is so very useful. By connecting directly to your wallets, you can import transactions into your accounting software, ensuring that nothing is missed and all taxable records are reported accurately.

Every country has its own approach to crypto taxation, but whichever country you live in, it is important to submit a true record of your earnings to the tax authorities. DeFi and yield farming can make completing tax returns hard work – but Skytale helps simplify the process.