What is Yield Farming in Crypto and How Does it Work?

If you’ve been following the developments around crypto, you must have heard of yield farming. This came as part of the DeFi package and has been growing in popularity. It is one of the easiest ways to earn passive income in DeFi.

It is also known as liquidity mining, and is simply the lending or staking of your crypto assets in DeFi to earn rewards from it. It allows people with assets such as ether (ETH) or stablecoins like DAI to stake or lend their assets and earn rewards in a way that is easier than traditional savings accounts.

This is a great way to make your assets work for you instead of having them lie there doing nothing. Yield farming is also a form of passive income stream, so it doesn’t involve much effort from you once you set up.

You can stake or lend assets on different platforms, including decentralized exchanges (DEX), lending and borrowing platforms, yield aggregators, liquidity protocols, as well as options and derivatives protocols. 

Rewards are paid through the platform’s native tokens, governance tokens or even a portion of the platform’s revenue in blue chip coins such as ether. How much reward you earn however depends on factors such as the type and amount of assets you lend, the duration of your participation, and the overall demand for the platform’s services.

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How Yield Farming Works

Yield farming works with unique protocols known as automated market makers, which work with liquidity pools. You’ll need to provide liquidity to the protocol as a liquidity provider. Your provided assets are then used for borrowing, lending, or swapping of tokens.

In return, you’ll be rewarded from the transaction fees users of the protocol pay. Your reward will depend on how much liquidity you provide to the pool. Many times, the reward is paid in what is referred to as liquidity pool (LP) tokens. 

You can then use the LP tokens to farm yield by depositing to another protocol, known as a yield farm, that mints new tokens. 

Risks of Yield Farming

Yield farming can be a very rewarding way to earn some passive income with your crypto portfolio. However, it involves certain risks that you should know about before you get involved. The following are some of the risks involved in yield farming.

Smart Contract Vulnerabilities 

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Yield farming protocols run on smart contracts. These are computer programs with instructions on how the platform should run. Smart contracts are a good idea because they reduce human interference in the entire yield farming process. However because they are written by humans, they are bound to have vulnerabilities that can expose them to risks.

Such vulnerabilities can lead to major losses including deposited funds and earned rewards. This isn’t a common occurrence, but you can’t rule out the possibility. Therefore it is important to check the security and audit history of the protocol you wish to use for your yield farming.

Protocol Risks

Yield farming protocols are also built using smart contracts, which also may have inherent issues such as bugs. Some platforms may even be programmed for scamming unsuspecting users, which can lead to a rug pull. Therefore, use only reputable and recognized protocols for farming yield.

Liquidity Risks

While yield farming involves providing liquidity to protocols, you also need liquidity to withdraw your deposited assets and the rewards you earn when the time is due. The liquidity in any protocol can actually dry up when the project becomes less popular for any reason, causing liquidity providers to pull out their liquidity, which can leave you stranded.

Price Volatility

Needless to say that the crypto market is a volatile one, which causes sudden massive price changes, such price changes can lead to a crash in the value of your deposited funds as well as your earned rewards, leaving you with much less to withdraw. However, a positive prive movement can be good for you.

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