Yield farming is a means of earning interest on your cryptocurrency, similar to how you’d earn interest on any money in your savings account. And similarly to depositing money in a bank, yield farming involves locking up your cryptocurrency, called “staking,” for a period of time in exchange for interest or other rewards, such as more cryptocurrency.
Since yield farming began in 2020, yield farmers have earned returns in the form of annual percentage yields (APY) that can reach triple digits. But this potential return comes at high risk, with the protocols and coins earned subject to extreme volatility and rug pulls wherein developers abandon a project and make off with investors’ funds.
Note: The returns you earn by yield farming are expressed as APY, or the rate of return you’d earn during a year.
Understanding how yield farming works
Also known as liquidity farming, yield farming works by first allowing an investor to stake their coins by depositing them into a lending protocol through a decentralized app, or dApp. Other investors can then borrow the coins through the dApp to use for speculation, where they try to profit off of sharp swings they anticipate in the coin’s market price.
Blockchain-based apps offer incentives for users to provide liquidity by locking up their coins in a process called staking. Staking occurs when centralized crypto platforms take customers’ deposits and lend them out to those seeking credit. Creditors pay interest, depositors receive a certain proportion of that and then the bank takes the rest.
This lending is usually facilitated through smart contracts, which are essentially just a piece of code running on a blockchain, functioning as a liquidity pool. Users who are yield farming, also known as liquidity providers, lend their funds by adding them to a smart contract.
Investors who lock up their coins on the yield-farming protocol can earn interest and often more cryptocurrency coins — the real boon to the deal. If the price of those additional coins appreciates, the investor’s returns rise as well.
Is yield farming safe?
Yield farming is rife with risk. Some of these risks include:
· Volatility: Volatility is the degree to which an investment’s price fluctuates. A volatile investment is one that experiences a lot of price movement in a short period of time. The price of your tokens could crash or surge while they’re locked up.
· Fraud: Yield farmers may unwittingly put their coins into fraudulent projects or schemes that make off with all of the farmer’s coins. In fact, fraud and misappropriation account for the vast majority of the $1.9 billion in crypto crimes in 2020, according to a report by CipherTrace.
· Rug pulls: Rug pulls are a type of exit scam where a cryptocurrency developer gathers investor funds for a project then abandons the project without returning investors’ funds. The previously mentioned CipherTrace report noted that nearly 99% of the major fraud that occurred during the second half of the year was due to rug pulls and other exit scams, which yield farmers are particularly susceptible to.
· Smart contract risk: The smart contracts used in yield farming can have bugs or be susceptible to hacking, putting your cryptocurrency at risk. Most of the risks with yield farming relate to the underlying smart contracts. Better code vetting and third party audits are improving the security of these contracts.
· Impermanent loss: The value of your cryptocurrency could rise or fall while it is staked, creating temporarily unrealized gains or losses. These gains or losses become permanent when you withdraw your coins, and may result in you having been better off if you’d kept your coins available to trade if the loss is greater than the interest you earned.
· Regulatory risk: There are still many regulatory questions around cryptocurrency. The SEC has stated that some digital assets are securities and thus fall under its jurisdiction, allowing it to regulate them. State regulators have already issued cease and desist orders against one of the biggest crypto lending sites, BlockFi.
Is crypto yield farming profitable?
While yield farming is unquestionably risky, it can also be profitable — otherwise no one would bother attempting it. CoinMarketCap provides yield-farming rankings with various liquidity pools’ yearly and daily APY. It’s easy to find pools running with double digit yearly APY, and some with those thousand-percentage point APYs.
But many of these also have a high risk of impermanent loss, which should make investors question if the potential reward is worth the risk. The profitability of yield farming, just like investment in crypto more generally, is still very uncertain and speculative. He believes the potential return pales in comparison to the risk involved in locking up your coins while yield farming.
Your overall profit will also depend on how much cryptocurrency you’re able to stake. To be profitable, yield farming requires thousands of dollars of funds and extremely complex strategies
While it’s possible to earn high returns with yield farming, it is also incredibly risky. A lot can happen while your cryptocurrency is locked up, as is evidenced by the many rapid price swings known to occur in the crypto markets.