Yield farming means generating rewards from assets lending. You can stake or lend your crypto and in return, you will receive a reward in terms of transaction fees, interest, or governance tokens. Yield farming is a category of decentralized finance that many investors are interested in. The main reason is insanely high returns that are calculated in terms of annual percentage yield (APY).
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What Is APY?
APY, short for annual percentage yield, is a rate of return on investment. Basically, you deposit crypto and receive a fixed or variable rate of return over a specific period of time. APY takes into account compound interest and calculates the amount of money earned over a year.
How Does Yield Farming Work?
Yield farming works by having liquidity providers place their crypto in a liquidity pool secured by a smart contract. You become a liquidity provider by adding funds to a pool where users can exchange, lend or borrow tokens. In return, the liquidity provider is rewarded for depositing his crypto.
How Much APY Can You Earn?
While banks on average offer 0.5% APY on your savings account, DeFi offers much higher rates. Aave, the biggest open-source DeFi protocol, offers 3-9% APY depending on the token, while centralized BlockFi for example offers up to 8% APY. In both cases, it is significantly higher than the 0.5% offered by traditional banks.
| Currency | APY |
|---|---|
| BTC | 0.1% – 4.5% |
| ETH | 0.25% – 5% |
| LTC | 0.1% – 4.75% |
| LINK | 0.1% – 3.5% |
| UNI | 0.1% – 3.25% |
| Stablecoin (USDC, GUSD, BUSD, DAI) | 5% – 8% |
There are some pools that offer 100% and higher APY, which are extremely risky. Those pools usually offer high rewards for depositing low-liquidity tokens that are highly volatile and can drop in price literally 90% in a day, resulting in losing you money.
What Are the Risks of Yield Farming?
Impermanent loss
The cryptocurrencies you’re lending could decrease or increase in value resulting in an impermanent loss. Impermanent loss occurs because of volatility in a trading pair where pools are set to balance the pair by selling it for less price.
Decrease in returns
Interest rates decrease as liquidity pools become more popular. Thus, your returns can potentially become lower than expected.
Potential fraud
DeFi is an extremely young sector that is not immune to errors and therefore is vulnerable to hacker attacks. Also, some liquidity pools turn out to be scams. It’s important to do good research before getting into high-risk investments.
Conclusion
Yield farming is a great way to earn interest while holding to your cryptocurrencies. But like with any other investment, it’s not risk-free. A good investor knows his risk tolerance and makes due diligence before jumping into new financial opportunities. My advice would be to start yield farming with stablecoins and gradually progress towards riskier assets. The DeFi sector will surely continue to grow and potentially become a heaven for investors that want reliable passive income.
