One of the most exciting parts of passive income on decentralized finance is the sheer amount of options. I’m trying to cover as many of these techniques as possible during the Passive Income in DeFi series (101, 102, 103). Today, we are looking into one of the more complex techniques called yield farming.
Other names for yield farming are “liquidity farming” or “liquidity mining.” Yield farming is the act of “staking” (or lending, loaning) your crypto assets to earn more crypto assets. In Passive Income in DeFi 103, we talked about staking. Yield farming is similar but more complex than staking.
Staking was relatively simple. If I had 300 USDC, I could stake it with a platform holder and earn interest in USDC. Staking was almost like buying a certificate of deposit at your local bank. The bank would then use your money to make higher returns on the cash.
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I am going to try to break down yield farming as simply as I can. I will then refer you to some more in-depth articles on the topic. It is truly fascinating; however, it can be hazardous as well.
With yield farming, you are staking your crypto assets within a crypto pair. The decentralized platform usually pairs your well-known crypto (ETH, BTC, USDC, etc.) with an up-and-coming crypto asset.
When new coins arrive, liquidity is the number one way for them to survive. Liquidity provides investors the means to move in and out of the coins with ease. You can see the amount of liquidity in the spread.
The spread is the difference between the bid/ask price. The bid represents demand, and the ask represents supply. See more about the bid/ask spread on Investopedia. When there is a vast difference between bid/ask spread (demand and supply), the transaction cost may outway the need to deal business with this particular coin, meaning they are too expensive to trade.
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That’s where yield farmers come into play. By staking their coins into liquidity pools, they make the currencies more attractive for other investors to trade. Would you buy a coin knowing you would lose money when you attempt to deal it away?
Now, the DeFi platform establishes your crypto pair with the young crypto—what’s next? Now, you inject your crypto into the pair’s liquidity pool. You will then earn interest on your crypto assets. However, this is where things get interesting.
You will most likely not earn interest in the form of the asset you stake. So if you insert USDC, you will not make interest in USDC. There are many ways that the platform can pay your interest.
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Most platforms have a governance (or platform) coin. So you may need to convert your USDC (or ETH, BTC) into a governance coin before inserting it into a liquidity pair. Your interest may be in the form of the governance token. Here is an excellent article on Coinmarketcap explaining yield farming and also provides us with a list of ten popular DeFi Yield Farming protocols.
Okay, so now you are earning interest, usually in the form of a platform’s governance token. This still seems like staking, right? Things get EVEN more interesting from here. As your crypto is sitting in liquidity pools, it may also be eligible to partake in a percentage of the transaction fees that the platform earns from your pair.
Even better, your percentage of the fees may come as the new crypto that is part of the pair—this is where the term “mining” comes into play. So not only are you staking your crypto assets, but the more transactions people conduct with the new coin, the more new coins the platform mints and pays to liquidity providers (LPs). LPs are the yield farmers.
Therefore, you could be earning interest on your assets in the liquidity pool AND a percentage of the fees in the form of newly-minting coins in the liquidity pair. I know, super confusing. It will take you some time to understand these concepts because they are brand-new.
Let me give an example to help illustrate this phenomenon. Let’s say the JOSHUA Platform is offering a liquidity pool for the new coin KING. The governance token for the JOSHUA platform is JOSH.
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First, we would have to exchange our USDC for JOSH tokens. Then we deposit our JOSH tokens into the liquidity pool between JOSH/KING. I will earn a yield on this pair; for this example, it will be 15%.
In addition to my 15% interest, I may also earn rewards in the form of KING tokens. When I extract my crypto, the platform will pay me in JOSH tokens, and I will also have a wallet full of KING coins. Depending on how popular KING coins are on other centralized/decentralized exchanges, they may be worth more than my USDC or JOSH coins over time.
Getting a bunch of newly mined coins is never a bad thing. I have no guarantee that KING coins will become popular, but they can be highly lucrative if they do. That is one of the benefits of yield farming. You can see some examples of the marketplace on Curve.Fi.
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What are some of the pitfalls of yield farming? As you can see, yield farming can be complex. Also, the crypto you stake can have substantial price swings. The crypto you lock into the liquidity pool may suffer colossal price swings; therefore, the pair may become unstable or unequal.
There is also the risk that someone will pull the liquidity from the new coin. There is no guarantee that someone has vetted the new coin. A liquidity pool could open, have tons of interest, gather lots of funding, and then the coin holders disappear—with all of the liquidity. It has happened before.
This risk is why I wrote the article “Due Your Due Diligence.” You need to gather as much information about your coin as possible. Yes, one power move into the right new coin can set you up for life, financially. But, on the other hand, it could also destroy you.
Conclusion. Yield farming is a fantastic way to gain yield on your coins. It can be complex, but it can be a great, fun passive income tool in moderation. However, it is incumbent on you to conduct your due diligence, control yourself, and provide safety measures for yourself.
Decentralized finance is the land for adults; no one is going to hold your hand. I highly recommend reading the book “How to DeFi -Beginner” to ensure you know as much as possible before you even consider yield farming. “There are no risky investments, only risky investors.”
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