Charlie Martin is the head of operations at Gro, a decentralised finance platform based in the UK. Prior to Gro, he started his career in law at Freshfields, before moving to become a consultant with the Boston Consulting Group. He also has had a number of operations roles at fintech startups, including his most recent, Monzo in London.

Decentralised finance, also known as DeFi, has become vastly popular among cryptocurrency traders thanks to the extremely high yields on investment compared to the traditional markets. At the most fundamental level, DeFi operates by paying people a return for leaving their funds, so the bank has the liquidity needed to facilitate trading or lending activities. 

However, yields on offer in DeFi can go far beyond the base level of interest paid on deposits – thanks to the feature that allows anyone to mint tokens on a blockchain. This improves capital efficiency and allows users to earn governance token rewards simply for participating in DeFi. As such, the sector attracts people looking for higher returns through a practice known as yield farming. 

Types of yield in DeFi

Yield farming simply refers to the practice of deploying your cryptocurrencies in exchange for returns. However, there are many interesting ways to generate these returns. 

Interest on lending deposits

Earning interest on deposits is perhaps the most straightforward way to earn DeFi yields for a newcomer. Lenders deposit their cryptocurrencies into pools governed by smart contracts and receive an interest-earning token in return. The interest is generated by borrowers taking loans from the pool. 

There are many different lending protocols available, operating thousands of pools paying varying levels of interest. Some of the best-known applications are Aave, Compound, and Maker. 

Transaction fees for providing liquidity

Another highly popular way to farm yield is to supply cryptocurrencies as liquidity to token pools on decentralised exchanges (DEXs). A DEX typically charges users around 0.3 per cent to swap tokens, and these fees are distributed to the pool’s liquidity providers. 

Thanks to an insatiable demand for token swaps, there are even more DEXs than lending protocols, so users are spoiled for choice. Flagship DEXs include Uniswap, stable coin-focused Curve Finance and PancakeSwap. 

Token incentives from protocol operators

Over the summer of 2020, Compound Finance made a pioneering move as part of its commitment to being a decentralised autonomous organisation. It issued its own governance token, COMP, which was an immediate success and inspired other projects to do the same. However, it was the launch of Uniswap’s UNI token that boosted this concept in yield farming. 

Whereas Compound simply released its token onto the market where anyone could buy it, UNI was the first token to undergo what Uniswap called a “fair launch”. 

Rather than putting the token on the market, Uniswap airdropped a generous allocation to all current and past users of the protocol. Its token launch acted as a very effective way to reward users for their loyalty, generating even more goodwill and providing them the right to participate in the future governance of the projects. 

So it is hardly surprising that many other projects have taken a similar approach, rewarding users in governance tokens for participating in the protocol. PancakeSwap and Curve Finance are two other examples, allowing you to earn CAKE and CRV tokens, respectively, for being a user. 

Token incentives from pool operators

A fourth way to engage in yield farming is to stake in incentivised pools. Imagine a scenario where a new blockchain project launches its own token. The project founders list the token on a DEX, but as it is a new token, liquidity in the pool is low. 

It has become common practice for project operators to engage in “liquidity bootstrapping”. This means projects attract liquidity providers with the promise of additional token incentives. 

For that reason, these kinds of incentives do not exist on larger pools of established cryptocurrencies like ETH or USDC. They are only available on smaller token pools where the project founders need to deepen liquidity. 

Putting it all together

You may now have figured out why the practice is called “yield farming”. Yield farmers will seek out DeFi protocols and pools where they can get the best combination of these rewards at the same time. For example, if you contribute to a stablecoin pool on Curve, you can earn a share of the pool transaction fees and an allocation of Curve DAO (CRV) tokens at the same time. 

Similarly, many DEXs offer the opportunity of a triple-whammy – a share of pool fees, rewards paid in the native DEX token, and rewards from the pool operators on the DEX too. 

A word of caution

Yield farming can be lucrative, but it comes with considerable risks. DEXs are blockchain-based applications using open-source code, so they are generally permissionless and open to everyone who wants to trade. Similarly, anyone can create a token pool. Unfortunately, this means that while there are many legitimate projects run by authentic teams, there is a risk of encountering scam operators. Users should perform full due diligence on any new tokens before depositing their funds. 

Even legitimate token pools can be risky for depositors, as the volatility of cryptocurrency can lead to a phenomenon known as “impermanent loss”, which can result in a user having less to withdraw than they deposited. Anyone depositing funds in a DEX pool should be fully aware of these risks before engaging. One way DeFi users can mitigate the risk of impermanent loss is to use yield farming strategies only based on stablecoins. For example, by depositing funds to pools on the Curve stablecoin DEX, or by holding Gro’s yield-generating PWRD stablecoin. 

Finally, it is worth noting that DeFi protocols rely on the underlying programming, which can be subject to bugs or vulnerabilities. Protocol hacks can happen even to well-established projects, resulting in funds being drained out of smart contracts. There is no sure-fire way to avoid this, but sticking with reputable projects and only using protocols that have undergone code audits are two ways to keep funds safe. 

Yield farming is not just a lucrative way to earn returns on cryptocurrencies; it is also a fun opportunity to engage with a vibrant and growing sector that is set to transform the future of finance. However, as with any decisions involving investments, users should proceed with a healthy degree of caution.

Please be aware that this article is for information purposes only and should not be construed as financial advice.