Yield farming is a method of earning rewards or interest by depositing your cryptocurrency into a pool with other users. The pooled funds are used to carry out smart contracts such as cryptocurrency lending that generate interest in return.

Definition and Example of Yield Farming

Yield farming is a system where users can deposit cryptocurrency in a pool with other cryptocurrency users to pursue investment gains, most typically through interest earned by lending the pooled cryptocurrency. Yield farming is a very risky strategy with the potential for high rewards.

You can find yield farms through decentralized finance platforms. 

Cryptocurrencies are a high-risk asset class. It’s possible to lose your entire investment, so research every opportunity before investing. Due to the risk and complexity of yield farms, they are not appropriate for many investors.

How Yield Farming Works

In many ways, yield farming works like a savings account, where you deposit money with a bank, which then pools depositor money and lends it forward while you earn interest on the funds you deposited. But instead of being converted into a mortgage or a business loan, the cryptocurrency in a yield farm is invested in smart contract applications.

Smart contracts are types of computer programs using blockchain technology, which powers most digital currencies.

With yield farming, users stake their currency—the cryptocurrency equivalent of making a deposit—with others investing in the same farm. Staking may require you to leave your funds invested for a specific period. Your cryptocurrency may then be used as collateral or to provide liquidity to mining pools, depending on how it is invested.

Cryptocurrency prices are volatile. It’s possible for a currency value to quickly drop while your funds are locked in a liquidity pool or yield farm. This is known as impermanent loss.

Yield farming begins with the creation of a pool of cryptocurrency assets. These are the steps that take place to facilitate yield farming:

• Liquidity pool is created: The first step in yield farming is creating a liquidity pool. This relies on a smart contract that facilitates all investing and borrowing for that specific yield farm.

Investors deposit assets: Investors can connect their digital wallets to deposit currency in the liquidity pool. This is sometimes referred to as “staking.” This is somewhat similar to customers making a deposit in a bank or investing in a mutual fund or ETF.

• The smart contract enables borrowing: The smart contract can facilitate several processes, including adding liquidity for a cryptocurrency exchange market, or lending to others.

• Reward payout: Interest, bonuses, and rewards may vary by yield farm. You may be paid at regular intervals or on a specific future date.

You may have to pay a small fee when you “harvest” your yield farming rewards.

Yield Farming vs. Staking

Staking is a process of depositing cryptocurrency. Anytime you earn rewards from holding specific cryptocurrencies, it can be considered a form of staking. Depending on the exchange and currency, this may be automatic or require additional steps to make a staking deposit.

Here are some basic differences between staking and yield farming:

That said, staking and yield farming are often used interchangeably since both effectively are ways of earning rewards on cryptocurrency deposited in a pool. However, there is a subtle and important nuance to highlight here. Some cryptocurrency holders do not wish to receive a yield on lending due to faith-based values that prohibit the use of usury or interest received on the lending. In that case, staking can be an option for them rather than yield farming.

Not all methods of staking are yield farming, but all yield farms rely on some form of staking.

Pros and Cons of Yield Farming

Pros

• Potential to earn high-interest rates online

• Managed by smart contracts

• Part of the global DeFi system

Cons

• Risks of impermanent losses

• Scams and fraud

• Tax-reporting challenges
  

Pros Explained

• Potential to earn high-interest rates online: Yield farms may come with a potential to earn returns over 100% APY.

• Managed by smart contracts: Smart contracts take out middlemen and allow anyone to participate if they have a compatible cryptocurrency wallet.

• Part of the global DeFi system: New decentralized finance applications enable innovative financial products across international borders.

Cons Explained

• Risks of impermanent losses: If a cryptocurrency goes down in value while you have it locked in a yield farm, your losses are called impermanent losses.

• Scams and fraud: As with other parts of the cryptocurrency ecosystem, bad actors are out to steal funds through fraudulent yield farms and other scams.

• Tax reporting challenges: Cryptocurrency transactions require somewhat complex tracking and reporting, and yield farming only adds to that challenge.

How to Start Yield Farming

These are the steps to participate in yield farming yourself

1. Research yield-farm investments: Start by researching potential yield-farm investments. You can choose from many different DeFi providers or centralized exchanges to access yield-farming markets.

1. Connect your wallet or fund your account: You need a compatible account funded with the correct currency to participate in a yield farm. For decentralized yield farms, you need to use a compatible wallet such as MetaMask or Coinbase Wallet. You should buy or transfer the desired currency into your account for yield farming through an exchange.

1. Stake your cryptocurrency: Once connected or funded, navigate to the specific yield farm to stake your funds. Once staked, your currency may be locked into the farm for a certain number of days.

1. Collect your earnings: Depending on your yield farm and deposit method, you may have to head back to the yield-farm website to collect your earnings.

Is Yield Farming Worth It?

Yield farming is an interesting way for cryptocurrency enthusiasts to earn a return for investing their cryptocurrency, not just from an increase in the currency’s value. However, yield farming may not be worthwhile for many investors, particularly newer investors, due to the risks involved.

The idea of earning 100%, 200%, or more in annual interest can be enticing. However, you should not participate unless you fully understand how yield farming works and the risks involved. Run your due diligence about the exchanges, the coins, and the teams behind the yield farming engagement you will enter into. All those are requirements to mitigate the risks associated with this investment