In more familiar terms, yield farming allows investors to earn crypto like one might earn interest on money in a bank savings account. This example highlights passive yield, in which an asset holder can put money in an interest-bearing account and allow the system to pay them at regular intervals.
However, the term yield farming implies a more active process. Though the term originally described the metaphorical process of “planting” crypto in a protocol to “grow” and then “harvest” the earned crypto, it also conveniently describes how many DeFi users mimic the behavior of real farmers by rotating their crops.
Yield farmers often move their assets from protocol to protocol, or even from chain to chain, to take advantage of the highest yields. These yields are measured in annual percentage rate (APR) or annual percentage yield (APY). The key distinction between the two is that only APY factors compounding interest into the gain rate.
Where does the yield come from?
This depends on what function a user’s deposited crypto is serving. The majority of naturally generated yield comes from transaction fees, block production, protocol fees, or interest paid by borrowers of digital assets.
However, many DeFi platforms initially boosted their yields using venture capital, supplementing organic ecosystem payouts in order to attract yield farmers and drive adoption. This trend among DeFi platforms decreased and, crucially, preceded the rise of CeFi institutions looking to replicate the high rates of growth found within DeFi in the latter's earlier days.
How does yield farming work?
Yield farming consists of ‘farmers’ using their funds in one of three main methods: staking, lending, and providing liquidity. By providing one of these services with their crypto, users are granted the opportunity to earn a portion of fees, interest, or rewards and collect new crypto (mostly) in real time.
Staking is the process of allocating cryptocurrency to a Proof of Stake network—like Ethereum, Cardano, or Solana—to secure the blockchain and validate transactions on the network. Locking coins in a blockchain’s smart contract for the purposes of staking often gives a lower, but reliable, yield.
Of note, many of these smart contract platforms have an unlock period for staked assets. This means that it could take days or weeks to unstake coins after deciding to withdraw those funds, which would slow down the process of farming.
Lending cryptocurrencies to other users is a common practice in DeFi. By lending your tokens to borrowers, you earn the right to collect interest from them.
This mirrors the traditional financial system, but the rates are set almost exclusively by supply-and-demand dynamics rather than by third party institutions.
Decentralized exchanges (DEXs) often use an automated market making (AMM) system centered around liquidity pools. Liquidity providers contribute to these pools by depositing cryptocurrencies for traders to swap against, while paying a small fee for the service. These fees are then distributed to all liquidity providers.
Liquidity pool rewards can be paid in the form of pool assets (e.g., DAI in an ETH/DAI pool), or in the form of a platform’s unique token (e.g., UNI for Uniswap). Some protocols even issue liquidity provider (LP) tokens to depositors, and these LP tokens can be staked on the platform for compounded rewards.
Yield farming process
Imagine a lending protocol that offers 5% APY on the DAI stablecoin. A user can deposit 100 DAI to take advantage of that yield.
However, they learn that a DEX offers 8.5% APY for DAI deposited into a liquidity pool. Because the user wants to optimize their crypto rewards, they move their 100 DAI from the lending protocol to the DEX.
If the DEX’s DAI APY ever goes below 5%, they can rotate their original purchases, plus earnings, back into the lending protocol. In doing so, they become a yield farmer.
What are some dapps that can be used for yield farming?
Staking is possible on multiple blockchains including Ethereum, Cardano, Polkadot, Solana, Polygon, and Avalanche. Unlike other yield generating practices, staking is not always reliant on a specific decentralized applications (dapps) and instead can be performed through a wallet or by directly interacting with a smart contract. Some platforms even offer staking by delegating if users are not able to provide enough capital to meet the minimum staking requirement.
For lending, two of the most popular platforms are Maker, who offers overcollateralized crypto-backed loans of its DAI stablecoin, and Aave, which offers a rich marketplace for lending and borrowing many different cryptocurrencies.
Decentralized exchanges that use AMMs create the opportunity for users to provide liquidity. These include Curve’s stablecoin DEX, Uniswap, Sushiswap, Compound, and Balancer. Each of these differs in how it rewards its users for becoming liquidity providers, and all offer rewards in their own tokens to drive further use of the platforms.
Further, it is worth mentioning three dapp aggregators that can be used to track blockchain data and find the best farming opportunities:
- DappRadar – a website that collects information about dapps according to blockchain and category.
- DeFi Llama and DeFi Pulse – websites that focus specifically on DeFi platforms and track important information like total volume locked (TVL) and yield offerings.
Yield farming essentials
- Yield farming is similar to finding the bank account with the highest interest rate; it involves choosing DeFi protocols with high gains and locking crypto in them.
- There are three primary ways to generate yield through using cryptocurrency: staking, lending, and providing liquidity.
- Whereas staking can be accomplished by interacting directly with a blockchain platform or through delegation, lending is done through protocols like Maker and Aave, and DEXes like Curve and Uniswap offer the opportunity to provide liquidity to generate yield.