Yield Farming: Risks and Rewards?

If you’re into cryptocurrency and are looking for a decent return over your long-term crypto investments, look no further than yield farming!

Yield farming – you hear the term everywhere these days. But what exactly is yield farming, and is it something you should really be doing? We will explain to you what it is, the pros and cons of yield farming, and which platforms give you the best opportunities to capitalise on your
investment.

Some interesting facts about yield farming:
+It is similar to opening a deposit account.
+The interest rate is calculated in APY (annual percentage yield).
+Interest rates are significantly higher than those for bank deposits.
+The price you pay for high interest rates is the increased risk.

What is yield farming?

Yield farming is a crypto investment method that allows people to earn fixed or variable interest by investing their crypto in a DeFi market. Lending ETH on platforms, such as Binance, for a return on top of the Ether price, is called yield farming. A yield farmer is an investor who uses decentralized finance (DeFi) to earn on their investments. They borrow and lend cryptocurrency in order to generate interest on their loans, which they can then reinvest into other DeFi platforms or use as they wish.

Yield farming has created a new market that relies on smart contracts, which are math-based agreements capable of automatically executing the terms of a contract. Since they can execute trades without human intervention, they can provide the same levels of liquidity as an electronic
stock exchange. Yield farming puts the power in the hands of the people to buy and sell their money with Automated Market Makers (AMM’s).

Yield farmers only have one goal: to get the highest possible return on investment. To accomplish this, they use complicated strategies to invest their cryptos while minimizing risk and maximizing profits. However, these strategies aren't as easy as they seem – there are many
nuances and unexpected variables that can throw off even the most skilled investor.

Yield farming vs staking – What are the differences?

Yield farming is essentially a method of generating extra coins with the crypto you already have. It bears the name 'yield farming' because you grow your portfolio, as it were, by fixing it in a certain way. The process consists of you lending your crypto for a return on all the different DeFi platforms available today. These platforms lock up your crypto in a liquidity pool, which is essentially a smart contract that manages all the funds on the platform. Users of the platform can then use that liquidity to trade, borrow, or lend capital.

Staking (explained here) provides a return in a different way than yield farming. With staking, you basically support a blockchain network that runs on the Proof-of-Stake (PoS) consensus mechanism, in which you can participate as a staker. For example, you can stake ethers in the Ethereum 2.0 network at the time of writing. For this, you hand in Ethereum 1.0 coins and get Ethereum 2.0 coins in return as soon as the network launches. You will be paid a return of a few percent in Ethereum 2.0 coins. A typical example of staking is NFT art where people earn rewards when their stake their tokens.

Staking and yield farming are similar in many ways. In both cases, you basically lock your crypto for a certain period in exchange for a return. The difference between staking and yield farming is that staking is often a lot simpler. With yield farming, you get higher returns, but there is also a higher risk in return. The contracts are a lot more complex, and it is more common for a yield-farming platform to collapse than a PoS chain. Both yield farmers and stakers lose money if the crypto's value falls, but you would also have taken that loss if you had simply held your coins, so this argument is irrelevant here.

Cryptocurrencies that run on PoS are inflationary currencies. After all, the people who participate in the PoS process are rewarded with new coins. You can use staking to escape inflation in the coin in question while taking advantage of the positive price movements. If you do not participate in staking, your portion of the coins will lose value relative to the rest of the holders that do participate after the issuance of each new coin. The advantage of staking is that with a coin such as Cardano (ADA), for example, you only run the risk of a possible price loss, while with yield farming, you also run the risk that the protocol is not properly put together and falls over.

How do you calculate yield farming returns?

Calculating interest rates can be confusing, especially when you have to consider the difference between annual percentage yield (APY) and annual percentage rate (APR). By APR, compound interest is not considered. This simply means that you earn a set percent of your capital at the end of the year, no matter what. However, if you decide to reinvest it back into crypto farming, this will boost your profits – which is just as important as receiving the interest.

What are the biggest risks of yield farming?

The disadvantage of yield farming is that you naturally run a risk in exchange for the return (apart from the risk impermanent losses bring with them). If the price makes a huge shift in a short time, then the collateral of the platform users may not be enough to cover the losses. That is ultimately the risk that you take with yield farming. Many people who believe in crypto for the long term and expect large returns are not so keen on yield farming. They are already satisfied with the returns of crypto itself and do not want to risk losing their wealth in exchange for a short-term spike. But there are other risks that are worth considering before starting your yield farming journey:

Smart Contract Breaches
Smart contracts are written computer codes that are executed on decentralized networks like blockchain. They replace third-party intermediaries, such as lawyers or banks, and once deployed cannot be corrupted. Unfortunately, they are not perfect. There are many reported cases of smart contracts being hacked and money being stolen. And since cryptocurrencies aren’t regulated, there is no way you can get your money back.

Pool Liquidation
Because crypto-backed loans are often issued against crypto collateral, the value of the collateral can be volatile. For example, if you take out a loan in ETH while the price of ETH is rising, and if the price of ETH continues to rise without stopping, you might find yourself with a
loan worth more than your collateral – forcing your lender to liquidate your collateral and sell it off to cover the loan.

Market Complication
It's a risky endeavor! If you have no experience in cryptocurrency, it is a good idea to educate yourself on the industry before diving right in. Investing in yield farming could result in large gains or losses. Be careful before you get in there. It’s a jungle. Only the strong individuals “survive”.

What is impermanent loss?

The most significant risk of yield farming is the exposure to impermanent loss. This is the case because of the fluctuations in prices from the crypto you deposit. If you deposit funds into a liquidity pool or yield farm, and then that crypto goes up in price, it would have been better to hold it. You can also suffer impermanent loss if the crypto that you're providing drops in value whilst still being locked up. You both lose in these situations because with yield farming, there are always two cryptocurrencies involved, with one of them being a stablecoin to which your initial deposit and promised APR/APY are pegged.

What are the biggest advantages of yield farming?

Yield farming is a high risk, high reward move which can generate a lot of value for both parties. Instead of keeping your cryptocurrency peacefully in your wallet, you can actually drive more revenue from it. A lot of investors are willing to borrow cryptocurrency to speculate on the price. That’s how you can earn up to 12% APY on your investment – even investment funds are not able to match these numbers.

According to ValuePenguin, the most “lucrative” (if we can mention the word in that case) deal is offered by Citibank – 0.6%. And Chase gives 0.02%. There’s no mistake – 0.02%! Even mediocre liquidity pools offer more than 5%. You can calculate the difference. But the biggest advantage of yield farming over HODLing is that you can HODL your crypto and receive a return simultaneously. Due to the design of the smart contracts and the relatively large margins that users of the platform must maintain to be able to borrow your crypto, the risks of yield farming are relatively low.

What is a liquidity pool and how is it related to yield farming?

Liquidity pools are smart contracts that, using a set of rules, allowing token holders to earn rewards by staking their tokens on the contract. The rewards can come from many different sources, like the fees generated by the underlying DeFi platform, or some other new source. Liquidity pools let you stake your tokens and earn rewards in return. Liquidity pools are the roots that hold DeFi together – and they work by pooling their resources, creating a large network of users who can borrow, lend, and swap DeFi.

And what about liquidity providers?

Liquidity providers are investors who deposit money into the platform. The liquidity pool is a smart contract filled with cash – it's a self-sustaining piece of the platform that allows the yield farmer to receive returns without external impact on profits. The yield farmer receives returns based on the automated market maker (AMM) model. With conventional order books, users need to place buy and sell orders for tokens or cryptocurrency assets on the same trading platform. This can be time-consuming and confusing for customers, who might have to search through multiple exchanges with different interfaces in order to complete a trade.

Which are the best sites for yield farming?

Some of the best sites for yield farming are eToro, Crypto.com, and BlockFi. Let’s see what they offer their customers.

eToro
If it's safety you're after when searching for the best yield crypto farming sites, eToro (see review) is a name that comes up time and time again. The platform – which is regulated by the likes of ASIC, and hence offers top-notch security, is a market leader. Still, it doesn’t offer the high interest rates of BlockFi. But do not estimate the “bulls” – because they are totally worth it. Give eToro a try today!

Crypto.com
Crypto.com (see review) is a top-rated platform that offers a simple solution to those looking to earn high interest rates on their crypto assets. The company offers the opportunity to earn an APY of up to 14% by depositing stablecoins such as Tether and USDC to your account. Though some variables can affect the actual amount you are paid, this should not deter crypto investors from using this service. Of course, the APY depends on the contract – are you willing to lock in your money, or not? Sign up for Crypto.com now and find out more!

BlockFi
BlockFi has earned a name for itself in the crypto world with its unique investment services, which cover everything from cryptocurrency investment and savings to auto-investing. Their most popular product, however, is the BlockFi Interest Account – which lets you earn up to 11% on your crypto savings. Currently, Polygon (MATIC) is their most profitable option. Looking for some of the best options in yield farming? Then give BlockFi a try today!

Summary

Yield-farming is a risky investment. While the potential for growth and increased liquidity in the market is undeniably attractive, investors must understand and be aware of the consequences.

While yield farming may be a lucrative way to raise capital and generate returns, it comes with an adverse: it can empty your pockets.