“Turn $100 into a $100,000,000!”
Really? That easy? Then why isn’t everyone else doing this?
The truth is that wealth isn’t truly created but transferred from one pocket to another. And if the best yield farming crypto platforms are saying otherwise, you might need to take a step back and rethink it.
Although decentralized finance (DeFi) is different from centralized finance, it is still bound by the laws of economics, math, and logic. If you’re unaffected by the FUD (fear, uncertainty, and doubt) and still feeling the FOMO on yield farms that have created millionaires out of ordinary people, just remember, for every one person getting rich, the money that comes into their wallet had to come from thousands of other wallets.
Our guide will explain yield farming 101 and what you need to know to make sure you don’t get scammed in DeFi.
What is Yield Farming?
Yield farming involves the use of decentralized finance (DeFi) to maximize gains through various tactics, ranging from simple to complicated. Yield farming generally involves either lending or staking cryptocurrency to gain interest and/or rewards that are measured in annual percentage yields (APY).
It is incredibly risky and becomes even more so when you don’t understand what you’re doing. In order to better navigate through high-risk markets, it’s important to understand the different aspects of the scheme.
Elements of Yield Farming
There are many elements to yield farming and in order to not be clueless when investing, you’ll have to understand the following:
- Lending: Lending is the process of letting a platform or others borrow your crypto.
- Staking: Staking is the process of locking up your crypto in order to gain rewards.
- Interest: Interest is the percentage you are expected to gain and is standardly pegged to the amount of crypto you put in (not in fiat currency).
- Rewards: As the name suggests, rewards are incentives to attract investors to either stake or lend their crypto.
Best Yield Farming Crypto Explanation
Although yield farming is a broad term, it is often used as a substitute term by platforms or protocols to signify a specific type of investment. An example of this is how it is often used by platforms like Pancakeswap or Alpacafinance.
Yield farming is usually used as a term to describe using two assets and providing liquidity for a platform to execute trades in between. Let’s clear up the confusion.
Yield Farming vs Staking
Yield farming is often synonymous with staking which involves locking in your crypto for rewards. But it may be more than just staking since it can also involve lending out your crypto to earn interest.
Yield Farming vs Liquidity Mining
Yield farming can also be synonymous with liquidity mining, wherein users add a pair of crypto to the liquidity pool to enable transactions in between the pair. This is the most popular use of the term yield finance.
Actual Definition vs Platform Definition
When used around staking and being a liquidity pool provider, yield farming is used to describe a paired investment to earn rewards (usually in the protocol’s native currency). In the event that it is used with staking and liquidity pool provision, staking would refer to singular cryptos being locked up to earn rewards, and liquidity pool providing would refer to pairs of cryptos being locked up to earn interest based on transaction fees.
Although this can be a bit confusing, remember this:
- Staking: Singular crypto being locked up to earn rewards
- Liquidity Pool Provider: Providing a pair of crypto and earning transaction fees based on purchases in between
- Yield Farming: Providing a pair of crypto and earning an APY usually in the protocol’s native token.
The definition above applies more to platforms but when talking about yield farming specifically, you could be talking about a wide range of topics.
What Factors to Look at When Yield Farming?
In order to strategically engage in yield farming, you’ll have to understand the risks that come with it and what factors to look out for. Here are some things to watch out for when yield farming:
Coin/Token Research
Like any other crypto investment, you should assess the coin or token performance of the crypto before investing. When looking at purchasing new types of crypto specifically for yield farming, make sure the crypto was created with an actual use case.
Some cryptocurrencies were created for the sole purpose of yield farming and this can be extremely dangerous. If you go deeper into the DeFi space, you’ll find certain things called “degen DeFi protocols” or “degen yield farms” and these are often the riskiest of the bunch.
When crypto is created with no real use case and its sole purpose is to be used in earning rewards, this can be extremely dangerous since the main purpose of the coin is to be used to cash out.
Rewards/Interest
Aside from the crypto pair you are using to yield farm, it is also equally important to understand the tokenomics of the cryptos that are being given out as rewards. If the rewards don’t have actual value and have a depleting TVL, this could be a bad sign for investors.
Say you’re investing in a yield farm with the imaginary cryptocurrency $IMAGI and $USDT and are being given rewards in $IMAGI, the moment you get your rewards, you are usually left with two options, either compound it or cash out. If a lot of investors cash out, this can result in the price of $IMAGI tanking heavily.
It can either be a slow or fast decline, but the point is that since there’s no real demand for buying $IMAGI, aside from using it for yield farming, you won’t be able to expect its price to blow up.
Knowing the Risks of Yield Farming
Like any investment, it is important to know the risks involved before actually depositing funds. Yield farming, like any other DeFi investment, is extremely risky and could deplete your entire investment in a matter of seconds.
There are a few things that are absolutely important for you to learn when you want to invest in yield farming:
Impermanent Loss
Impermanent loss happens when you make less money yield farming than actually holding on to the crypto. Think of it this way, let’s say you farm the $IMAGI-$USDT pair by providing liquidity. If more people purchase $IMAGI with $USDT, there will be less $USDT left in the pair.
Let’s say you placed 100 $IMAGI at $1 and 100 $USDT at $1 during the beginning but after the investment period, you were left with 20 $IMAGI and 180 $USDT. Although you might have earned say a hypothetical $20 in fees, what if the price of $IMAGI went up to $2?
If this were the case, you’d walk home with a total of $240 because of the value of your pair and what you got from transaction fees making you $40 in profit. If you held your $IMAGINARY crypto, however, your $100 spent on $IMAGINARY would have turned to $200 raking in a $100 profit instead of $40 if you staked it.
High APYs
Let’s say a yield farm promises 1,000,000% APY, this isn’t designed to give out money, it’s designed to attract new investors. Although not all low-market cap cryptos are a scam, these low-cap tokens are still considered extremely risky.
Say you have a particular DeFi protocol giving out high staking or liquidity pool rewards to investors in its native currency and the top 10 wallets holding the crypto are the founders and their friends. Hypothetically if the crypto only had a $10,000 market cap, to begin with, and 50% was owned by the founders and their friends at $500 each, if the crypto’s market cap goes up to $100,000, since owners still own 50% of it, they get to walk away with around $5,000 each.
Since they owned 50% of the crypto, the price would then tank heavily and even if you invested when the founders and their friends were positioning themselves to cash out and were promised a 1,000,000% APY, by the time you get 1,000,000% on your investment, they could become worthless.
Computing Profit
One mistake a lot of new investors make is computing the APY in fiat currency instead of crypto. One of the main reasons why crypto is considered high-risk is because it is highly volatile and this is no different from when yield farming.
Generally speaking, investors will only make a profit when yield farming either when the cryptocurrency stays the same or increases in value. If the cryptocurrency used to invest remains constant in price, investors will be able to get a fixed interest with a more accurate APY.
If the price of the crypto increases, not only will investors earn from the APY but they will also be earning from appreciation. In the case of impermanent loss, however, profits may be decreased depending on how much of the appreciated crypto you have left in your pair.
High-Risk Yield Farming vs Low-Risk Yield Farming
Yield farming can be played out either with a high-risk strategy that could result in big gains or a low-risk strategy that can result in secured gains.
High-Risk Yield Farm Strategy
A high-risk yield farm strategy is getting in when a liquidity pool has just been created and the liquidity is still small. Rewards are distributed evenly depending on the amount of crypto you have in the pool and the more cryptos there are in a pool, the lower the APY will become.
The high-risk strategy is to go in early and exit right away while the pool, crypto, and reward tokens are still rising and this is still not a guarantee that you’ll make it out in time. This technique, however, does not guarantee profit and is one of the riskiest types of investments in the crypto space.
Low-Risk Yield Farming Strategy
A low-risk yield farming strategy is to either pair with or use stablecoins. By pairing with stablecoins, you will minimize the risk of one loss since only crypto is more vulnerable to depreciation. If both cryptos in the pair are stablecoins, investors can enjoy a fixed APY.
Oh yeah, don’t forget about what happened with LUNA’s UST when choosing a stablecoin. Although they might be stable, it’s still important to do your own research (DYOR) when choosing your investments.
Yield Farming Pros and Cons
Like any investment, yields farming comes with its own advantages and disadvantages.
Yield Farming Pros
- You can earn interest on cryptos you were planning to hold anyway
- Stablecoins can give you safer APYs
- Some projects appreciate in value, compounding your rewards
Yield Farming Cons
- Not all projects are good long-term
- Some investments are plain pump-and-dump schemes
- A lot of yield farming tokens tank sooner or later
Conclusion
The world of DeFi is filled with both perils and opportunities. As with any practice, the key to making it is to educate yourself properly before diving in. But there is no substitute for doing it. While learning the theoretical aspects helps you prepare, you need to also learn by doing. Maybe get burned a little in the beginning. Most did.
Eventually, as long as you remain optimistically cautious and manage your risks as you learn how to do yield farming properly, you can potentially make money too. Be happy with the wins and let the losses serve as learning experiences.
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