What is Yield Farming? – A complete Beginner’s Guide

Yield farming involves lending crypto, usually via the Ethereum network. In traditional finance, when a bank issues a loan, the amount is repaid with interest. The same concept is applied in yield farming. Instead of your crypto sitting in a wallet, you can lend it to DeFi protocols to get returns.

Yield farming is mostly conducted using ERC-20 tokens on the Ethereum blockchain. While this might change in the coming days, almost all present yield farming transactions are carried out in the Ethereum ecosystem.

How Does Yield Farming Work?

To get started in yield farming, you must first add your crypto to a liquidity pool. These pools play a crucial role in DeFi as they power the marketplaces where users can borrow, lend, or exchange tokens. That said, adding funds to a certain pool makes you a liquidity provider.

As a liquidity provider, you are entitled to rewards generated from fees collected on the underlying DeFi protocols. It is worth noting that investing in ETH itself doesn’t count as yield farming, but lending it out on protocols such as Aave and then getting rewards, is yield farming.

The Rewarded tokens can also be moved to a variety of liquidity pools with the aim of chasing higher yields. This process can be complex, so being well-versed with the Ethereum blockchain and its technicalities is important.

Moreover, yield farming is not easy money. Liquidity providers are rewarded according to the amount they have locked in the pools. Meaning to reap big rewards, you have to risk significant capital.

What’s So Special About Yield Farming?

The major benefit of yield farming is that you stand to earn a profit. For example, suppose you join a new project as a liquidity provider early enough. In that case, you could earn token rewards that might quickly increase in value, enabling you to sell the rewards at a high profit.

Yield farming provides more lucrative interest than traditional banks, but of course, risks are also involved. In DeFi, interest rates can be highly volatile, making it difficult to anticipate the number of rewards you will receive in the future. In addition, DeFi is a risker space to invest your money than traditional finance.

Why Should We Care?

Yield farming is essential as it helps DeFi projects to be liquid and makes it easier for users to take out loans.

However, yield farming has been a divisive topic in the crypto world, as some community members think it is not important. Prominent names in the industry, like Ethereum’s co-founder Vitalik Buterin, recently said he would stay away from yield farming while criticizing Flash Farms, a newly-launched yield farming project, for its very high risk. Also, some other big crypto personalities have advised people to avoid yield farming.

Which projects are Involved?

Several DeFi projects are involved in yield farming, with Aave being the largest in terms of value locked into its liquidity pools. This project allows crypto users to borrow and lend various cryptocurrencies.

The second is yearn.finance. This project moves users’ money between a number of liquidity and lending protocols like Aave, dYdX, and Compound to obtain the best interest rates.

Another project involved in yield farming is Compound. The DeFi protocol allows users to earn interest on the cryptocurrency they save.