1. What is yield farming?
Income farming or yield farming is the process of generating additional profit (usually in the form of control tokens) by DeFi-protocol users for lending or borrowing, as well as for providing liquidity to decentralized exchanges (DEX).
Decentralized derivatives platform Synthetix is considered the first successful farming project, but the revenue farming boom began after the launch of the Compound protocol management token (COMP). With its distribution, the project attracted many liquidity providers, and the price of the token increased significantly. Almost immediately, other projects followed Compound’s example.
2. How to make money from income farming?
Earning interest through borrowing funds
Both receiving and extending credit involve placing a participant’s funds in a liquidity pool, either as collateral or as a deposit. A farmer registers with a project that issues loans and transfers funds to another user who applies for a loan on the condition that interest is paid later. The farmer’s income is the bonus tokens received along with the loan interest.
A liquidity pool is a smart contract on decentralized exchanges (DEX) based on Automated Market Making (AMM) technology. During trading, the ratio of tokens in the pool changes, as does the price of tokens. For example, a user purchases 100 ETH using the ETH/USDT pool. The volume of USDT in the pool increases, while the volume of ETH decreases. At the same time, the price of ETH rises.
A participant who provides liquidity receives two types of coins: revenue LP tokens, which serve as a unit and confirmation that liquidity has been provided to the pool and are “burned” on the blockchain when the liquidity is withdrawn; and bonus DEX or DeFi-protocol tokens, which serve as rewards for activity.
The pool can incentivize participants to provide more liquidity for a particular asset through increased rewards in bonus tokens. The pool’s income commission is distributed in proportion to the funds that participants place.
Farmers sell bonus tokens on the exchange in exchange for the underlying liquidity, which is again delivered to a specific pool and bonus tokens are again awarded to participants. Such manipulation is done as long as it remains profitable, overriding the trading fees and commissions of the Ethereum network.
3. How do I calculate profits from income farming?
Profit from income farming is calculated in the form of annual interest, like in a bank, says Streamity founder Vladislav Kuznetsov.
The most common metrics are annual percentage rate (APR) and annual percentage yield (APY). The difference between them, according to Kuznetsov, is that APR does not take into account compound interest. In this case, compound interest accrual means directly reinvesting income in order to get a higher return.
4. What are the risks associated with income farming?
Among the main risks associated with farming, Streamity founder Vladislav Kuznetsov names errors and vulnerabilities in smart contracts, fraud, token drop on the background of inflated yield percentages or economic insolvency of the project as a whole.
- Smart contracts. In the DeFi sector, many protocols are developed by small teams with limited budgets, which increases the risk of bugs and vulnerabilities in the code.
- High fees in Ethereum, which can make farming-related transactions unprofitable.
- Withdrawals from liquidity pools. Any user of the DeFi-platform can withdraw their liquidity from the market, except in scenarios where it is blocked through a third-party mechanism. In addition, in most cases, developers dispose of large amounts of underlying assets and can easily dump those tokens into the market.
- AMMs work on the basis of persistent functions to determine the value of tokens in liquidity pools. Because of price changes in external markets, quotes in AMMs can diverge, arbitrageurs take advantage of this. On withdrawal, liquidity providers may receive fewer tokens due to the risk of non-permanent losses.