The Decentralized Finance (DeFi) surge in 2020, pumping major parts of cryptos, yield farming is said to be the greatest driver of this event. It’s a crucial component of how blockchain technology works, especially with respect to cryptos like Ethereum and Solana. Risk-taking investors realized the potential of yield farming and grabbed the opportunity of using their cryptos to earn “free” interest. However, it isn’t precisely free, and depending on the project, the rewards involve a great deal of risk.

In this article, let’s learn about yield farming in detail.

What is yield farming?

To put it simply, yield farming is a way for investors to earn interest on their digital assets. Lending crypto to DeFi protocols or platforms helps the market become more liquid, and investors who do so are rewarded with interest on their investment by the allocation of transaction fees.

These fees are acquired from trades and interactions on the platform – which is typically small, like 0.3% from each trade – and then given back to users as “rewards.” In addition, DeFi platforms and protocols have also begun to offer investors their own governance ‘tokens’ as rewards.

These tokens let owners discuss, make suggestions, and vote on how the protocol is employed and changed. They are also equivalent to shareholding in a traditional finance system. An example is the use of Uniswap tokens to vote on governance ideas inside the Uniswap DAO protocol.

By combining these tokens and interest, yield farmers can begin to make a genuine return from their crypto investments.

How does yield farming work?

You’ll have a better understanding if we compare this with traditional finance.

First, you’ll have to open a bank account. Then, the full thread of never-ending paperwork and signatures starts. After some sweet time, the bank certifies that you can deposit your money with them. You gladly follow some laws regarding minimum balances, minimum first deposits, privileges depending on slabs, etc. All this is for a pitiful yield that hardly outperforms inflation.

On the other hand, in the Decentralized Finance (DeFi) ecosystem, all you need is some crypto in hand. After that’s done, you can choose from a number of methods to lock (stake) your funds to obtain a considerably higher yield. The entire process takes a few minutes to complete without needing a single document.

All this process is done using smart contracts, which self-execute when specific circumstances are met. Smart contracts, which self-execute when specific circumstances are satisfied, are used for all these procedures. Since the smart contracts are created on a blockchain, they are immutable. It is usually said that smart contracts would be the law if blockchain were a city.

Another pertinent question to be addressed is why these protocols or decentralized apps enable these yields. Some of these protocols function the same way as banks do. They take the funds and lend them to someone else (your money remains secure in this situation because the borrower has deposited collateral). Other protocols merely incentivize participants to create money pools where traders could gather and trade their assets.

After understanding the definition and working of yield farming, let’s see some pros and cons to help you make a better and informed decision on whether you should look forward to yield farming.

Let’s see!

Pros and cons of yield farming

Pros of yield farming

• High APYs

One advantage of yield farming is the potential for extremely high Annual Percentage Yields (APYs). Some farms offer APYs as high as 100%, while it is relatively easy to find farms providing yields of around 30%. These yields are significantly higher than what most other investment instruments offer, making yield farming an attractive option for many investors. You can easily track the daily yields of major protocols to stay informed.

• Decentralized nature

Another benefit of yield farming is its decentralized nature. The complete process is governed by smart contracts, eliminating any subjective elements. Additionally, there are no barriers to entry. Anyone with an active internet connection can be a part of yield farming, although there is a learning curve involved. Nonetheless, having an internet connection is the primary requirement.

• No barriers

DeFi yield farming transcends geographical limitations. The origin of a protocol holds little significance when it comes to investing. Regardless of where a protocol originates, investors can participate in yield farming without concerns about geographical barriers.

Cons of yield farming

• High volatility

Like any other investment, the crypto market is characterized by high volatility, causing the value of cryptos to fluctuate rapidly. Such volatility can result in substantial losses if the value of the assets being lent or borrowed experiences a decline.

• Impermanent loss

When providing liquidity to a pool, the value of the assets being lent can change relative to the other assets within the pool. Consequently, when withdrawing the assets, there may be a loss even if the individual asset prices have not decreased.

• Scams and frauds

Due to the lack of regulation in the DeFi space, it is relatively easy for scammers to create fraudulent decentralized applications (dApps) that promise high APYs to liquidity providers. In some cases, these dishonest dApp creators may take the crypto deposits from yield farmers and vanish, commonly known as a “rug pull.” Unfortunately, such rug pulls often occur abruptly and without warning, leaving investors with no means of recovering their funds.

Conclusion: Is it worth doing in 2023?

DeFi platforms have made strides in improving user interfaces and introducing new features to enhance user experience and simplify interactions with protocols since gaining popularity in 2020. These changes, such as streamlined user experiences and improved documentation, help users better understand platforms and reduce the chances of costly mistakes. Major DeFi platforms like Uniswap and Aave have undergone significant upgrades.

One crucial improvement is the implementation of measures to mitigate risks in yield farming. Notably, audited smart contracts have become more accessible, reducing the risk of hacking and fraudulent activities. This fosters trust in DeFi platforms and encourages greater participation in yield farming.

These recent developments make yield farming a more attractive way to earn from idle assets. However, it remains a dynamic and rapidly evolving space that requires vigilance and time to identify the best strategies.

Overall, yield farming has seen substantial improvements since 2020 and can be profitable in certain cases. Yet, it remains a high-risk, high-reward investment strategy. Therefore, proper research and understanding of the risks are essential before engaging in yield farming.

Disclaimer: Cryptocurrency is not a legal tender and is currently unregulated. Kindly ensure that you undertake sufficient risk assessment when trading cryptocurrencies as they are often subject to high price volatility. The information provided in this section doesn't represent any investment advice or WazirX's official position. WazirX reserves the right in its sole discretion to amend or change this blog post at any time and for any reasons without prior notice.