Yield farming: An investing strategy involving staking or lending crypto assets to generate returns

• Yield farming involves lending or staking cryptocurrency in exchange for interest and other rewards.
• Yield farmers measure their returns in terms of annual percentage yields (APY).
• While potentially profitable, yield farming is also incredibly risky.

Yield farming is a means of earning interest on your cryptocurrency, similar to how you'd earn interest on any money in your savings account. And similarly to depositing money in a bank, yield farming involves locking up your cryptocurrency, called "staking," for a period of time in exchange for interest or other rewards, such as more cryptocurrency.

"When traditional loans are made through banks, the amount lent out is paid back with interest," explains Daniel R. Hill, CFP, AIF and president of Hill Wealth Strategies. "With yield farming, the concept is the same: cryptocurrency that would normally just be sitting in an account is instead lent out in order to generate returns."

Since yield farming began in 2020, yield farmers have earned returns in the form of annual percentage yields (APY) that can reach triple digits. But this potential return comes at high risk, with the protocols and coins earned subject to extreme volatility and rug pulls wherein developers abandon a project and make off with investors' funds.

Note: The returns you earn by yield farming are expressed as APY, or the rate of return you'd earn during a year.

Understanding how yield farming works

Also known as liquidity farming, yield farming works by first allowing an investor to stake their coins by depositing them into a lending protocol through a decentralized app, or dApp. Other investors can then borrow the coins through the dApp to use for speculation, where they try to profit off of sharp swings they anticipate in the coin's market price.

"Yield farming is simply a rewards program for early adopters," says Jay Kurahashi-Sofue, VP of marketing at Ava Labs, a team supporting development of the Avalanche public blockchain that works with several defi applications that offer yield farming.

Blockchain-based apps offer incentives for users to provide liquidity by locking up their coins in a process called staking. "Staking occurs when centralized crypto platforms take customers' deposits and lend them out to those seeking credit," Hill says. "Creditors pay interest, depositors receive a certain proportion of that and then the bank takes the rest."

"This lending is usually facilitated through smart contracts, which are essentially just a piece of code running on a blockchain, functioning as a liquidity pool," says Brian Dechesare, former investment banker and CEO of financial career platform Breaking Into Wall Street. "Users who are yield farming, also known as liquidity providers, lend their funds by adding them to a smart contract."

Investors who lock up their coins on the yield-farming protocol can earn interest and often more cryptocurrency coins - the real boon to the deal. If the price of those additional coins appreciates, the investor's returns rise as well.

This process provides the liquidity newly launched blockchain apps need to sustain long-term growth, says Kurahashi-Sofue. "[These apps] can increase community participation and secure this liquidity by rewarding users with incentives like their own governance tokens, app transaction fees and other funds," Kurahashi-Sofue says.

Kurahashi-Sofue adds that you could compare yield farming to the early days of ride-sharing. "Uber, Lyft, and other ride-sharing apps needed to bootstrap growth, so they provided incentives for early users who referred other users onto the platform," he says.

Another incentive for staking is to accumulate enough shares of the cryptocurrency to force a hard fork where a major infrastructural change is made to the design of the cryptocurrency, says Daniel J. Smith, professor of economics in the Political Economy Research Institute at Middle Tennessee State University.

Note: A hard fork is a change in a cryptocurrency network's protocol that causes blocks or transactions to be either validated or invalidated, forcing developers to upgrade their protocol software.

"Hard forks enable the holders of crypto to force changes that would, at least in the opinion of the majority of the holders, improve the cryptocurrency going forward," Smith says. In a way, hard forking gives crypto investors a power similar to what share voting does for stockholders. The same way shareholders can vote on key matters affecting the management or direction of the companies they invest in, cryptocurrency holders can use hard forks to push a cryptocurrency protocol in a certain direction.

Staking coins to cause a hard fork "allows crypto to take on (this) important characteristic of equity investments," Smith adds, and "moves crypto from a cash-like investment in a portfolio to a quasi-equity investment."

Is yield farming safe?

Yield farming is rife with risk. Some of these risks include:

• Volatility: Volatility is the degree to which an investment's price fluctuates. A volatile investment is one that experiences a lot of price movement in a short period of time. The price of your tokens could crash or surge while they're locked up.
• Fraud: Yield farmers may unwittingly put their coins into fraudulent projects or schemes that make off with all of the farmer's coins. In fact, fraud and misappropriation account for the vast majority of the $1.9 billion in crypto crimes in 2020, according to a report by CipherTrace.
• Rug pulls: Rug pulls are a type of exit scam where a cryptocurrency developer gathers investor funds for a project then abandons the project without returning investors' funds. The previously mentioned CipherTrace report noted that nearly 99% of the major fraud that occurred during the second half of the year was due to rug pulls and other exit scams, which yield farmers are particularly susceptible to.
• Smart contract risk: The smart contracts used in yield farming can have bugs or be susceptible to hacking, putting your cryptocurrency at risk. "Most of the risks with yield farming relate to the underlying smart contracts," Kurahashi-Sofue says. Better code vetting and third party audits are improving the security of these contracts.
• Impermanent loss: The value of your cryptocurrency could rise or fall while it is staked, creating temporarily unrealized gains or losses. These gains or losses become permanent when you withdraw your coins, and may result in you having been better off if you'd kept your coins available to trade if the loss is greater than the interest you earned.
• Regulatory risk: There are still many regulatory questions around cryptocurrency. The SEC has stated that some digital assets are securities and thus fall under its jurisdiction, allowing it to regulate them. State regulators have already issued cease and desist orders against one of the biggest crypto lending sites, BlockFi.

"There's always risk in using decentralized apps," Kurahashi-Sofue says. "It's all about minimizing the risk enough for you to be comfortable with using them, based on your own research. Users should always look into the team behind the application and its transparency and diligence with security audits."

In the news: The biggest cryptocurrency theft to date involved hackers stealing $600 million from the Poly Network in August 2021.

Is crypto yield farming profitable?

While yield farming is unquestionably risky, it can also be profitable - otherwise no one would bother attempting it. CoinMarketCap provides yield-farming rankings with various liquidity pools' yearly and daily APY. It's easy to find pools running with double digit yearly APY, and some with those thousand-percentage point APYs.

But many of these also have a high risk of impermanent loss, which should make investors question if the potential reward is worth the risk. "The profitability of yield farming, just like investment in crypto more generally, is still very uncertain and speculative," Smith says. He believes the potential return pales in comparison to the risk involved in locking up your coins while yield farming.

Your overall profit will also depend on how much cryptocurrency you're able to stake. To be profitable, yield farming requires thousands of dollars of funds and extremely complex strategies, Dechesare says.

5 yield-farming protocols to know about

Yield farmers sometimes use DeFi platforms that offer various incentives for lending to optimize the return on their staked coins. Here are five yield-farming protocols to know about:

• Aave is an open source liquidity protocol that lets users lend and borrow crypto. Depositors earn interest on deposits in the form of AAVE tokens. Interest is earned based on the market borrowing demand. You can also act as a depositor and borrower by using your deposited coins as collateral.
• Compound is an open source protocol built for developers that uses an algorithmic, autonomous interest rate protocol to determine the rate depositors earn on staked coins. Depositors also earn COMP tokens.
• Curve Finance is a liquidity pool on Ethereum that uses a market-making algorithm to let users exchange stablecoins. Pools using stablecoins can be safer since their value is pegged to another medium of exchange.
• Uniswap is a decentralized exchange where liquidity providers must stake both sides of the pool in a 50/50 ratio. In exchange, you earn a portion of the transaction fees plus UNI governance tokens.
• Instadapp is designed for developers and allows users to build and manage their decentralized finance portfolio. As of Oct. 31, more than $12 billion is locked on Instadapp.

The financial takeaway

Yield farming involves staking, or locking up, your cryptocurrency in exchange for interest or more crypto. "As crypto becomes more popular, yield farming will become more mainstream. It's a simple concept that has been around for as long as banks have existed and is just a digital version of lending with interest for profit to the investors," Hill says.

While it's possible to earn high returns with yield farming, it is also incredibly risky. A lot can happen while your cryptocurrency is locked up, as is evidenced by the many rapid price swings known to occur in the crypto markets.

"As with anything in life, if something is too good to be true, it likely is," Kurahashi-Sofue "It's best to understand how yield farming works and all of the underlying risks and opportunities prior to participating in yield farms."