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What is yield farming?

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Written byMichelle Legge | Koinly Head of Crypto Tax Education

What is Yield Farming?

Written byMichelle Legge | Koinly Head of Crypto Tax Education

Last updated: Sunday, 19 March 2023

Yield farming lets you maximize your passive earnings from DeFi protocols by using apps in combination to maximize your earnings. Learn more in our guide. 🧑‍🌾

What is yield farming?

Yield farming is an umbrella term for a variety of investment strategies that utilize different DeFi protocols (or dApps) to maximize profits. Crypto yield farmers chase the largest returns by using dApps in combination to multiply their earnings.

Yield farming strategies vary in complexity. They can range from simply putting your asset in a given liquidity pool and letting it do its thing to earn you liquidity pool tokens to later sell all the way up to stacking multiple DeFi protocols to reap the highest returns.

To understand more complex yield farming strategies, you first need to understand the concept of composability in the DeFi space.

What is yield farming?

What is composability in DeFi?

Composability refers to the interoperability of DeFi protocols and how different protocols can work together. Yield farmers ‘stack’ these protocols to receive the highest yields possible.

This is much easier to understand with an example, so let’s use Lido, Curve Finance, and Yearn Finance to explain.

You want to stake ETH to earn staking rewards, but you don’t want to lock up your ETH and lose liquidity, so you use a DeFi staking protocol, which in this instance is Lido. When you stake your ETH with Lido, you receive stETH tokens in return, These tokens represent your staked ETH in the pool and they’ll accrue value in relation to your staking rewards, but you can also use them on other protocols, including Curve Finance.

So you take your stETH tokens and add them to a liquidity pool on Curve Finance. You’ll receive a portion of the trading fees from this pool as well as a reward in the form of Curve LP tokens. As well as this, for some specific liquidity pools on Curve, you’ll also receive CRV tokens as an additional reward. You can then take your CRV tokens to other platforms like Convex Finance or Yearn Finance, and deposit them there to earn even further rewards. 

This is just one example of many, but it explains how composability in DeFi is what allows yield farmers to reap such high rewards. 

What is composability?

How does yield farming work?

Many different kinds of protocols make up yield farming strategies. Some of the most common kinds of dApps used in yield farming include:

  • Decentralized exchanges: Liquidity providers are what make decentralized exchanges work - and they’re rewarded for their contributions handsomely. Yield farmers often then go on to deposit tokens from liquidity provision - like governance tokens or liquidity pool tokens - into other protocols to amplify their gains. Learn about top 10 decentralized exchanges.
  • Lending: Lending protocols like Aave or Compound offer an easy way to earn passive income from crypto. All investors need to do is deposit their capital and start earning interest, as well as potentially governance tokens on top of this.
  • Borrowing: Most DeFi lending protocols also let you borrow crypto - so when you’re depositing your crypto into a lending protocol, you may also be able to use that as collateral to borrow further crypto to invest elsewhere. Learn more about DeFi lending and borrowing.
  • Staking: Staking protocols are a very popular way to earn interest on PoS cryptocurrencies, as well as other tokens. Whether you’re looking to stake ETH or another cryptocurrency entirely, with DeFi staking, you’re able to keep more of your rewards (as well as potentially increase your liquidity with liquid staking solutions) thanks to non-custodial models. Get started by learning about the best crypto coins to stake.

As you can see, there’s no one size fits all approach to yield farming. In fact, yield farming strategies are often kept secret to ensure other investors don’t follow suit. This said, there are several DeFi protocols, out of the hundreds available, that have a good reputation and many yield farmers use. These include:

  • MakerDAO: a protocol for minting fiat-backed stablecoins.
  • Aave: A crypto lending platform including flash loans.
  • Compound: an instant crypto lending and savings platform.
  • Yearn: An automated yield generation platform for the Ethereum blockchain.
  • Curve: a stablecoin exchange platform.
  • Lido: A liquid staking solution for ETH, MATIC & Solana.
  • SushiSwap: a decentralized exchange and automated investment platform.
  • Convex Finance: a yield optimization platform for CRV holders.

But there’s a catch - your yield farming gains or income may be taxable. Find out more in our Yield Farming Tax Guide.

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FAQs

More questions about yield farming? Here are the answers to some of the most frequently asked.

What is APY in yield farming?

APY stands for annualized percentage yield. It is a figure showing the rate of return on investment annually, including compounding returns.

Can I yield farm Bitcoin?

In a manner of speaking, yes. While the Bitcoin blockchain doesn’t yet offer the vast smart contract capability Ethereum and other blockchains do, you can use Wrapped Bitcoin (WBTC) on a huge number of yield farming protocols. Learn more about wrapped tokens and how they work.

Is yield farming profitable?

Yes. Yield farming can and has been profitable for many investors. With a comprehensive yield farming strategy, 100% APY is not unattainable. However, yield farming is very competitive and investors are often using higher-risk investments in order to chase larger gains. 

How risky is yield farming?

Yes. Yield farming comes with significant risks and generally, the higher the reward, the larger the potential risk. Not only is there the standard risk of price volatility in the crypto market, but risks that are unique to DeFi investments include smart contract hacking, rug pulls, and impermanent loss.

The information on this website is for general information only. It should not be taken as constituting professional advice from Koinly. Koinly is not a financial adviser or registered tax agent. You should consider seeking independent legal, financial, taxation, or other advice to check how the website information relates to your unique circumstances. Koinly is not liable for any loss caused, whether due to negligence or otherwise arising from the use of, or reliance on, the information provided directly or indirectly, by use of this website.