Yield Farming in DeFi for Beginners

Since the creation of Bitcoin in 2009, other cryptos started to appear one by one, which sparked countless opportunities within the crypto sphere. And we now have tons of different ways to use this technology and earn extra profits without making much effort.

To many, buying and holding your cryptos for long-term market maturity is the most effective strategy to earn and beat the market. But did you know that you could earn additional income by leveraging the tokens you hold?

You’re in luck because we’ll introduce you to one of the most common ways to earn passive income with your cryptos. And that’s through yield farming.

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But what is Yield Farming?

What is Yield Farming?

Glad you asked! Yield farming refers to the process of utilizing decentralized exchange to lend or borrow money from the liquidity and earn interest from it as a reward. And there are various ways and methods to do it.

4 Methods to earn from Yield Farming

Yield farmers can employ more complex tactics and methods to earn even more rewards with their cryptos. And we’ll go over them one by one in full detail.

1. Being a liquidity provider

You can become a liquidity provider by supplying a decentralized exchange (DEX) with tokens to help the platform facilitate trades and transactions. The interest or profit you earn comes from traders and investors performing transactions on the crypto exchange you support.

Investors or traders make trades all day, and fees are associated with every transaction. And by becoming a liquidity provider, you get a slice of those fees as “interest” on the tokens you’ve put into the exchange.

Picture out a decentralized exchange like 1inch, and you supply them with funds to help their platform. And let’s say that your funds make up 1% of the total liquidity pool. This would entitle that you to have 1% of the total interest they earn.

2. Borrowing and lending

Another way of yield farming is by borrowing, lending, and leveraged lending. We’ll go over these three features and explain how you can produce income in three different ways.

  • Lending: DEX platforms provide rewards for those who lend their cryptos to the platform. You can even check a platform’s lending rate to see how much return they reward lenders.
  • Borrowing: This is a form of yield farming where you can use the funds you’ve put into the liquidity pool without withdrawing them. How does it work? Imagine that you’ve put $20,000 worth of crypto into the liquidity pool. You can borrow money from that same liquidity pool by leaving your cryptos inside it as collateral.

Note that when borrowing from the liquidity pool, it should be overcollateralized. This means the amount you’re going to borrow should be less than the amount you’ve put into it. And that assures them that you won’t run away with the funds you’ve borrowed.

So since you have $20,000 funds worth of crypto inside the liquidity pool, you can borrow $15,000 and use it however you like. This is a neat trick that allows you to use your investment without actually pulling it out and just letting it stay and appreciate in the liquidity pool. But note that you’ll have to pay interest for the funds you’ve borrowed.

  • Leveraged Lending: This is where you push your investment to its full potential by leveraging your funds currently inside the liquidity pool.

Let’s take the example earlier where you currently have $20,000 inside the liquidity pool earning interest. And since you’ve borrowed $15,000 from the same pool or collection, you can invest it back into the same pool along with your $20,000 and again borrow $10,000 from the $15,000 you’ve recently put in and invest it back into the same liquidity pool.

You are earning interest from a total fund of $45,000 even though your initial capital was only $20,000. Isn’t that awesome? But please know that there are risks when doing this. If the price of the crypto crashes, the platform may sell or liquidate your funds to cover the lender’s funds.

3. Staking

Staking means buying crypto and locking it up into the blockchain that uses proof of stake (PoS) for a certain amount of time. And in return, you earn more cryptos as a reward.

4. Holding coins that have a redistribution fee

One good example of this is SafeMoon, with a transaction fee of 10%, of which 2% is burned, 3% is added to its liquidity, and 1% is added to the SafeMoon Ecosystem Growth fund.

The remaining 4% is evenly distributed to its holders. And the idea here is to hold onto its token as the price continuously increases due to its decreasing supply. So you’ll earn additional SafeMoon tokens just by holding it.

Best Decentralized Exchanges for Yield Farming

There are dozens of decentralized exchanges, but only a few are profitable and reliable. Thorough research is always a must before you put your money out there. But today, we’ve got you covered because below are the best DEX you can use today!

1inch homepage

1inch has been dubbed the “Leading DEX Aggregator.” It runs on the Ethereum blockchain, Binance Smart Chain, and Polygon networks. 1inch is also a non-custodial exchange, which means instead of functioning as an exchange itself, it splits orders between other DEXs to find the best possible exchange rates for you. And you’ll also need a third-party wallet to use its services.

And the best part? It doesn’t have any withdrawal or deposit fees. It also works with various wallets like Metamask, WalletConnect, Fortmatic, etc. 1ich is also compatible with around 400 varieties of cryptos. This is why 1inch is one of the most recommended DEX. And you can leverage your funds by earning farm yields through 1inch’s DEX.

Uniswap homepage

UniSwap is also a decentralized exchange with a liquidity pool in which you can earn profits through yield farming. Uniswap’s best feature is its function to swap any Ethereum tokens without using a separate exchange, which is convenient, especially when trading.

Uniswap charges a 0.3% fee for all swaps, and this fee doesn’t return to Uniswap. Instead, it gets distributed to the liquidity providers as an incentive for supporting its pool. Though a separate payment for gas would be required when doing transactions on the Ethereum blockchain.

Aave homepage

Aave is also a non-custodial exchange for borrowers, lenders, and liquidity providers. Its liquidity protocol allows you to earn interest through lending and providing liquidity and borrow from its liquidity to leverage it.

Its lending protocol is also open-source, meaning you and other developers can make customizations. And just like other DEX platforms, Aave allows collateral swaps for maximum profit.

Aave also offers flash loans for a small or limited amount, which don’t require any collateral but are subject to fees. Flash loan is a unique and revolutionary new feature of DeFi. Although it’s also worth mentioning that hackers have exploited it in the past.

PancakeSwap homepage

PancakeSwap is an automated market maker (AMM), just like Uniswap. In fact, Pancakeswap was launched in September of 2020 and started as a copy of Uniswap on the Binance Smart Chain.

However since then, PancakeSwap developed its platform and made a name of its own in the DeFi space. And they now offer their service, doing more daily transactions with low fees and higher speed.

PancakseSwap also takes pride in its security as it has never been hacked. The only risk involved is if you’d carelessly invest in a non-legitimate project. Another risk is impermanent loss, a complicated topic that needs an in-depth explanation, so we’ll go over it later.

Binance homepage

Binance is one of the largest and most well-known crypto exchanges suitable for advanced traders. It is also known for its low fees and several options and features.

But it might get overwhelming, especially if you’re a beginner. Binance also has a wide variety of cryptos to choose from. And its platform currently supports over 365 cryptos and fiat currencies like USD, AUD, EUR, and more.

I previously wrote about Binance alternatives which you can check in case Binance is not avaialble in your region. A lot of these alternatives also offer yield farming.

How to become a liquidity provider for 1inch protocol

As mentioned above, 1inch is one of the best liquidity protocols you can farm. And below are the following steps to become one of its liquidity providers.

  1. Visit 1inch pools tab.
  2. Click on “Connect Wallet” in your screen’s upper right corner. If you are new to wallets, read up on how to use MetaMask or check out some MetaMask alternatives.
  3. First step of 1Inch yield farming
  4. Pick a token pair you like, and then click the “+” symbol on the right to provide liquidity.
  5. Next step of 1Inch yield farming for providing liquidity
  6. You can adjust the amount of each token you want to provide by changing the number of LP tokens in the “enter LP tokens to mint” field.
  7. You’ll need to unlock both assets in the pool. So click on “unlock,” then confirm the transaction on your wallet.
  8. 1inch Provide Liquidity Option
  9. Click “provide liquidity,” then confirm the transaction in your wallet.
  10. Confirm providing liquidity by accepting the transaction via wallet

    Next, you’ll need to participate in farming by staking those LP tokens for additional profit.

  11. Click on the ‘farming‘ tab, look for the pair you’ve provided liquidity, and click on ‘deposit.’
  12. Click on the ‘balance‘ to enter the max number of LP tokens.
  13. Enter max number of LP tokens
  14. In the upper right corner of the field, click on ‘unlock token‘ and then select one of the two unlocking options.
  15. Confirm the transaction in your wallet. Click on ‘deposit‘ and confirm it on your wallet once again.
  16. Confirm the transaction on 1inch to become a Liquidity Provider

It’s as easy as that! You’ve completed the process of providing liquidity to its pool, and you now have LP tokens of that pool in your wallet, representing your share of liquidity.

How Yield Farming calculations work

The yield farming returns are calculated over the course of the year by APR (Annual Percentage Rate) and APY (Annual Percentage Yield).

APR is the amount of interest you pay annually, ignoring the compounding impact. On the other hand, APY is the actual percentage of return you’ll receive while accounting for the compounding interest.

Note that these two measurements are estimations and never 100% accurate due to the volatility of the market and its ever-changing incentives.

Finding coins with great yields

Finding coins with great yields can be tricky and very dangerous. So it’s highly advised that you stick with the well-established mainstream coins with a solid foundation. Some coins offer high returns to attract many investors, leading to their growth and success.

But as you already know, cryptos are insanely volatile, and choosing a new or unknown coin could result in profit loss. So critical and thorough research is crucial when diving into the unknown.

What are the risks of Yield Farming?

As enticing as all of this sounds, liquidity pools are known to be a playground for hackers. So there’s always an imminent danger when farming. And there are some drawbacks that you need to be aware of when farming liquidity pools:

1. Impermanent loss

Impermanent loss happens when the liquidity you’ve provided in the pool decreases in value. And by the time you withdraw, you’ll have less amount than your initial deposit. But this can be lessened or even negated through your interest rate.

Let’s say you lost 15% in impermanent loss due to some crash but were able to gain 35% APR. This means you still managed to profit despite the recession.

2. Interest rates decrease as the pool gets popular

When one liquidity pool performs well, it will catch the attention of other investors, making a congested pool with a whole lot of investors to divide the profit. Remember that the profit comes from the fees of people doing trades and transactions. So it is not an unlimited source that everyone can farm.

3. Scam liquidity pools

The liquidity pool you’re invested in could turn out to be a scam. Some liquidity pools are designed to have very high yields to entice other investors to pour their funds into them.

The developers could then take away all the funds you’ve invested, leaving everyone with nothing. This scheme is also known as rug pull. But if you’d stick with trusted and well-established liquidity pools, this should be the least of your concern.

To End

Suppose you made it till the end, congratulations! You now have a better understanding of yield farming and how to profit from it. And please know that this article is intended for educational and entertainment purposes only. So this should not be taken as financial advice, and you should always do your due diligence.