Yield farming: how cryptocurrency farming works and what the risks are

Decentralized blockchain-based technologies have opened up new ways to earn income from cryptocurrency. One of them is yield farming in DeFi: users deposit assets into a protocol and receive variable rewards while taking on market and technical risks.

In this article, we will explain what crypto yield farming is, how yield farming works, the different ways to earn returns, how to calculate profitability, and which risks to consider before depositing funds.

Key Takeaway

• Yield farming is a way to earn rewards by depositing cryptocurrency into DeFi protocols. Sources of income may include lending interest, trading fees, and additional tokens.
• The main areas of yield farming are supplying assets to lending pools and providing liquidity on decentralized exchanges. These mechanisms can be combined with staking and other DeFi tools.
• To get started, you need a compatible crypto wallet, assets on the selected network, and funds to cover network fees. Before depositing cryptocurrency, you should check the protocol, pool parameters, and withdrawal conditions.
• APR and APY indicate estimated returns: APR does not include reinvestment, while APY accounts for compounding under specified conditions. Actual results also depend on fees, changing rates, and asset prices.
• Strategies involving borrowed funds make risk management more complex. Yield farming returns may be lower than borrowing costs, while a decline in collateral value can result in liquidation.
• The main risks include smart contract hacks, volatility, impermanent loss, stablecoin depegging, and withdrawal restrictions. A high APY, large TVL, or the existence of an audit does not guarantee profits or the safety of funds.
• A platform should be selected based on its mechanism and the conditions of the specific market. Lido, EigenLayer, Aave, Sky, Uniswap, and the other projects discussed below offer different tools; their rates, supported assets, and reward programmes change over time.

AI Summary:

What Is Yield Farming?

In simple terms, yield farming is a set of methods for earning rewards by putting digital assets to work in decentralized protocols. DeFi users supply cryptocurrency to liquidity pools or lending markets and receive interest, a share of trading fees, or additional tokens if such rewards are provided by the protocol. Returns are not guaranteed and change over time.

The foundations of the decentralized finance market emerged in 2015 after the launch of Ethereum, which introduced smart contracts. This made it possible to create decentralized applications, including DEX platforms, lending protocols, and AMM protocols.

2020 became an important milestone for DeFi due to reward programmes and growing protocol usage. The size of the sector is commonly tracked using TVL — total value locked in smart contracts. This metric changes along with asset prices and capital inflows; up-to-date data can be viewed on DeFiLlama. TVL is not the same as the market capitalization of project tokens and does not by itself indicate profitability or security.

How Yield Farming Works in DeFi

Yield farming is built around smart contracts. Two common approaches are lending — supplying assets to lending pools — and providing liquidity for token swaps. In the first case, returns are usually linked to interest paid by borrowers; in the second, they come from swap fees. In both cases, the protocol may also add token incentives. This allows cryptocurrency to participate in DeFi rather than simply sitting in a wallet. Let us look at these methods in more detail.

Through yield farming, asset holders can become lenders or liquidity providers (LPs). They deposit funds into smart contracts and receive variable rewards; however, capital losses and network fees are also possible.

Returns are generated from interest paid by borrowers and swap fees on decentralized exchanges, and sometimes from tokens issued by the protocol. Rates depend on supply and demand and can change quickly. They are often displayed as APR — annual percentage rate without reinvestment — or APY — estimated annual percentage yield including compounding under specified conditions.

Lending

Blockchain lending protocols allow users to supply cryptocurrency to lending pools and take out loans secured by digital assets. Conditions, supported assets, and collateral thresholds depend on the specific market.

Here is how it works:

• By depositing coins or tokens into a smart contract, suppliers (lenders) create a shared liquidity pool for borrowers and receive variable interest when this is provided for by the market rules.
• Borrowers deposit eligible collateral and receive borrowed assets that must be repaid with accrued interest or another applicable fee. For example, if a hypothetical market requires a loan of 100 DAI to be backed by collateral worth twice as much, $200 worth of assets would be required, including ETH if the protocol accepts it as collateral. The actual parameters of the DAI market and liquidation threshold should be checked immediately before entering the position.

Two scenarios are then possible:

1. If the value of the collateral falls to the liquidation threshold or the debt grows relative to the collateral, an external liquidator may repay part or all of the debt and receive the corresponding portion of the collateral plus the bonus specified by the protocol. A conventional overdue-payment event, as in traditional banking, is not required for most such loans.
2. If the user repays the loan and accrued interest, the collateral becomes available for withdrawal, subject to the protocol’s conditions and available liquidity.

Interest is distributed to suppliers according to the rules of the specific pool. An increase in total value locked (TVL) does not automatically increase the interest rate: if demand for borrowing remains unchanged, an influx of liquidity may reduce returns. Assets can usually be deposited and withdrawn without a fixed term, provided there is enough available liquidity in the pool and normal withdrawal conditions apply.

Liquidity Mining

Another common form of yield farming in DeFi is providing liquidity and farming on DEXs. The term “liquidity mining” is sometimes used specifically for additional token rewards paid for holding an LP position. During periods of strong incentives, some projects displayed estimated annual yields of thousands of percent, but such figures were short-lived and did not represent guaranteed profits.

Here is a brief explanation of how liquidity mining works:

1. The asset holder deposits assets into a pool used by traders for swaps and becomes a liquidity provider. Depending on the DEX version, their share may be represented by LP tokens or by a separate position, such as an NFT with a selected price range.
2. When making a swap, the trader pays a fee. The portion of that fee defined by the pool rules is distributed to providers according to their share and, in the case of concentrated liquidity, according to whether the position is active within the selected price range.

Yield farming returns can consist of swap fees and protocol tokens if an incentive programme is active. After accounting for costs, price changes, and possible impermanent loss, two factors affect the outcome:

• Demand: the higher the trading volume, all else being equal, the greater the total amount of fees that may be earned by active liquidity providers.
• Supply: if more liquidity enters the pool while trading volume remains unchanged, each participant’s share of fees generally decreases.

How to Start Crypto Yield Farming: Step-by-Step

First, you will need a compatible crypto wallet that supports the selected network and connection to the required protocol, where you can hold supported crypto assets and use any purchase or exchange methods available in the app. Before carrying out a transaction, check the network, fees, service-provider conditions, and whether the wallet can connect to the selected DeFi protocol; registration and identity verification may be required by certain partners.

Then fund the wallet with the required assets and keep some of the network’s native coins to cover fees. Connect the wallet to the protocol’s official website through WalletConnect or another supported method, verify the website address, network, permissions, and transaction parameters. You can then deposit assets into a lending pool or add liquidity to a trading pair; if token rewards are offered, you may also need to stake the LP position separately in a farm. Below, we will examine yield farming strategies and their risks.

How to Calculate Yield Farming Returns: APY vs APR

To estimate returns, DeFi protocols use APY (annual percentage yield) and APR (annual percentage rate). APR shows the estimated annual rate without reinvestment. APY includes compounding at a specified frequency or reinvestment schedule: with a positive rate and all other things being equal, APY is higher than APR. For example, with an APR of 12% and monthly reinvestment, the estimated APY is about 12.68%, but this is not a forecast of actual profit.

Liquidity-provision returns are often displayed as APR, while some interfaces show APY assuming automatic reinvestment. Check whether trading fees and token rewards are included, how often compounding occurs, whether the rate changes, and whether network fees are included. Native protocol tokens may increase nominal returns, but their prices are volatile, so the actual result in your chosen currency may be lower than estimated or even negative.

Yield Farming Strategies

Crypto yield farming includes a variety of strategies with different sources of rewards and risks. Higher advertised returns often come with additional risks, but a high rate alone does not prove that a strategy is profitable.

Let us look at popular investment strategies used in DeFi yield farming and the conditions that can affect the final return.

• Strategy 1: Single-Asset Yield Farming

If you already invest in cryptocurrency, you can use it in a pair with a closely priced wrapped asset or liquid staking token. For example, WETH represents ETH in ERC-20 format, while stETH represents staked ETH; these are different instruments, and neither completely eliminates the risk of price divergence. The availability of a specific pair on Balancer or PancakeSwap should be checked before depositing funds.

Suppose you hold 10 ETH. If the selected Balancer pool supports a pair consisting of ETH and a wrapped or liquid staking token, you can exchange part of your ETH for the second asset and deposit both into the pool in the required proportion. For illustration, with equal value shares, this could mean 5 ETH and tokens worth the remaining 5 ETH; income from fees and rewards should be compared with swap fees, changes in the relative prices of the tokens, and smart contract risks.

• Strategy 2: Lending and Yield Farming

Sometimes the estimated return from staking exceeds the borrowing rate in a lending pool, and investors attempt to earn the difference by using borrowed funds. However, borrowing interest, liquidation, and possible restrictions on access to funds can make the final result negative. Lending can also be used to obtain a second asset for a liquidity pool without selling the entire original asset.

Suppose you have 10 ETH. An ETH/USDT pool usually requires both assets in the proportion specified by the pool. You could deposit part of your ETH as collateral, borrow USDT, and add it to the pool together with the remaining ETH. This allows you to retain some exposure to ETH and potentially earn pool fees, but you also pay borrowing interest, face impermanent loss, and may lose collateral through liquidation. An increase in the price of ETH does not guarantee an overall profit either.

• Strategy 3: Yield Farming + Staking

Staking in a Proof-of-Stake network and depositing tokens into a DeFi pool are different mechanisms. In the first case, rewards are linked to securing and operating the network; in the second, they depend on the rules of the application. On PancakeSwap, farms for supported trading pairs may distribute CAKE for depositing an LP position; separate single-token pools, where available, have their own conditions. The available assets and rewards should be checked directly in the interface, as older examples involving BUSD or USDT may no longer be relevant.

This strategy is built around combining two sources of rewards. Suppose you hold BNB and USDT: if an active BNB/USDT farm is available, you can deposit the pair into a pool and place the position in the farm to earn CAKE. The CAKE received can then be used in an available single-token pool or another product supporting CAKE if its conditions are suitable. Fees, a decline in the CAKE price, and impermanent loss may exceed the rewards.

• Strategy 4: Lending + Lending

Some platforms introduce additional incentives for both suppliers and borrowers of certain assets. In that case, borrowed tokens can be deposited into another lending market, but borrowing interest remains a cost, and rewards do not guarantee a positive net return. Here is what this strategy might look like:

• Deposit a supported collateral token, such as POL (formerly MATIC), and borrow USDC within the permitted limit.
• Deposit the borrowed USDC into a lending pool with available liquidity and compare the deposit return with borrowing costs and all associated fees.

This strategy is sometimes described as interest-rate arbitrage: for example, borrowing on Compound and depositing funds into another market may make sense if the net rate after costs is positive. It can quickly turn negative because of changes in interest rates, collateral value, transfer fees, or liquidation. Some protocols do not pay interest on assets supplied solely as collateral.

Risks and Benefits of Yield Farming

High estimated yield farming returns come with substantial risks that should be evaluated before depositing assets into DeFi. Some apply to almost every strategy, while others are associated with borrowing, staking, or a specific trading pair. We will begin with the general risks.

Protocol Hacks and Asset Theft

Analytics service PeckShieldAlert reported numerous hacks and major losses in the crypto industry in 2023. This historical data does not reflect the current probability of a specific project being hacked, and methods for counting incidents also vary. Smart contract vulnerabilities, integration errors, compromised keys, and phishing remain risks for DeFi protocols and their users.

Attackers may exploit errors in code, price oracles, or access-control settings and withdraw funds from smart contracts. A decentralized protocol usually has no single authority that can reliably reverse a transaction or return assets. Code audits and large TVL can reduce some uncertainty, but they do not eliminate the risk of a hack.

Volatility

Cryptocurrency prices can change significantly over a short period. An investment worth $100 today may be worth much more or much less a year later; the exact result cannot be predicted, and extremely high return promises should not be treated as guarantees. Prices and liquidity are influenced by:

• Platform development;
• Market trends;
• Competition;
• Unexpected events;
• Partnerships and many other factors.

To manage volatility risk, investors use position-size limits, diversification, and investment portfolio rebalancing. These measures do not guarantee capital preservation. Now let us examine the risks associated with specific strategies.

Liquidation

Liquidation risk primarily affects borrowers who have supplied collateral. If the value of the collateral relative to the debt falls below the protocol’s threshold, a liquidator may repay part of the debt and receive part of the collateral plus a bonus; in some models, the entire position can be liquidated. Risk is assessed using LTV — loan-to-value ratio, not to be confused with TVL — the liquidation threshold, and the position’s health factor. The closer the position is to the threshold, the higher the risk; exact parameters are defined by the specific market.

For example, suppose you borrowed USDT using ETH as collateral. If the ETH price falls or the debt grows enough for the position to reach the liquidation threshold, some or all of the collateral may be sold through the liquidation mechanism. The supplier of funds faces different risks, including protocol failure, liquidity shortages, and bad debt.

Impermanent Loss

This risk affects liquidity providers on DEXs. Impermanent loss is the difference between the value of a position in a liquidity pool and the value of simply holding the same assets, caused by changes in their relative prices. It can occur even when one of the assets rises in price; pool fees may partially or fully offset it, but there is no guarantee. Once funds are withdrawn, the result is realized, and any future reversal in relative prices will not restore that specific position.

What Are the Benefits of Yield Farming?

After examining the risks, let us look at the potential benefits of yield farming when conditions are favorable:

• Potentially high returns. In certain stablecoin pools, estimated rates can sometimes reach 20% per year or more, but they can change quickly and may involve stablecoin depegging risk and capital loss.
• Access to markets with different reward structures: the APY of some DeFi products may exceed the return on a bank deposit, but a direct comparison requires accounting for fees, currency exposure, risks, taxes, and the absence of guaranteed results.
• The ability to earn additional rewards on crypto assets you already hold. If you own cryptocurrency, an investment strategy involving yield farming may generate returns, but it also adds smart contract risk, price risk, and potential withdrawal restrictions.

Yield Farming Platforms and DeFi Protocols

DeFi includes many protocols for yield farming, lending, staking, and trading; not all of them offer yield farming specifically. Their TVL and interest rates change constantly, so current data should be checked in the project interface and on analytics platforms. Beginners often focus on high APY figures and overlook the risks of newer protocols. Large TVL, an audit, and a long operating history can help assess a project, but they do not make it risk-free or guarantee returns.

The first widely used DeFi protocols developed on Ethereum, followed by applications on BNB Chain (formerly Binance Smart Chain), Tron, Solana, the Polkadot ecosystem, NEAR, and other networks; projects also exist on Waves. Below are several well-known platforms using different DeFi mechanisms. Before choosing one, check the supported networks and the availability of the specific service you need.

• Lido

Lido is an ETH liquid staking protocol rather than a traditional yield farm for a trading pair. Its size is usually measured by TVL, which changes daily; presenting an old figure of $34 billion as current capitalization would be inaccurate. Following Ethereum’s transition to Proof-of-Stake, demand for liquid staking grew, and Lido became a major participant in the ecosystem.

Back in 2021, Lido did not have its current scale, while its usage expanded significantly after Ethereum moved to PoS. However, comparisons with Aave and Uniswap depend on the selected metric and date: staking, lending, and trading serve different purposes.

Another reason for Lido’s popularity is the ability to deposit a relatively small amount of ETH into staking without operating your own validator and receive stETH. The token can be used in supported DeFi protocols, but its market price may differ from the value of ETH, while returns and withdrawal timing depend on protocol conditions.

• EigenLayer

EigenLayer is a restaking protocol: it allows already-staked ETH or supported liquid staking tokens to be used to secure additional services. Users may receive separate rewards for doing so, but additional risks also arise, including slashing conditions, withdrawal delays, and smart contract errors. EigenLayer’s TVL changed significantly throughout 2024 and afterwards; historical growth should not be treated as a forecast of future returns.

• Aave

Aave is a lending protocol with multiple markets: suppliers deposit assets and receive variable interest, while borrowers pay according to the conditions of the relevant market. AAVE tokens are not automatically paid as rewards for every deposit. TVL, rates, and additional incentives vary by network and asset, so figures such as $10.3 billion TVL or 15% annual returns from older reviews should not be treated as current for every user.

• MakerDAO (Sky)

The MakerDAO project is now known as Sky. It is associated with the issuance of the DAI stablecoin and the development of USDS; its mechanisms allow the use of collateral assets and certain savings or reward products under Sky’s current rules. An earlier TVL estimate of more than $8 billion should be treated as historical rather than current — always check current metrics and stablecoin risks before using the protocol.

• JustLend

JustLend is a DeFi lending protocol on the Tron network. Interest rates in its pools depend on asset supply and demand, and the conditions of each market can change. A TVL estimate of $7.4 billion referred to March 2024 and does not describe the protocol’s current size; available liquidity and risk parameters should be checked before depositing funds.

• Uniswap

Uniswap is one of the best-known decentralized exchanges. The project began on Ethereum, while support for other networks and deployments — including BNB Chain, Arbitrum, Optimism, Polygon, Base, Avalanche, and Celo — expanded over time. Liquidity providers can earn a share of trading fees; in concentrated-liquidity versions, selecting a price range is important because positions outside that range do not earn swap fees.

• Instadapp

Instadapp helps users manage positions across multiple DeFi protocols through a single interface. Instadapp users can manage portfolios and automated strategies, while developers can use the project’s integration tools, including its SDK. Risks also depend on the connected protocols and the conditions of the specific strategy.

• Compound

Compound is a lending protocol with variable rates that depend on liquidity utilization and the specific market. Claims about the “lowest” rates and a fixed 0.08–5.40% range quickly become outdated. In Compound III, suppliers of the base asset may earn interest, while additional rewards, including COMP, depend on market settings; assets supplied solely as collateral generally do not earn interest.

• Curve Finance

Curve Finance is a trading and liquidity protocol known for pools of similarly priced assets, including stablecoins. Instead of relying on an outdated TVL estimate of $2 billion, it is more useful to review current metrics for the specific pool. The StableSwap mechanism is designed for relatively low slippage when exchanging similarly priced assets; however, the risks and potential losses increase if a stablecoin loses its peg or the pool becomes imbalanced.

• PancakeSwap

The PancakeSwap AMM exchange originally developed primarily on BNB Chain and offers trading and liquidity farming; the project now operates on other supported networks as well. Calling it the largest platform in its ecosystem without specifying a date and metric would be inaccurate because trading volume and TVL change continuously.

In addition to trading BEP-20 tokens, PancakeSwap offers other products, including a lottery. The exchange also issued NFTs and launched an NFT marketplace, which is now listed among its archived legacy products. The availability of a specific farm, network, or reward programme should be checked in the current interface.

Conclusion

Yield farming in DeFi gives cryptocurrency holders access to interest, trading fees, and sometimes additional token rewards. At the same time, high estimated rates come with market and technical risks, including hacks, liquidation, impermanent loss, changing protocol conditions, and the possible loss of funds. Before depositing assets, it is useful to compare expected rewards with costs and potential losses.

The rules governing crypto assets and user protection mechanisms depend on the circumstances and may change; recovering funds after an irreversible transaction is often difficult. On the other hand, DeFi allows users to interact with financial tools through a compatible wallet without relying on a traditional intermediary. Potentially higher returns compared with conventional products are not the same as guaranteed profits: always check the protocol, its terms, the website address, and your own risk tolerance.

FAQ: Common Questions About Yield Farming

What Is Yield Farming in Simple Terms?

Yield farming means earning potential rewards by depositing cryptocurrency into a DeFi protocol. Assets may provide liquidity for swaps or loans, while participants receive a share of fees, interest, or additional tokens. Returns change over time and are not guaranteed.

How Do You Start Crypto Yield Farming?

Choose a protocol and network, verify the official website and risks, prepare a compatible wallet and enough funds to cover network fees. Then connect the wallet, review the pool composition, rates, withdrawal conditions, and smart contract permissions, and only after that deposit a small amount to test the process.

What Is the Difference Between Yield Farming and Staking?

Traditional staking helps secure and operate a Proof-of-Stake network and generates network rewards. Yield farming uses assets in DeFi pools for swaps, lending, or incentive programmes. Liquid staking and restaking can also be combined with farming, introducing additional risks.

What Is the Difference Between APR and APY in Yield Farming?

APR is the estimated annual rate without reinvestment. APY includes compounding at a specified frequency and under specified conditions. Both metrics are usually based on current rates and do not guarantee a full-year return; they should be compared only after accounting for fees and the risk of asset price changes.

What Are the Risks of Yield Farming?

The main risks include smart contract bugs and hacks, falling asset prices, stablecoin depegging, impermanent loss in trading pairs, collateral liquidation when borrowing, changing rates, expensive transactions, and withdrawal problems. Even an audited protocol does not guarantee the safety of funds.

Can You Lose Money Through Liquidity Mining?

Yes. The value of a liquidity position may end up lower than the value of simply holding the same assets because of changes in their relative prices; volatility, fees, and smart contract risk also apply. Trading fees and token rewards may not be enough to offset losses. Before exiting, compare the final value of the position with the original investment and the alternative of simply holding the assets.