Farming (also known as Yield Farming) is a process of earning income from cryptocurrency investments by providing loans or staking assets within the DeFi platforms. The pivotal point of the yield farming mechanism is that users lock their cryptocurrencies in the protocol, often paired with another cryptocurrency, and receive in return tokens representing their stake in the protocol or a protocol token.
Yield farming profit is formed from several sources. One of the major sources of income is the interest rates that users receive for providing liquidity. These rates can be changed and depend on the demand for liquidity in the protocol. In addition, users can receive additional tokens from the protocol as a reward for participating in its ecosystem.
One of the main benefits of yield farming is that it’s possible to gain high-interest rates compared to traditional investment tools. However, it’s worth noting that the following mechanism is associated with definite risks such as liquidity loss, protocol safety risks, cryptocurrency exchange volatility, and some other factors that might have an impact on returns.
Liquidity providing happens within the DeFi space on the platforms belonging to one of the following types:
Let’s have a look at farming in each of the areas more intently.
DEX is a decentralized exchange running on the smart-contracts. Such exchanges need liquidity to fully function. Liquidity is provided by liquidity providers, who, as a rule, contribute the equivalent value of 2 tokens to a liquidity pool within a pair. Although there are some DEXs where pools consist of more than 2 tokens. Liquidity providers assume the risks associated with providing liquidity and get compensation in the form of fees charged to traders for swaps.
The Uniswap exchange was the pioneer to introduce AMM (Automated Market Making) technology, which means that market-making takes place automatically according to a certain formula and is completely decentralized. The pool, which is necessary to make exchanges, consists of 2 tokens. The number of tokens in this pool is determined by the formula x*y=k, where k = const.
In Uniswap V2, the liquidity provided by the LP provider is distributed equally across the entire price range. Yet, this model is not ideal in terms of capital efficiency. Uniswap V3, in turn, offers the so-called ‘concentrated liquidity’, that makes it possible to provide liquidity within a strictly specified price range. In addition to Uniswap V3, the concentrated liquidity model is also used by Trader Joe V2.
How Does Uniswap Work?
The diagram above shows that LP provides 2 tokens (A and B) to the pool, in return receiving an LP token confirming the ownership of a certain share of the pool. On the other hand, a trader, exchanging token A for token B, puts token A into the pool and also pays a commission, and acquires token B in return.
The scheme above shows that LP provides 2 tokens (A and B) to the pool, in return receiving an LP token, which confirms the ownership of the pool shares. Alternatively, a trader, exchanging token A for token B, puts token A into the pool (and also pays a commission) and receives token B in return.
The trader, in turn, exchanging their token A for token B, changes the ratio of tokens in the pool because the sum of tokens is constant. This leads to a token’s price change. Thus, slippage occurs, and the trader receives a little bit less than token B:
To understand concentrated liquidity, it’s better to use the vessels analogy. In Uniswap V2, the liquidity is provided over the entire price range from 0 to infinity equally. LP providers get their fees based on their share within the pool. As for Uniswap V3, liquidity could be provided in any width range. This range is limited by a minimal unit — Ticks (Uniswap V3) or Bins (Trader Joe V2):
One liquidity provider can provide liquidity in a range of [1.0 - 1.01], and another one in a range of [1.01 - 1.02]. Depending on where the price is, LP providers will receive commissions from the difference. For example, if the price = 1.0, then all commissions will be received by the first LP provider, while the second provider receives nothing because the price went beyond the provided liquidity.
Concentrated liquidity enables creating of pools that are more exposed to slippage, concentrating on significant liquidity in a narrow price range. This means reducing the pool, using it free of charge — no high slippage, low fees, and keeping a high yield for LP providers.
It is crucial to find the right price range to provide liquidity. On the one hand, when a range is too wide, it leads to the capital will not be used efficiently. The matter is that in a wide price range case, can be a great number of participants providing liquidity. This can result in high competition for rewards and, as a consequence, lower returns for each participant.
On the other hand, when a range is narrow, there is a risk that the price may quickly go beyond this range, which in turn will lead to the fact that you will no longer receive commissions for the provided liquidity.
Therefore, it is extremely important to monitor your open positions and respond in time to price changes in the pool by rebalancing open positions.
By providing multiple tokens to the liquidity pool, the liquidity provider will face so-called ‘impermanent loss’. Volatile loss is the difference between holding tokens and providing them to a liquidity pool. So, when the price of one token changes, arbitrageurs will equalize the cost of this token in the pool, which leads to a change in the ratio of tokens and a change of the pool’s cost, as well.
Losses are called non-permanent, because if the price returns to the point where the LP provider originally provided liquidity, then its loss will be equal to 0. In addition, the provider will receive a commission for the swaps made by traders.
All pools can be conditionally divided into the following types:
Stable pairs (USDC/USDT; ETH/wstETH, etc);
Correlating pairs (wBTC/ETH; BTCB/BNB, etc);
Volatile pairs (USDC/ETH; GMX/ETH, etc).
The higher the volatility, the greater the non-permanent losses incurred by the liquidity provider. Both Uniswap's concentrated liquidity and Curve's stable swap model manage the stable pairs issue. Curve V2 is a great example of solving a volatile pair problem. In fact, they implemented an additional parameter callied amplification coefficient that shows how dense liquidity should be concentrated for a price to change in a definite range in its minimum. Then it could function as a usual volatility pool’s curve.
Some DEXs apply both approaches — they have both stable and volatile pools with regular and concentrated liquidity options. The Balancer pools are especially worth mentioning, as more than 2 tokens can be represented there. For instance, 5 different tokens can be added to the pool.
Decentralized perpetual exchange is a platform where perpetual contracts are exchanged in a decentralized way. Let's figure out how providing liquidity to decentralized platforms works and allows traders to trade with leverage.
The largest platform in terms of trading volume is GMX. GMX is represented on the Arbitrum and Avalanche networks. GMX is based on a model including 2 tokens: GMX and GLP.
GMX is the platform’s governance token that receives 30% of the platform's revenue distribution.
GLP is a GMX’s liquidity provider (LP) token, which consists of an index of assets used for swaps and leverage trading. It can be minted using any index asset and burnt to redeem any index asset and it is specific to the chain that it is minted on. For example, on Arbitrum, GLP consists of a diversified basket of tokens like ETH, BTC, LINK, USDC, USDT, and DAI.
Each token included in the GLP composition has both its target and current weight. Depending on which token is provided by the LP provider, then the token’s weight increases. By holding the GLP pool token, the user holds the entire composition of the pool. The main advantage here is that there is no implement loss, because with the volatile assets’ growth, their number in the pool does not decrease, and the pool is constantly rebalanced.
GMX distributes 70% of the yield to liquidity providers. This includes fees for pool exchanges, opening/closing positions, using leverage, and liquidating positions fees.
Other Perpetual DEXs may differ from GMX, but generally, they have similar mechanics.
Lending platforms are for lending one’s funds to others and borrowing if necessary. Crypto lending protocols are one of the most common apps in the DeFi ecosystem. Thus, according to DefiLliama, the total TVL of the whole DeFi segment is $44.18 billion, while landing protocols account for 33.3% or $14.73 billion. Crypto lending is represented by a large number of protocols operating on various mechanics.
The largest lending protocols are AAVE, Compound, Venus, and some others. The received credit funds can be further used to profitably provide liquidity to the pool, thereby covering interest payments and earning profit.
Let’s look through the most rapidly developing lending platform — Radiant.
Each of the tokens within the Radiant platform corresponds to two different APYs:
the first one (highlighted in black) — possible profitability in a case when you provide a token to the pool;
the second (highlighted in color) is the profitability that will be if, in addition to providing the token, at least 5% of the funds in the form of a dLP token are also locked into the pool.
dLP- LP-token on Balancer: open position consisting of 80% RDNT and 20% WETH (on the Arbitrum network).
The yield from providing liquidity depends on several factors. The first of them is the demand for loans: the higher it is, the higher the loan rate will be, and as a result, the profitability from farming. The second factor is the period for which dLP is locked (1,3,6 or 12 months) - the longer the period, the greater the profitability.
Cross-chain bridges are solutions that allow a user to transfer assets from one network to another. Some cross-chain bridges run upon liquidity pools, with the following workflow:
The mechanism of operation of pools in cross-chain bridges is in many ways similar to the mechanism of operation of DEXs operating on liquidity pools. Some traders who swap tokens and pay a commission for each trade. However, there are liquidity providers that provide liquidity in exchange for a share of these fees. You can provide liquidity on any of the following bridges:
Still, it should be taken into account that bridges are the most insecure place in DeFi and are often the subject of hacker attacks, which adds risks for LP providers. According to a report by crypto data aggregator Token Terminal, cross-chain bridges are the victim of 50% of DeFi exploits.
The farming process itself is not a trivial issue. First, there is a vast variety of protocols to which you can contribute liquidity. Each of these protocols has its own unique set of characteristics that need to be taken into consideration: TVL, the number of supported assets, the level of return on each of the pools, etc.
At this stage, the Notum platform can help you. You can find a large number of options for farming cryptocurrencies using convenient filtering and flexible settings. All protocols are aggregated in one place. Instead of visiting multiple platforms, it is much more convenient to keep track of all the yield-farming opportunities on Notum.
Secondly, if you have chosen a pool or strategy that supports assets that you do not have available, you need to exchange existing assets to provide liquidity to the selected pool or strategy. This, in turn, leads to additional difficulties in finding appropriate DEX/CEX sites, and associated gas costs.
It is also necessary to take into account that when adding liquidity to the pool/strategy - it is necessary to pay for gas for approving/signing the transaction. In addition - for effective money management - you need to constantly monitor the open position.
The difficulties listed above are helped by the Notum platform. Our solution allows you to find pools according to the main protocols in one place, and make a deposit in them in one swap, saving 80% on gas compared to the traditional process. Also in our application, the user can easily monitor their assets and exit them in one click.
Some common mistakes that prevent you from getting income with yield farming. Here are some of them:
- Applying farming with a token that is decreasing in its value due to emission and lack of utility;
- Lack of understanding of the difference between APR and APY to the full extent;
- Providing liquidity to a volatile pair and receiving a large IL;
- Setting too wide range;
- Setting too narrow range;
- Choosing an unverified platform to provide liquidity;
- Relying only on passive income and not managing the position;
- Not considering commissions.
Farming, as part of decentralized finance, is relatively new and it is one of the most innovative features of DeFi. Most DeFi protocols are peer-to-peer (P2P) financial applications in which dedicated capital is used to provide services to end users.
The fees charged from users are then shared between the capital providers and the protocol.
Investors are called “farmers”, and the process of earning income is called “farming.”
Generally, farmers constantly change their places of work in search of opportunities for obtaining the highest profit. However, it is worth taking into account the risks that are characteristic of this way of earning.
Disclaimer: Notum does not provide any investment, tax, legal, or accounting advice. This article is written for informational purposes only. Cryptocurrency is subject to market risk. Please do your own research and trade with caution.