Besides plain staking, another way to earn passive income from your crypto holdings is through yield farming.
Also referred to as liquidity mining, this is a way to generate rewards by locking up cryptocurrencies in DeFi protocols rather than centralized exchanges.
Farming works with users called liquidity providers (LP) that add funds to liquidity pools.
In basic terms, a liquidity pool is a smart contract that contains funds. In return for providing liquidity to the pool, LPs get a reward. That reward may come from fees generated by the underlying DeFi platform or some other source.
The liquidity pool typically powers a marketplace where users can lend, borrow, or exchange tokens.
Yield Faming marketplaces come in 2 forms:
Automated market makers (AMMs) such as Uniswap and Pancakeswap or
Lending protocols like Aave
Usage of these protocols incurs fees from which LPs are then paid out according to their share of the liquidity pool.
The funds deposited are commonly stablecoins pegged to the USD though this isn’t a general requirement.
Some of the most common stablecoins used in DeFi are:
Some protocols will mint tokens that represent your deposited coins in the system.
For example, if you deposit DAI into Compound, you’ll get cDAI, or Compound DAI. If you deposit ETH to Compound, you’ll get cETH.
Yield farmers will typically move their funds around quite a lot between different protocols in search of high yields. As a result, DeFi platforms may also provide other economic incentives to attract more capital to their platforms.
Typically, the estimated yield farming returns are calculated annualized. This estimates the returns that you could expect over the course of a year.
Some commonly used metrics are:
Annual Percentage Rate (APR) and
Annual Percentage Yield (APY)
The difference between the 2 is that APR doesn’t take into account the effect of compounding, while APY does.
Compounding, in this case, means directly reinvesting profits to generate more returns. However, be aware that APR and APY may be used interchangeably.
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.
Yield farming thus provides the liquidity newly launched blockchain apps need to sustain long-term growth.