What is DeFi Yield Farming? Make Money From DeFi Yield Farming Today
Yield farming is a popular DeFi product that gives you the opportunity to earn interest on idle crypto tokens.
The overarching objective of yield farming is that you will deposit crypto tokens into the liquidity pool of a trading pair – such as BNB/USDT or DAI/ETH.
In return, you will earn a share of any fees that the liquidity pool collects from buyers and sellers.
In this beginner’s guide, we explain the ins and outs of how DeFi yield farming works with some clear examples of how you can make money from this investment product.
- 1 What is DeFi Yield Farming – Quick Overview
- 2 How Does DeFi Yield Farming Work?
- 3 How Much Can You Make From Yield Farming?
- 4 Is Yield Farming Profitable? Benefits of DeFi Yield Farming
- 5 Risks of Yield Farming
- 6 Is Yield Farming Taxed?
- 7 How to Choose a Platform for DeFi Yield Farming
- 8 Start Yield Farming Today on DeFi Swap – Step-by-Step Walkthrough
- 9 DeFi Yield Farming Guide: Conclusion
- 10 FAQs
What is DeFi Yield Farming – Quick Overview
The main concept of DeFi yield farming is explained below:
- Yield farming is a DeFi product that allows you to earn interest on idle crypto tokens.
- You will be required to deposit tokens into the liquidity pool of a trading pair at a decentralized exchange.
- You need to deposit equal amounts of each token. For example, if providing liquidity for DAI/ETH – you might deposit $300 worth of ETH and $300 worth of DAI.
- Buyers and sellers that use this liquidity pool to trade will pay fees – which you will earn a share of.
- You can often withdraw your tokens from the liquidity pool at any time.
Ultimately, yield farming is a win-win situation for all parties involved in the DeFi trading space.
While decentralized exchanges can ensure that they have sufficient levels of liquidity, traders can buy and sell tokens without going through a third party. Moreover, those providing liquidity for a yield farming pool will earn an attractive rate of interest.
How Does DeFi Yield Farming Work?
DeFi yield farming can be a lot more complicated to grasp in comparison to other DeFi products like staking or crypto interest accounts.
As such, we will now break down the DeFi yield farming process step-by-step so that you have a firm understanding of how things work.
Liquidity for Decentralized Trading Pairs
Before we go into detail on how yield farming works, let’s first explore why this DeFi product exists. In a nutshell, decentralized exchanges allow buyers and sellers to trade crypto tokens without a third party.
Unlike centralized platforms – such as Coinbase and Binance, decentralized exchanges do not have traditional order books. Instead, trades are facilitated by an automated market maker (AMM) mode.
This is backed by a liquidity pool that contains tokens in reserve – which trades can access to swap a specific token.
- For example, let’s say that you wish to swap ETH for DAI.
- In order to do this, you decide to use a decentralized exchange.
- This trading market would be represented by the pair DAI/ETH
- In total, you wish to swap 1 ETH – which based on market prices at the time of the trade, would get you 3,000 DAI
- Therefore, in order for the decentralized exchange to facilitate this trade – it would need to have at least 3,000 DAI in its DAI/ETH liquidity pool
- If it didn’t, then there would be no way for the trade to go through
And as such, decentralized exchanges need constant flows of liquidity to ensure that they are able to offer a functioning trading service to buyers and sellers.
Equal Amount of Tokens in a Trading Pair
When you deposit digital currency into a staking pool, you are only required to transfer one individual token. For instance, if you were to stake Solana, you would need to deposit SOL tokens into the respective pool.
However, as we noted above, DeFi yield farming requires both tokens to form a trading pair. Furthermore, and perhaps most importantly, you need to deposit equal amounts of each token. Not in terms of the number of tokens, but the market value.
- Let’s say that you wish to provide liquidity for the trading pair ADA/USDT.
- For illustrative purposes, we’ll say that ADA is worth $0.50 and USDT at $1.
- This means that if were to deposit 2,000 ADA into the staking pool, you would also need to transfer 1,000 USDT
- In doing so, you would be depositing $1,000 worth of ADA and $1,000 in USDT – taking your total yield farming investment to $2,000
The reason for this is that in order to provide functional trading services in a decentralized manner, exchanges require – as best as practically possible, an equal amount of each token.
After all, while some traders will look to swap ADA for USDT, others will look to do the opposite. Moreover, there will always be an imbalance of tokens in value terms, as each trader will look to buy or sell a different quantity.
For instance, while one trader might look to swap 1 USDT for ADA, another might wish to exchange 10,000 USDT for ADA.
Now that we have covered trading pairs, we can now explain how your share in the respective liquidity pool is determined.
Crucially, you won’t be the only person that provides liquidity for the pair. Instead, there will be lots of other investors depositing tokens into the yield farming pool with the view of making a passive income.
Let’s look at a simplistic example to help clear the mist:
- Let’s say that you decide to deposit funds into the BNB/BUSD trading pair
- You deposit 1 BNB (valued at $500) and 500 BUSD (valued at $500)
- In total, there are 10 BNB and 5,000 BUSD in the yield farming pool
- This means that you have 10% of the total BNB and BUSD
- In turn, you own 10% of the yield farming pool
Your share of the yield farming agreement will be represented by LP (liquidity pool) tokens on the decentralized exchange that you are using.
You will then sell these LP tokens back to the decentralized exchange when you are ready to withdraw your tokens from the pool.
Trading Fees Fund Yield Farming APYs
We briefly mentioned earlier that when buyers and sellers swap tokens from a yield farming pool, they will pay a fee. This is a standard principle of accessing trading services – irrespective of whether the exchange is decentralized or centralized.
As an investor in the yield farming pool, you are entitled to your share of any trading fees that buyers and sellers pay to the exchange.
First, you will need to determine what percentage the exchange shares with the respective yield farming pool. Second, you will need to assess what your share of the pool is – which we covered in the previous section.
In the case of DeFi Swap, the exchange offers 0.25% of all trading fees collected to those that have funded a liquidity pool. Your share will be determined by the number of LP tokens that you hold.
We offer an example of how to calculate your share of collected trading fees shortly.
How Much Can You Make From Yield Farming?
There is no single formula to determine how much you can make from yield farming. Once again, unlike staking, DeFi yield farming does not operate on a fixed interest rate.
Instead, the main variables at play include:
- The specific trading pair that you are providing liquidity for
- What your share of the trading pool amounts to in percentage terms
- How volatile the respective tokens are and whether they increase or decrease in value
- The percentage split that your chosen decentralized offers on collected trading fees
- How much volume the liquidity pool attracts
To ensure that you begin your DeFi yield farming journey with your eyes wide open, we take a close look at the above metrics in more detail in the sections below:
Best Trading Pair for Yield Farming
The first thing to consider is the specific trading pair that wish to provide liquidity for when engaging with DeFi yield farming. On the one hand, you might choose a pair based on the specific tokens that you currently hold in a private wallet.
For instance, if you currently own Ethereum and Decentraland, you might elect to provide liquidity for ETH/MANA.
However, it is wise to avoid choosing a liquidity pool just because you are currently in possession of both tokens from the respective pair. After all, why target a smaller yield when higher APYs are perhaps available elsewhere?
Crucially, it is easy, fast, and cost-effective to obtain the tokens that you need for your preferred yield farming pool when using DeFi Swap. In fact, it’s just a case of connecting your wallet to DeFi Swap and placing an instant conversion.
You can then use your newly purchased tokens for the yield farming pool of your choosing.
Higher Stake in a Pool Can Yield Greater Returns
It goes without saying that if you have a higher yield in a liquidity pool, then you stand the chance of earning greater rewards than other users of the same yield farming agreement.
For instance, then support that the yield farming pool collects $200 worth of crypto in a 24-hour period. If your stake in the pool amounts to 50%, then you will earn $100. On the other hand, somebody with a stake of 10% would earn just $20.
Volatility Will Impact the APY
Although we discuss the risks of impairment loss later, we should make it clear the volatility of the tokens that you are providing liquidity for can have a major impact on your APY.
Therefore, if you simply want to earn interest on your idle tokens without worrying about ever-changing market prices, it might be a good idea to opt for a stablecoin when yield farming.
For instance, let’s suppose that you decide to farm ETH/USDT. Assuming that USDT does not lose its peg to the US dollar, you can enjoy a stable yield without constantly having your APY adjusted by rising and falling prices.
Percentage Split From Decentralized Exchange
Each decentralized exchange will have its own policy when it comes to the percentage split offered on its yield farming services.
As we noted earlier, at DeFi Swap, the platform will share 0.25% of any trading fees collected for the pool that you have a stake in. This is proportionate to the stake that you have in the respective farming pool.
- Let’s say that you are staking ADA/USDT
- Your stake in this farming pool amounts to 30%
- On DeFi Swap, this liquidity pool collects $100,000 in trading fees for the month
- DeFi Swap offers a split of 0.25% – so based on $100,000 – that’s $250
- You own 30% of the collected fees, so on $250 – that’s $75
Another important thing to mention is that your yield farming profits will be paid in crypto as opposed to cash. Moreover, you need to check the specific token that the exchange will distribute your interest – as this can vary from one platform to the next.
Trading Volume of the Farming Pool
This metric is one of the most important drivers that will determine how much you can make from DeFi yield farming. In a nutshell, the more volume that a farming pool attracts from buyers and sellers, the more fees that it will collect.
And, the more fees that the farming pool collects, the more you can earn. For instance, it is all good and well to have an 80% stake in a farming pool. But, if the pool attracts a daily trading volume of $100 – it will likely only collect a few cents in fees. As such, your 80% stake is somewhat meaningless.
On the other hand, let’s say that you have a 10% stake in a farming pool that attracts a daily volume of $1 million. In this scenario, the pool will likely collect a significant amount in trading fees and thus – your 10% stake could be very lucrative.
Is Yield Farming Profitable? Benefits of DeFi Yield Farming
DeFi yield farming can be a great way to earn a passive income on your digital assets. However, this area of the DeFi space might not be suitable for all investor profiles.
As such, in the sections below, we examine to core benefits of DeFi yield farming to help you arrive at an informed decision.
Perhaps the most obvious benefit of DeFi yield farming is that other than selecting a pool and confirming the transaction – the entire process is passive. This means that you will earn an APY on your idle crypto tokens without needing to do any work.
And don’t forget, this is in addition to any capital gains that you make from your crypto investments.
You Retain Ownership of Crypto
Just because you have deposited your crypto tokens into a yield farming pool – this isn’t to say that you give up ownership of the funds. On the contrary, you always retain full control.
This means that when you eventually get around to withdrawing your tokens from the farming pool, the tokens will be transferred back to your wallet.
Huge Returns Can be Made
The overarching objective of DeFi yield farming is to maximize your crypto returns. While there is no knowing for certain how much you will make from a yield farming pool – if at all, historically, returns have superseded traditional investments by a significant amount.
For instance, by depositing funds into a traditional bank account, rarely will you generate more than 1% annually – at least in the US and Europe. In comparison, some yield farming pools will generate double or even triple-digit APYs. This means that you can grow your crypto wealth at a much quicker rate.
No Set-Up Costs
Unlike cryptocurrency mining, yield farming does not require any capital outlay to get started. Instead, it’s just a case of choosing a yield farming platform and depositing the funds into your preferred pool.
As such, yield farming is a low-cost way to generate a passive income.
No Lock-Up Period
Unlike fixed staking, yield farming is a completely flexible way to generate interest on your idle tokens. This is because there is not a lock-up period in place.
Instead, at any given time, you can withdraw your tokens from a liquidity pool at the click of a button.
Easy to Target the Best Farming Pools
As we briefly mentioned earlier, it is easy to target the best yield farming pools to maximize your APYs.
This is because if you do not currently have the required duo of tokens for your preferred pool, you can perform an instant swap on a decentralized exchange like DeFi Swap.
For instance, let’s suppose that you own ETH and DAI, but you want to make money from an ETH/USDT farming pool. In this scenario, all you need to do is connect your wallet to DeFi Swap and exchange DAI for USDT.
Risks of Yield Farming
While there are a plethora of benefits to enjoy, DeFi yield farming also comes with a number of clear risks.
Before proceeding with a yield farming investment, consider the risks outlined below:
The main risk that you might have come across when a DeFi yield farming investment is related to impairment loss.
The simple way to view impairment loss is as follows:
- Let’s say that the tokens in a yield farming pool attract an APY of 40% over a 12-month period
- During the same 12-month period, had you held both tokens in a private wallet, the value of your portfolio would have increased by 70%
- Therefore, impairment loss has occurred, as you would have made more simply by holding your tokens as opposed to depositing them into a liquidity pool
The underlying formula to calculate impairment loss is somewhat complex. With that said, the main concept here is that the wider the divergence between the two tokens held in the liquidity pool, the greater the impairment loss.
Once again, the best way to reduce the risk of impairment loss is to opt for a liquidity pool that consists of at least one stablecoin. In fact, you might also consider a pure stablecoin pair – like DAI/USDT. As long as both stablecoins remain pegged to 1 US dollar, there shouldn’t be an issue with divergence.
The value of the tokens that you deposit into a yield farming pool will rise and fall throughout the day. This means that you need to consider volatility risk.
For instance, let’s say that you decide to farm BNB/BUSD – and your rewards are paid in BNB. If the value of BNB has declined by 50% since you deposited the tokens into the farming pool, then you will likely make a loss.
This will be the case if the decline is greater than what you make from the yield farming APY.
While greater returns might be on the table, yield farming offers a lot of uncertainty. That is to say, you never quite know how much you will make from a yield farming exercise – if at all.
Sure, some decentralized exchanges display APYs next to each pool. However, this will only be an estimate at best – as nobody can predict which way the crypto markets will move.
With this in mind, if you are the type of individual that prefers to have a clear investment strategy lined up – then you might be better suited for staking.
This is because staking typically comes with a fixed APY – so you know exactly how much you are likely to generate in interest.
Is Yield Farming Taxed?
Crypto tax can be a complex area to grasp. Moreover, the specific surrounding tax will depend on a number of variables – such as the country in which you live.
Nonetheless, the consensus in many countries is that yield farming is taxed in the same way as income. For instance, if you were to generate the equivalent of $2,000 from yield farming, this would need to be added to your income for the respective tax year.
Furthermore, many tax authorities around the world require this to be reported based on the value of the yield farming rewards on the day they are received.
For more information about tax on DeFi products like yield farming, it is best to speak with a qualified advisor.
How to Choose a Platform for DeFi Yield Farming
Now that you have a comprehensive understanding of how DeFi yield farming works, the next thing to do is to select a suitable platform.
In order to choose the best yield farming site for your requirements – consider the factors discussed below:
Supported Farming Pools
The first thing to do when searching for a platform is to explore what yield farming pools are supported.
For instance, if you are holding an abundance of XRP and USDT, and you wish to maximize your returns on both tokens, you will want a platform that supports the XRP/USDT trading pair.
Furthermore, it’s best to choose a platform that offers access to a wide range of farming pools. This way, you will have the opportunity to swap from one pool to the next with the view of generating the highest APY possible.
We mentioned earlier that those with a lot of experience in yield farming will often move from one pool to the next.
This is because some farming pools offer more attractive APYs than others – depending on market conditions surrounding pricing, volume, volatility, and more.
Therefore, it is wise to choose a platform that not only supports yield farming – but token swaps too.
At DeFi Swap, users can exchange one token for another at the click of a button. As a decentralized platform, there is no requirement to open an account or provide any personal details.
You just need to connect your wallet to DeFi Swap and choose the tokens that you wish to exchange alongside your desired quantity. Within a few seconds, you will see your chosen token in your connected wallet.
You will make more money from yield farming when your chosen platform offers a higher percentage split on the trading fees that it collects. Therefore, this is something that you should check before choosing a provider.
While you might be under the impression that all yield farming platforms are decentralized – this isn’t always the case. On the contrary, centralized exchanges like Binance offer yield farming services.
This means that you will need to trust that the centralized platform will pay you what it owes – and not suspend or close your account. In comparison, decentralized exchanges like DeFi Swao never hold your funds.
Instead, everything is executed by a decentralized smart contract.
Start Yield Farming Today on DeFi Swap – Step-by-Step Walkthrough
If you wish to start generating a yield on your crypto tokens and believe that yield farming is the best DeFi product for this purpose – we will now get you set up with DeFi Swap.
Step 1: Connect Wallet to DeFi Swap
To get the ball rolling, you will need to visit the DeFi Swap website and click on the ‘Pool’ button from the left-hand corner of the homepage.
Then, click on the ‘Connect to a Wallet’ button. You will then need to choose from MetaMask or WalletConnect. The latter allows you to connect pretty much any BSc wallet to DeFi Swap – including Trust Wallet.
Step 2: Choose Liquidity Pool
Now that you have connected your wallet to DeFi Swap, you will need to choose the trading pair that you wish to provide liquidity for. As the upper input token, you will want to leave ‘BNB’.
This is because DeFi Swap currently supports tokens listed on the Binance Smart Chain. In the near future, the exchange will also support cross-chain functionality.
Next, you will need to determine which token to add as your second input token. For instance, if you wish to provide liquidity for BNB/DEFC, you would need to select DeFi Coin from the drop-down list.
Step 3: Select Quantity
You will now need to let DeFi Swap know how many tokens you wish to add to the liquidity pool. Don’t forget, this needs to be an equal amount in monetary terms based on the current exchange rate.
For example, in the image above, we typed in ‘0.004’ next to the BNB field. By default, the DeFi Swap platform tells us that the equivalent amount in DeFi Coin is just over 7 DEFC.
Step 4: Approve Yield Farming Transfer
The final step is to approve the yield farming transfer. First, click on ‘Approve DEFC’ on the DeFi Swap exchange. After confirming one more time, a pop-up notification will appear within the wallet that you have connected to DeFi Swap.
This will ask you to confirm that you authorize the transfer from your wallet over to the DeFi Swap smart contract. Once you confirm the final time, the smart contract will take care of the rest.
This means that both the tokens that you wish to farm will be added to the respective pool on DeFi Swap. They will remain in the farming pool until you decide to make a withdrawal – which you can do at any time.
DeFi Yield Farming Guide: Conclusion
In reading this guide from start to finish, you should now have a firm grasp of how DeFi yield farming works. We’ve covered key factors surrounding potential APYs and terms, as well as the risks associated with volatility and impairment loss.
To begin your yield farming journey today – it takes just minutes to get started with DeFi Swap. Best of all, there is no requirement to register an account to utilize the DeFi Swap yield farming tool.
Instead, just connect your wallet to DeFi Swap and choose the farming pool that you wish to provide liquidity for.