World of DeFi: Yield Farming

Table of Content

• Introduction
• Different types of Yield Farming opportunities
• What is APY and APR and how are they calculated?
• Pros and Cons of Yield Farming
• Yield Farming protocols on Solana
• Closing Thoughts

Introduction

In the past two blogs, we shed some light on yield farming and its relation to AMMs and liquidity pools. However, in this blog, we will dive deeper into what exactly yield farming is, how it works, the pros and cons of it, and much more.

Previously, we learned that yield farming is a process of using your funds via different protocols and receiving rewards in return. The use could vary from providing liquidity to lending your assets etc. The people involved in yield farming are called farmers and are rewarded for offsetting any losses or risks associated with such practices.

This craze behind yield farming started when Compound launched its token, COMP, which is a governance token. A governance token is a type of token that gives its holders the power to vote on decisions related to the protocol. A common practice to start a dApp is to reward tokens to liquidity providers or farmers, and this incentive helps attract farmers to the protocol.

Now, while this is easy to understand on a basic level, it may be harder to understand how it works and what goes on in the background.

So, let’s dive right into it!

How does it work?

As we already discussed above, there are multiple ways of farming yields and it's dependent on the type of protocol you are interacting with:

Liquidity Provider

There are several ways to farm yield, but one of the most common is providing liquidity to decentralized exchanges (DEXs) that use an automated market maker (AMM) model. In this case, users deposit two assets in a liquidity pool and earn a portion of the fees generated by every swap that occurs on the DEX. There are no capital requirements to become a liquidity provider; anyone can deposit their assets in a pool. However, it's essential to be aware of the risks associated with liquidity pools, such as impermanent losses, and to take steps to manage and reduce these risks.

Lending/Borrowing

Lending and borrowing protocols, such as Compound, allow users to lend their assets and earn interest on them, which the borrower pays. While these protocols may not offer high returns on your assets, they are generally considered safe and reliable places to put your assets to use and earn rewards.

Higher Order Lending/Borrowing

One way to earn interest is by borrowing assets from one protocol and using those borrowed assets to earn a yield on another protocol that offers a higher annual percentage yield (APY) or return compared to the interest you're paying. Yield farmers often choose this option, but it involves a complex chain of lending and borrowing, making it challenging to execute successfully.

One significant risk involved in this scenario is that your debt could increase substantially due to market volatility or a drop in the price of the asset you used as collateral. If this happens, the protocol where you borrowed the money may liquidate your account to recoup their funds.

Staking

Whether or not staking should be considered yield farming is debatable, and some people exclude it from their definitions. However, this article will include staking in our discussion of yield farming. Staking refers to depositing tokens to help improve the security and performance of a proof-of-stake (POS) blockchain. Examples of POS blockchains include Solana, Polkadot, and Ethereum (which recently switched from a proof-of-work to a proof-of-stake mechanism).

In a later blog, we'll cover the different types of consensus mechanisms in crypto.

These blockchains reward stakeholders for participating in the network's consensus mechanism by approving and confirming transactions on the blockchain.

What is APY or APR and how are they calculated?

If you've interacted with various yield farming protocols, you may have noticed that some use annual percentage yield (APY) to describe their returns, while others use annual percentage return (APR). While both terms refer to the returns you earn on your assets, there is a subtle difference between them.

APY stands for annual percentage yield, while APR stands for annual percentage return. Both terms refer to the returns you earn on your assets, but APY considers the effects of compounding, which can increase your returns over time. APR does not account for compounding.

It's important to note that these APY and APR values are estimated and can change over time. It is because if a particular yield farming strategy is successful and offers attractive returns, more people may try to participate in it, which can reduce the overall returns.

What are the Pros and Cons of Yield Farming?

While yield farming can offer attractive returns and help you grow your portfolio, the amount of profit you can earn depends on how much effort you put into it and how much risk you're willing to take. If you're looking for high-yield farming opportunities, you need to be quick and understand the risks involved with these strategies.

It's crucial to weigh the potential benefits and risks of yield farming before deciding whether it's right for you. While it can be a great way to earn more capital on your assets, it has challenges and potential drawbacks.

Crypto farming can be rewarding, but it's essential to be aware of the risks involved. A few factors to consider are volatile market prices and the potential for hacking and fraud before getting started.

It's essential to research and carefully weigh the potential risks and rewards before embarking on your crypto farming journey. By understanding the challenges and potential pitfalls, you can make more informed decisions and take steps to protect yourself and your investments.

Impermanent Loss

We've discussed impermanent losses (IL) in a previous blog, but it's worth reviewing again. IL refers to the difference in value between holding tokens in a liquidity pool versus keeping them in your wallet. If the assets for which you've provided liquidity change in value by more than you anticipated, you may face impermanent losses.

One way to reduce these losses is to use liquidity pools with one or both assets as stablecoins, reducing the risk of volatility and loss. Another option is to use single-sided liquidity (SSL) pools, where you only have to provide a single asset, eliminating the potential for IL.

It's essential to be aware of the potential risks associated with liquidity pools, such as IL, and to take steps to manage and reduce these risks. By doing so, you can protect your assets and maximize your returns from yield farming.

Regulatory Risks

Crypto is an unregulated space, and there have been several instances in the past year where legal issues have been raised against centralized finance (CeFi) companies, such as BlockFi and Celsius. If you're considering yield farming on CeFi protocols, managing your risk and only using funds you're willing to lose completely is essential.

It's crucial to be aware of the potential risks and challenges involved in yield farming and to take steps to protect yourself and your investments. By understanding the legal and regulatory environment and making informed decisions, you can reduce your risk and maximize your potential rewards from yield farming.

Rug Pulls/Exploits risks

While decentralized finance (DeFi) doesn't necessarily face regulatory risks, it does face the risk of rug pulls or smart contract exploits, which have been a significant problem in recent years. The collapse of Luna and Anchor is one well-known example of this. According to a report by ImmuneFi, the total amount of capital lost in 2022 was a staggering $2.3 billion, with Q3 2022 contributing $430 million to this total.

This type of risk is something other than what users can reduce on their own. Instead, it's up to the developers and contributors of the protocol to reinforce smart contracts and address any bugs or vulnerabilities. Stress testing and auditing by multiple firms can help reduce the likelihood of exploits and protect users' funds.

It's essential to be aware of these risks and to take steps to manage them when farming on DeFi protocols. Doing so can protect your assets and maximize your potential returns.

Yield Farming Protocols on Solana:

How can you earn yield farming rewards? Different protocols have different strategies and approaches to yield farming, so it's up to you to decide which ones are right for you based on your risk appetite and investment goals.

With that being said, let's explore some of the yield farming opportunities available on Solana.

Each protocol may have unique features and requirements, so it's necessary to research and carefully evaluate the potential risks and rewards before deciding which ones to use. Understanding the different options and making informed decisions can maximize your yield-farming returns.

Solend

Solend is one of the most prominent native protocols offering to lend and borrow on Solana. Before the collapse of FTX and a significant liquidation of an entity, it had over $450 million in total value locked (TVL).

Raydium

Raydium is an on-chain orderbook based AMM on Solana. You can earn a yield on Raydium by providing liquidity to its various pools. Before the collapse of FTX, it had over $100 Mil in TVL.

Francium

Francium is a yield strategy protocol on Solana that allows you to create your own DeFi/on-chain strategies and leveraged/hedged farming. Through Francium, you can also lend your assets and earn returns on them. It has a total value locked (TVL) of $15 million and offers a variety of ways to earn a yield on your capital. It would be advisable to read through their documentation and understand how each yield farming strategy works.

Hedge Labs

Hedge is a borrowing platform that provides access to 0% interest loans on Solana. You can put various assets, such as SOL, wBTC, and soETH, as collateral and borrow $USH, a stablecoin. The current total value locked (TVL) for Hedge is $2.08 million, which was $10.5 million before the FTX collapse.

GooseFX

GooseFX is a suite of decentralized finance (DeFi) and non-fungible token (NFT) protocols that could be considered Solana's super-app. It offers outstanding and sustainable yield opportunities through single-sided liquidity (SSL) pools, where there is no risk of impermanent loss.

You can check out our available SSL Pools at: https://app.goosefx.io/farm

Closing Thoughts

Yield farming is a way to earn rewards by locking up your capital. If you plan on holding your crypto investments long-term, using yield farming protocols can be beneficial. While many protocols offer attractive yields, not all of them are sustainable.

Suppose you're investing a significant amount of your capital. In that case, it's essential to research the protocols you're using and consider splitting your capital among multiple protocols as a healthy risk management practice.

Yield farming can be rewarding, but it's essential to be aware of the risks involved. From volatile market prices to the potential for hacking and fraud, there are many factors to consider before diving in. By understanding these risks and carefully evaluating the available yield farming opportunities, you can maximize your returns and minimize your risk.

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Disclaimer: The statements, proposals, and details above are informational only, and subject to change. We are in early-stage development and may need to change dates, details, or the project as a whole based on the protocol, team, legal or regulatory needs, or due to developments of Solana/Serum. Nothing above should be construed as financial, legal, or investment advice.