What is yield farming?
The traditional way to farm yield is through providing liquidity into a protocol. It is essentially committing a cryptocurrency pair into a liquidity pool in exchange for yield. Liquidity providers are then able to earn a percentage of the pool reward based on the amount they contributed to the pool.
Liquidity providers have to provide a cryptocurrency pair in equal value to the pool. For instance, if the liquidity provider wants to participate in the USDT-ETH pair, US$100 worth of ETH and US$100 worth of USDT must be deposited into the pool.
In return for providing liquidity to the protocol, liquidity providers earn trading fees and crypto rewards from the platform. Rewards are distributed based on the proportion of liquidity they contributed to the pool.
Some examples of yield farms include
Things to consider before committing into a Liquidity Pool
- Project fundamentals – Naturally, projects with strong teams would have a better potential to do well. Receiving funding or some form of backing from investors or the main ecosystem itself is also a positive sign. Look at the project’s community, and their marketing efforts. The best projects cannot succeed without either.
From the project’s Telegram and Discord channels, you can get a sense of how supportive the members are. You can also discern if they are there for the long haul, or just for a quick flip. You can also get a good sense of the project’s marketing success on their Twitter or other social channels. Bonus points if reputable figures in the space are following and tweeting about them!
- Technical aspects – In most liquidity pools, you would be earning rewards in the form of its native project tokens. Hence it is crucial to understand where the value of the native token comes from. Ideally, the native token has multiple use cases in the project (e.g. governance, new liquidity pool pairing, new project staking). This way, there will be higher incentives for users to hold the token and maintain its price.
Finally, some key metrics I will look at are its TVL, APY and potential Impermanent Loss. TVL, or Total Value Locked, refers to the total value of assets that are being staked in the specific protocol. Generally, when the TVL is consistently high, it suggests a healthy protocol, with the trust of many users.
- Impermanent Loss – Simply put, it is the difference between holding 2 assets separately without adding them into the liquidity pool, versus the total value you would have received (including rewards) if you contributed them into the liquidity pool.
You provided liquidity of 2 tokens, Token A and Token B in a liquidity pool.
Token A was initially $100, while Token B was $5. You provided 5 units of Token A, and 100 units of Token B.
Token A’s price rose 50% in value, to $150. Token B’s price remained the same.
To maintain a 50/50 value balance between the 2 assets in the liquidity pool, the units of Token A falls, and the units of Token B increases.
You now own 4.08 units of Token A, and 122.47 units of Token B. This adds up to a total value of $1,224.74.
However, you would have earned 2.02% more if you held tokens A and B separately, compared to if you entered them into the liquidity pools. This is impermanent loss. If you want to calculate potential impermanent loss from liquidity pools for yourself, you can try out this calculator.