DeFi Yield Farming: A Beginner's Guide

INTRODUCTION

Yield farming refers to traders performing activities in DeFi in exchange for ‘yield’. These activities range from providing liquidity on a Decentralized Exchange (DEX), to offering collateral for a lending protocol. In return, a yield farmer seeks to earn interest payments from platform fees and other rewards such as governance tokens.

Yield farming often involves depositing crypto assets like WBTC, ETH and stablecoins into DeFi protocols. New products like real-world assets (RWAs), and flatcoins (stablecoins that accrue interest from underlying assets) allow holders to earn income on assets like US treasury bills (T-bills), and gold. This has led some traders to liken yield farming to interest-bearing bank accounts.

These opportunities aren’t without risks though. Unlike TradFi, DeFi is governed by smart contract code deployed on blockchains, introducing risks such as malicious code or protocol hacks.

SUMMARY

Yield farming involves depositing crypto assets into DeFi protocols to aid platform operations. In exchange, users receive rewards, such as a share of platform revenue or governance tokens.
There are several different types of yield farming platforms, which appeal to users with varying levels of risk tolerance.
Money markets, Liquid Staking Token (LST) protocols, and decentralized exchanges (DEXs) rank among the most popular yield farming platforms by Total Value Locked (TVL).
You can use Arkham to track deposits into DEXs and study the yield farming strategies top on-chain traders use.

WHAT IS DEFI YIELD FARMING?

‘Yield Farming’ is a phrase born out of the Summer of 2020 - DeFi Summer.

At that time, many new ‘DeFi’ protocols were being created and experimenting with new token distribution methods, as well as new ways of attracting users - one of which was yield farming.

The core idea is that a trader will provide their assets to a protocol - e.g. by depositing native ETH into a protocol smart contract. This increases the TVL (Total Value Locked) of the protocol, increasing its adoption and benefiting usage metrics, and in return the protocol emits a token to the trader who can then choose to hold the token, or swap it back to ETH. A protocol that does this is known as a ‘farm’. The trader can later withdraw their assets from the farm and look for other new farming opportunities once they believe the farm no longer provides sufficient yield.

During 2020 and 2021, a popular practice for protocols was ‘Liquidity Mining’. A new project would want traders to be able to swap into and out of its native token, but would not have sufficient capital to provide liquidity for its own protocol token. This led to the ‘Pool1/Pool2’ system. Pool1 is the process described in the previous paragraph, where traders receive tokens for temporarily depositing an asset in a smart contract. Pool2 is where traders pair the farmed token with ETH, deposit the pair as liquidity on a DEX, then deposit the Liquidity Provider (LP) token in the farm to receive a separate stream of farmed tokens. This is typically viewed as a higher-risk higher-reward strategy, as farmers take on significant directional risk with exposure to the asset they are farming. As such, this practice became vastly less popular from 2021 onwards, but the term ‘yield farming’ has persisted.

Today, ‘Yield Farmers’ are traders who aim to receive yield on their asset holdings by using them in DeFi, encompassing a broader range of strategies than the core ones described above. Rather than directly buying coins or making directional trades, yield farmers tend to employ strategies that allow them to retain the value of their underlying holdings while generating as much additional yield as possible.

HOW DOES YIELD FARMING COMPARE TO TRADITIONAL INVESTMENT METHODS?

Yield farming essentially offers a form of access to traditional-style investment methods like market-making and money markets in a decentralized environment with crypto.

While traditional investments often involve middlemen, in DeFi, smart contracts act as the middlemen. Using smart contracts as the intermediary should (in theory) improve efficiency as users do not need to deal with a bureaucratic organization and can directly undertake financial services through a simple UI and web app.

Ideally, once a developer deploys a smart contract, they have no say over who uses it, or when they use it. While this can vary in practice, as a developer may be able to maintain a backdoor, or use governance procedures to alter the actions of a smart contract, this principle is what underpins decentralized smart contracts and DeFi more broadly.

HOW DOES DEFI YIELD FARMING WORK?

DeFi protocols facilitate peer-to-peer (P2P) interactions between depositors (yield farmers) and platform users, using permissionless infrastructure. Permissionless means anyone can use these systems without intermediary authorization.

Protocols rely on traders with capital to deposit assets to support platform operations, like token swaps and leverage trading. This opens opportunities for yield farming; users who interact with the platform are charged a fee, and depositors (yield farmers) earn a share of the platform’s revenue.

For example, when users swap from one token to another, they need DEXs to facilitate the trade.

Yet DEXs themselves generally do not provide the liquidity required to support trading. Instead, they require third party Liquidity Providers (LPs) to provide assets to a ‘pool’ that traders can swap against. In exchange, LPs receive a share in protocol fees relative to their liquidity contribution.

DEFI YIELD FARMING PLATFORMS

Yield farming strategies and platforms vary depending on the assets held and a user’s risk tolerance. If a yield farmer prefers holding stablecoins such as USDC and USDT, they’ll likely consider different platforms and strategies compared to farmers holding more volatile assets like ETH and BTC.

Here's an overview of some of the most common types of protocols for yield farming and how they operate.

DECENTRALIZED EXCHANGES (DEXs)

Decentralized Exchanges (DEXs) allow users to swap from one crypto asset to another on-chain. When a user performs a swap, they pay swap fees, and a percentage of swap fees go to liquidity providers (LPs).

Here are the steps to providing liquidity on a DEX:

Select a trading pair (i.e. ETH/USD, BTC/ETH, etc.)
Deposit tokens into the liquidity pool at a 50/50 ratio (for example, 50% ETH, 50% USDC). In return, depositors receive LP tokens, representing their position.
Deposit the LP tokens into the associated “farm” to earn rewards in the form of trading fees and potentially other incentives (for example, governance tokens).

RISKS OF PROVIDING LIQUIDITY TO A DEX

Providing liquidity to DEXs was one of the top use cases for DeFi in its early stages. Over time, however, the market has become more aware of the various risks associated with providing liquidity to a DEX, challenging the idea that providing liquidity is a straightforward, risk-free passive yield generator.

These risks include:

Impermanent Loss (IL): Most DEXs use the Constant Product Market Maker (CPMM) formula of x*y=k. This is how the protocol determines the amount of tokens output from the liquidity pool for each swap. As traders swap to/from the assets in the pool, LPs end up with different amounts of assets from when they first deposited.
Inflationary rewards: Emissioned incentive rewards are commonly farmed and then swapped. The heavy sell pressure dilutes the value of earned rewards over time.
Unreliable interest rates: New farms advertising high APY may attract large amounts of new LPs. This can dilute the rewards, lowering the overall APY from when the farm was first created/discovered.

MONEY MARKETS

DeFi Money markets, akin to their traditional counterparts, are platforms for holding capital that is not currently being deployed by traders - referred to as ‘idle’ capital.

Money Markets (aka Lending Markets) allow users to supply crypto assets as collateral and earn interest on their deposits. Once deposited, users can let their idle funds sit and earn interest, or take out a loan against their deposits.

These markets serve several purposes:

Earn Interest on Idle Assets (Lend Assets): By depositing crypto assets, users can earn interest on them while they aren’t in use. This allows them to generate a form of passive income without actively trading.
Take Out a Crypto Loan (Lend assets and borrow against them): For users that need liquidity but don't want to sell their crypto holdings, they can use them as collateral to secure a loan. This way, users can access funds without having to sell their assets.
Short Assets (Borrow assets and swap to a stablecoin): Money Markets also enable users to borrow assets which users can then sell or exchange for stablecoins. This strategy allows users to profit from the potential decline in the value of the borrowed assets. For example, the user borrows 1 ETH, sells this for $3,000 and waits for ETH’s price to decline to $2,800, then pays back the 1 ETH loan and pockets $200. If instead of declining ETH’s price goes up, they don’t make money.

LIQUID STAKING TOKENS (LSTs)

Liquid Staking Tokens (LSTs) allow users to stake native gas tokens (like ETH, FTM, AVAX) and earn validator rewards from blockchain networks. This lets anyone earn interest on layer 1 (L1) tokens, without the setup and overhead costs of operating a validator.

On top of this, LSTs are “liquid” in nature, meaning they can be transferred or used for activities like lending to money markets or providing liquidity on a DEX.

At first, Liquid staking experienced slow growth, but as LST providers began to expand to different ecosystems, and more integrations were created, the market for LSTs started to pick up.

LEVERAGE TRADING LIQUIDITY POOLS (LPs)

Leverage trading involves borrowing money to make bigger trades.

For example, to perform a trade with 10x leverage, a trader might deposit $100 to purchase $1,000 worth of an asset. Using leverage will increase profits on successful trades, but will also magnify losses on trades that don’t work out, increasing the risk of total loss of capital.

The most common use of leverage trading in crypto is in derivatives, which include futures, perpetuals, options, and more. Derivatives trading allows users to speculate on the price of a particular cryptocurrency without owning it.

For traders to use margin, DeFi leverage trading platforms require liquidity providers. The provided liquidity is used to issue loans to traders and potentially serves as exit liquidity when traders make successful trades.

Here’s how it works: let’s say a trader wants to short ETH and bet on its price declining. When setting up the position, they may wish for more exposure to price movements, so they would enable margin. When a trader enables margin, they essentially take out a loan from the liquidity pool.

If ETH drops, and the user closes their position, profits are taken directly from the liquidity pool. But, if ETH rises, then the user would need to deposit more collateral to avoid liquidation, which would increase the supply of the liquidity pool.

Leverage trading liquidity pools are typically restricted to a curated list of whitelisted assets made available for trading. Protocols generally only support blue-chip assets (i.e. ETH, BTC, and USDC) for trading.

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While becoming a leverage trading LP introduces the risk of becoming first-loss capital, it decreases the chances of impermanent loss that traditional liquidity pools experience.

GOVERNANCE TOKEN STAKING

DeFi apps with governance tokens allow holders to stake tokens for rewards and platform perks. These perks range from boosted yields on the platform to voting power in protocol decisions.

For instance, Curve, an EVM-based DEX, lets users stake its governance token (CRV) for boosted interest rates on LP deposits and CRV rewards.

Staking interest rates depend heavily on the protocol, the project’s available token supply, and incentive emissions campaigns.

To better understand a protocol’s platform or project details, users can review their documentation and tokenomics.

YIELD AGGREGATORS

Yield aggregators use DEX liquidity pools and money markets to create automated strategies that leverage multiple pools. This creates new yield farming strategies and “1-click” deposit vaults which should require lower maintenance compared to more active strategies.

Beefy Finance (a popular yield aggregator) on Arkham

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Some of the most popular yield aggregators include:

REAL WORLD ASSETS (RWAs)

Real-world assets (RWAs) are DeFi products that collateralize assets like gold, U.S Treasuries and real estate to represent them on-chain. Their tokens are often called flatcoins. In practice, the assets are commonly held in a trust or with a partner institution and then tokenized to account for them on-chain. Onboarding these traditional assets onto public blockchains should reduce transaction times of acquiring the underlying asset, and can offer steadily yielding interest rates to DeFi users.

For instance, Ondo Finance’s OUSG is a stablecoin that accrues interest from US Treasuries.

Other notable flatcoins include:

hyUSD (Yield-bearing stablecoin launched on Reserve Protocol)
stUSDT (Tron Staked USDT)
ISC (International Stable Currency)

Since most flatcoins on the market are backed by US treasury bills, notes, and bonds they typically yield anywhere between 5-8% APY. One of the largest flatcoins, Savings DAI (SDAI) has a market cap of over $1.2 Billion, and provides holders with a yield of 8% APY.

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DEFI YIELD FARMING: OPPORTUNITIES

DeFi yield farming introduces new asset classes and investment methods, offering the following advantages:

Passive Income: With protocols like yield aggregators and RWA providers, DeFi yields are becoming more stable, allowing users to earn interest without significant manual management
Diversification: DeFi offers users a way to diversify their holdings with cryptocurrencies and earn interest rates that rival traditional banks.
Self-custody: With yield farming, users hold the private keys to the wallet with their crypto, guarding against risks like platform bankruptcy, as witnessed with Celsius.
Globalization: DeFi allows for tokenization, enabling developers to represent global assets like national currencies and real estate, as crypto tokens.

DEFI YIELD FARMING: RISKS

Though innovative, the DeFi market is still in its early stages, making it more susceptible to certain risks compared to conventional investment methods. In addition, when users yield farm, they control the custody of their crypto, meaning it’s their responsibility to ensure the safety of their holdings.

Common yield farming risks include:

Volatile Yields: DeFi yield farming returns can fluctuate due to market conditions, changes in protocol incentives, or shifts in user behavior.
Counterparty Risks: Since DeFi platforms operate without intermediaries, users risk interacting with unknown or unreliable counterparties (smart contract developers), potentially exposing them to scams or fraudulent activities.
Depeg Risks: Some DeFi tokens aim to maintain a stable value, but they can deviate from their peg due to various factors. These factors include insufficient liquidity or market manipulation, resulting in a loss of value for investors.
Smart Contract Risks: Smart contracts, while designed to automate transactions and eliminate intermediaries, are still susceptible to bugs or vulnerabilities, which can lead to loss of funds.

HOW TO RESEARCH YIELD FARMING OPPORTUNITIES

Arkham provides tools to create dashboards to track crypto holdings and transactions of people and entities. These dashboards can inform yield farming decisions in the following ways:

Stablecoin Watch – track stablecoins with the most trading activity, to inform yield farming strategies.
Track Top On-chain Traders – Use the holdings of top traders to inform yield farming strategies.

STABLECOIN TRACKING

Using Arkham’s Stablecoin dashboard users can find stablecoins with high trading volumes. When stablecoins experience high trading volume, DEXs usually provide higher interest rates for LPs.

After finding a qualifying stablecoin, users can provide liquidity directly to DEXs or use yield aggregators to automate the process.

Looking at the Stablecoin dashboard, we can see when stablecoins experience spikes in trading volume, in this case with DAI.

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Let’s use this as a lead for our search for a profitable yield aggregator vault.

First, let's look for DAI vaults on Beefy Finance. Beefy is a yield aggregator that automates yield farming strategies using LPs from various platforms. The platform also automatically reinvests earnings offering users strategies with low maintenance.

DAI is a type of stablecoin called a collateralized debt position (CDP). This means it's supported by crypto loans with more collateral than necessary, using approved assets.

A DAI vault with one of the highest APYs on Beefy is the MIM/DAI/USDC/USDT Vault via Ethereum.

MIM is a CDP stablecoin similar to DAI. While USDC and USDT are centralized stablecoins, pegged to a basket of cash and other assets.

Picking this Beefy Finance vault lets users benefit from the volume of trades conducted between each of these assets, on Curve, a DEX.

Taking a closer look at this vault, the vault’s APY has increased over the past few months (at the time of writing), and now has a 30-day moving average of 19.56%:

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TRACK TOP ONCHAIN TRADERS

Arkham’s dashboard to track top holders is perfect for general discovery. This dashboard provides the opportunity to find new coins to trade and possibly yield farm with.

For example, @TardFiWhale has recently been interacting with Pendle Finance, making deposits and withdrawals with WeETH.

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WeETH is wrapped Ether Fi-ETH, a yield-bearing form of ETH that earns yield from re-staking.

Pendle Finance is a protocol that allows traders to speculate on the future yield of yield-bearing tokens by splitting them into Principal Tokens (PT) and Yield Tokens (YT). This allows users to earn a fixed yield by selling the YT and holding the PT, or bet on the interest rate of a specific token rising by selling the PT to purchase more YT.

Looking at Pendle Finance’s wallet in Arkham, WeETH is the largest holding.

On Pendle Finance, eETH fixed yield via holding eETH PT tokens is 22% – which is relatively high for staked Ether.

Traders providing liquidity to Pendle Finance stand to earn a ~13% baseline APY (at the time of writing).

CONCLUSION

As of 2024, the DeFi market is still maturing, even after the booming years of 2020 and 2021. For instance, DeFi’s market cap of $98.548B is still >500x smaller than the U.S. Securities market at $50.8T.

Yield farming introduces an alternative investment method for cryptocurrency holders. However, traders should always examine the risks before executing a yield farming strategy. These risks range from smart contract risks to depeg risks, which can result in a loss of funds.

Before getting started with any of this, traders determined to yield farm should bear in mind some of the core risks:

Lack of safety guardrails - users need to self-custody their crypto, as well as recognize scams. Many scammers create fake DeFi frontends to try and trick users into signing malicious transactions.
Need for CEX onboarding - there is still no simple way for users to conveniently onramp and offramp funds without using a CEX. Consequently, DeFi users will often need to use a CEX to acquire crypto.
Poor UX in many DeFi applications/wallet products - Users may need to understand confusing frontends and wallet interfaces in order to succeed in DeFi. Unlike in CeFi, there is little to no customer support for when things go wrong.

To stay ahead of yield farming trends, traders can use analytics tools like Arkham Intelligence to help in their research. With Arkham dashboards, traders can spot the holdings and activities of sophisticated users early, and use that to inform their future movements.