What is Yield Farming?
While the specifics can vary, 'yield farming' is a term that refers to the activity of lending crypto assets to protocols, platforms, or chain validators with the intent of generating additional income on the provided capital.
Liquidity providers can engage in yield farming with collateral in the form of native protocol tokens, stablecoins, application tokens, trading and lending positions (themselves represented as tokens), NFTs, and effectively any type of digital asset on a blockchain. The variety of options makes yield farming a large and complex corner of the DeFi universe with multiple sub-sectors in its own right.
In its most simplified form, yield farming is no more different than any other financial incentivization mechanism readily present in TradFi (i.e. lending assets for a passive return). The caveat is that the interoperability of DeFi applications gives birth to an unusually wide array of opportunities waiting to be unearthed by investors, and that factors such as smart contract risk and fund custody present different risk profiles for yield farmers. However, for users who are willing to dive into this exciting field of decentralized finance, there's an abundance of opportunities investors can choose from to bring productivity to their idle assets.
Let's take a look at key concepts and principles beginners need to know to get started making passive income with their crypto assets!
Why Yield Farming? The Benefits to Both Sides
Both liquidity providers and platforms offering rewards have their own motivations when it comes to yield farming. Investors enjoy the additional income on their crypto holdings while networks and applications leverage user liquidity for their unique purposes, such as ensuring network security with the funds or accessing capital for lending, trading, and creating network effects for their services. Refer to this article by Jump Trading, one of the leading institutional participants in DeFi, in which they extensively explore the incentives allocated to yield farming.
Yield Farming Strategies
Every investment strategy mentioned here essentially operates as a passive income strategy. However, given how quickly things can change in the yield farming world, hunting for the most profitable strategies can often feel like a full-time job, or active income generation. Indeed, there are professional yield farmers who pursue complex strategies to obtain the highest yields. Thus we can consolidate the approach to yield farming under two arbitrary categories: effortful and effortless.
In fairness, the effort input is more of a spectrum than two rigid categories but let’s use these two for the sake of simplicity. The effortless approach is settling with on-chain opportunities similar to those mostly present in traditional finance: slow-paced yield farming with a relatively stable, steady, and secure income inflow and without the need for a constant search for better yields. Staking at the protocol level for network security, lending and LPing with stablecoins or high marketcap cryptocurrencies, following some time-tested strategies, and farming on centralized exchanges constitute these opportunities that don’t require investors to stomach high risk or try to come up with elaborate strategies or catch fringe opportunities.
Effortful yield farming, on the other hand, is fast-paced, risk-on, and usually involves a mercenary approach to capital. It requires finesse in managing funds and a certain level of sophistication to navigate both the market and technology-related risks. Activities born through this approach offer lucrative results but demand a higher effort input and risk tolerance from the investor in return. Yield farming with high-risk assets like governance tokens and NFTs, searching for pool 2s, and combining numerous services to further financialize assets are some examples of high-effort farming.
Those who want to become yield farmers must know the differences between the two approaches and pursue strategies that fit their investment goals and risk appetite. Since it’s bear, investors willing to optimize for protection against volatility and minimize application-specific risks can refer to our article laying out the best stablecoin strategies for surviving the bear.
Below is a bird’s-eye view of the yield farming space, exploring some of the popular strategies investors can follow. Please note that some of these strategies may become obsolete with applications deprecating incentives.
If investors are holding native tokens for chains with inflationary tokenomics, staking may be crucial for protecting themselves against dilution and earning rewards on top. Staking is a relatively more secure way to utilize L1 tokens compared to lending and providing liquidity. One of the leading thought leaders in the industry, Arthur Hayes, goes as far as to call the staked Ether a commodity-linked bond. Here are some of the vanilla staking strategies.
- Staking native protocol tokens on PoS blockchains to participate in chain security and getting rewards for block validation. Investors who cannot afford to stake at the protocol level can stake ether on centralized exchanges or on SaaS (staking-as-a-service) applications like Lido, RocketPool, or Ankr; stake SOL on Lido or Marinade; stake the native tokens for Cosmos Ecosystem chains like Secret Network, Osmosis, and Cosmos Hub on Kepplr Wallet app (examples can be expanded to every PoS chain) and can start earning rewards on their deposit.
- Liquid representations of the staked positions such as stETH from Lido allows investors to use their locked assets in DeFi while contributing to the block validation. A well-adopted strategy for investors can be achieved through wrapping the stETH to wstETH, matching the amount with Wrapped Ether (WETH), and depositing it to Balancer’s wstETH-ETH pool as liquidity, increasing their total earnings.
- There is also a variation of staking not related to a technical security feature though one can argue that it contributes to the stability of applications and thus has a role in maintaining network effects and the security of services. Staking application tokens like ILV of Illuvium, CRV of Curve Finance, and BAL of Balancer Finance by locking funds for both financial and application-specific benefits belongs to this type of staking. If an investor holds a stakeable ERC20 token and doesn’t use it on any other DeFi service, this might be a good way to earn on their assets.
To learn more about ETH staking specifically, check out Nansen's guide!
Investors can lend stablecoins, majors (i.e. ETH and BTC), and alt native tokens (e.g. SOL and AVAX) on decentralized money markets like Aave and Compound, or alternatively, use platforms like Maple Finance and Goldfinch to lend to vetted businesses. There are many lending markets optimizing for different ranges of assets and offering countless on-chain opportunities. However, the more an investor strays further from battle-tested applications the more they need to pay attention to risks.
Apart from choosing less popular platforms, another risk-on strategy with decentralized money markets is lending volatile application tokens (e.g. MANA and BAT) If an investor plans to hold a token with the anticipation of an increase in price, it might be better to have these assets work for them rather than keeping them in their wallet doing nothing and probably getting diluted with token emissions or unlocks.
Investors can lend their assets to decentralized exchanges, increase the capital efficiency of the platforms, and get a portion of the trading revenues generated on their assets. Although liquidity provision is a vast land with a risk spectrum ranging from one of the safest heavens in DeFi (stablecoin pools) to the most degen opportunities on the market, it also hosts strategies with the most financial upside potential. Here are some of the examples readers can choose from:
- Providing liquidity to AMMs such as Uniswap and Sushiswap on EVM-compatible chains and L2 platforms; to Orca, Serum, and Raydium on Solana, TraderJOE on Avalanche, or on application-specific DEX chains like Osmosis and Thorchain. According to Nansen’s DeFi Paradise, Uniswap remains to host the most preferred pools by the smart money on Ethereum.
Alternatively, providing liquidity to CLOB DEXs like dYdX and Injective Chain or yield farming on option services like Hegic, Opyn, and Dopex.
- Depositing stablecoins and other major assets like ETH, stETH, BTC, and WBTC to stableswaps like Curve Finance as liquidity and getting compensated with trading rewards is another popular strategy. The ecosystem built around Curve Finance also introduced additional steps to this strategy. Users can take their LP tokens representing their lending position, lock them in CRV gauges or stake them to applications like Convex Finance or yveCRV vault on Yearn Finance, and increase their rewards.
A similar formula can be followed on Avalanche via Platypus Finance & TraderJOE and Vector Finance or on Solana via Saber Finance and Sunny.
- Looking for incentivized pool 2s with lucrative (and sometimes ludicrous) yields. This is a highly competitive and predatory zone which is often referred to as the PvP part of crypto as in some cases it directly emulates a Ponzi scheme where the application’s sole purpose is to reward the first participants with subsequent exit liquidity.
New applications attract capital with three, four, and occasionally ten or more digit APYs rewarded in their application token. Some pool 2s are sustainable while some are like hay fires, glowing spectacularly for a brief time until incentives dry out. That’s why they require extensive risk analysis, active monitoring, and extreme agility from the investor to be considered a pursuable farming strategy.
To know more about the returns on these pools and the ways to look for pool 2s, here is an example demonstrating how 0xYakitori harnessed the power of Nansen to follow the smart money and found a Pool 2 with mouthwatering returns.
Certain DeFi services provide automated fund management to investors with predetermined strategies executed through smart contracts. Here are some of the examples:
- Using yield generation services like Yearn Finance on Ethereum and Yield Yak on Avalanche to have an automated strategy to execute more complex farming strategies on behalf of them.
- Using automated option strategy platforms like Ribbon Finance, Katana, and Friktion.
- Referring to automated liquidity management platforms like Arrakis Finance and Gamma Finance for providing liquidity to next-generation AMMs (e.g. Uniswap V3) and having the position managed by these platforms.
Although it is a rather nascent industry, NFT-Fi offers investors several tools to get some passive returns on their assets.
- Staking the NFT for fungible tokens is one of the common earning strategies. Several projects (mostly games) design their tokenomics to use both NFTs and fungible tokens. Nyanheroes, a game on Solana, has been running a staking program through which the holders of the collection have been mining the rights to future fungible tokens through staking their NFTs. Another example is that the NFT lending platform JPEG’d offers its fungible token through staking JPEG cards.
- One other more generalized opportunity for the NFT holders is to deposit their assets to NFT lending platforms like NFTX to boost the liquidity for vaults and gain in return.
Apart from these examples, the next level of yield farming is the constant search for niche opportunities, discovering wild pool 2s, and extracting as much value from the composability of DeFi. Meaningfully farming with these activities is usually more suited for knowledgeable investors with relatively small capital sizes since both the risks entailed by the activities and the size of the funds narrow down the target segment who can join.
Similar to the Curve and stETH strategies mentioned above, users can create elaborate yield farming combinations and boost their earnings. The following one from @lemiscate is a good example for these strategies.
Or here is another example from @FabienC_dev combining services to increase yields: Lido to stake ether and APwine, a platform to speculate on yields, to provide stETH as liquidity.
Possibilities are limited to investors’ risk appetite. Put interest-bearing tokens to do leveraged yield farming on platforms like Alchemix and Apricot Finance, bridge your BTC through WBTC and combine Badger, Curve, and Convex for maximum results, or introduce an additional step to the Curve-Convex yield farming strategy with ButterflyDAO. Or opt in for a relatively safer option and seek profitability through complexity on stablecoins.
Yield Farming Risks
Most of the risks mentioned in our complete guide to DeFi article hold for yield farming activities, with the most emphasis should be put on the smart contract risk, the risks coming from exposure to highly volatile assets, rugpulls and scams, and the risk of impermanent loss.
Using majors instead of stablecoins introduces the risk of volatility. Meanwhile, using app tokens or the tokens for alt L1s amplify the risk of volatility as they are relatively less liquid and have concentrated ownership. Yield farming on less popular platforms with questionable auditing practices comes both with the risk of scams and exploits. On top of that, the more entrenched is an investor in a yield farming strategy, the more careful they need to be to outsmart the threats as the application-specific risks are cumulated by combining different DeFi services.
How can Nansen Help You Maximize Yield Farming Income?
Nansen sheds light on how the maestros of the craft orchestrate their yield farming strategies and therefore is an effective tool for building and tracking strategies. Simply heading to the Smart Money section and filtering it for “Smarter LP” allows users to see the contracts most profitable liquidity providers recently interacted with, which reveals the most popular pools and the newest opportunities they discovered.
Users unleash Nansen to its fullest to level up their yield farming game. Here Nel explains how using Nansen’s Hot Contracts feature allows finding patterns in smart money activity, entering positions before the market, and exiting just before the bell tolls for the pool. Also, here Nel again, specifically talking about avoiding risks in liquidity pools.
Alternatively, Nansen’s DeFi paradise allows users to rank the liquidity pools by the number of smart money holders to see the most preferred pools by the profitable wallets or rank by the smart money ownership to see the fresh opportunities discovered by these wallets.
Like investing, trading, or any activity that can be placed on a scale of risk tolerance, yield farming is also can be simple or complicated depending on investors’ approach. Subscribe to Nansen’s newsletter to learn more about the latest opportunities and keep yourself up-to-date with farming strategies.