Yield farming is now one of the hottest topics in decentralized finance, and chances are you've already heard about the insane returns some yield farmers are making. But what is Yield Farming? How did it all get started? What are the examples of application? And what are the risks involved? We'll cover all these points in this article.

Yield farming:

So what concept lies behind this expression?

In practical terms, it's a way of trying to maximize a rate of return on capital by taking advantage of different DeFi protocols.

Yield farmers try to generate the highest yield through several different strategies. The most profitable strategies generally involve at least a few DeFi protocols such as Compound, Curve, Synthetix, Uniswap or Balancer.

If the strategy no longer works, or if a better strategy is available, yield farmers move their funds around. They may, for example, move funds between different protocols, or swap some tokens with others that generate more yield.

To compare with traditional finance, you can imagine people trying to find the best savings account with the best APY. APY stands for "annualized percentage yield" and is a common way of comparing rates of return on your money between different products. It's also a common way of expressing the returns of different yield-growing strategies.

When it comes to annual percentage yields, it's common to see traditional savings accounts posting annual percentage yields of around 0.1 %, while anything over 3 % is virtually unheard of these days. When it comes to yield farming, returns can be pretty crazy, with some strategies offering up to 100 % of APY. So how is this possible, and where's the catch?

There are 3 main elements that make such returns possible: liquidity mining, leverage and risk. Let's take a look at all of them before discussing some common strategies.

Liquidity Mining :

Liquidity mining is the process of distributing tokens to users of a protocol.

One of the first DeFi projects to introduce liquidity mining was Synthetix, which began rewarding users who helped add liquidity to the sETH/ETH pool on Uniswap with SNX tokens.

Liquidity mining creates additional incentives for yield farmers, as token rewards are added to the yield already generated by using a certain protocol. Depending on the protocol, these incentives can be so strong that farmers may be willing to lose their initial capital just to get more token rewards distributed, making their overall strategy very profitable.

A good example of this is the COMP token liquidity mining introduced by Compound, which initially gave higher rewards to users who borrowed assets with the highest APY. This encouraged farmers to start borrowing these assets, as the value of the COMP tokens mined compensated them for the high borrowing rates they had to pay.

COMP cash mining has become very popular and has been the catalyst for a wider spread of yield farming.

Leverage and risk :

The final element missing from the double- and triple-digit APYs is the high risk farmers are willing to take.

The first risk is linked to the previous element - leverage. All the loans farmers take out are overcollateralized, and the collateral provided is liable to be liquidated if the collateralization ratio falls below a certain threshold.

In addition to liquidation risk, we have the usual smart contract risks, such as bugs, platform changes, administration keys and systemic risks, e.g. sudden loss of Ether value.

In addition to this, we have some new attack vectors specific to DeFi, for example, attacks aimed at draining certain pools of liquidity.

All these risks put together are yet another reason why yield farming is so lucrative. It's a high-risk, high-reward game.