Maximizing Returns with Yield Farming: A Beginner’s Guide

Contemporary investors have access to a much wider array of instruments than any of the previous generations of capital holders. TradFi solutions alone give everyone opportunities to focus on different asset classes and diversify their investments across a variety of options including stocks, bonds, and real estate. These are examples of traditional financial instruments, which include savings accounts, bonds, or stocks, and serve as a benchmark for comparing yields and risks with newer investment options. At the same time, a plethora of DeFi passive income opportunities became accessible to adventurous people seeking novel ways to generate money on the side. These DeFi opportunities often involve crypto assets, which are digital holdings such as cryptocurrencies and tokens that users can lock up or stake in protocols to earn interest, rewards, or governance tokens.

What Is DeFi Yield Farming?

This blanket term covers a wide range of interesting methods of using cryptocurrencies to earn interest. While many think that there is only one way to make money passively, many new opportunities have become available in recent times. Yield farming works by providing liquidity to DeFi protocols, allowing users to earn rewards such as interest, transaction fees, or token incentives.

Here are some examples of intriguing methodologies used by modern investors:

• Staking. PoS networks like Cardano and Ethereum give rewards for block generation assigning validator roles to people locking up funds, often for a set period to earn rewards. It can be quite expensive to become a validator with Ethereum demanding at least 32 ETH to create a node (roughly $80,000 as of August 2024). Rewards vary depending on the load and other factors. Investors can expect to earn around 4% APY which is comparable to generous bank deposits in the US (5% on average) and US treasury bonds (4.11% in 2024).

• Liquid staking. Some investors do not like the idea of locking up their funds for extended periods without the ability to use them. Protocols like LIDO give users equivalent in value stETH tokens in exchange for locked assets. stETH can be further used on partnered Dapps as collateral for loans in stablecoins or to be invested again using platforms like Kelp DAO. Users can also use other assets as collateral in various DeFi protocols. With LIDO generating a 2.76% base APY and Kelp DAO an additional 3.17%, you can expect a hefty 5.93%. 30-day averages have been even higher in August reaching 6.91%.

• Layering investments. The example above is a good illustration of how you can use stETH for other purposes. Let’s take an even crazier example with MakerDAO and its DSR system giving you sDAI which can be used as collateral on Ajna to borrow USDC at 1:1 rate. Acquired stablecoins, such as usd coin (USDC), can be further transferred to Coinbase which pays 5.2% for simply holding USDC in your wallet. The rate in MakerDAO is about 7%. With both stablecoins pegged to USD, you will have a sizeable 13.2% return.

• Lending. You can also join one of many lending protocols like Compound and Aave. The former is one of the most popular destinations for people who want to earn money or borrow digital assets against collateral. Returns on these platforms can be quite impressive. For example, Compound’s USDP pays 1.5% base APY, but the 30-day average was over 9.8%. Compound V2 also has a SUSHI with a 9.16% base APY. You can also focus on many stablecoins for up to 4.5% and receive COMP as a reward.

Yield farming work involves users depositing tokens into a yield farm or farm, providing liquidity, and earning rewards through interest, transaction fees, or token incentives.

In many cases, you will be able to compound interest by reinvesting rewards. One of the issues with many sophisticated approaches to capital allocation in the decentralized finance sector is that projects often have unbounding windows during which assets remain locked despite not producing interest. Users have to take out rewards or holdings within this time. If you are used to operating DeFi trading bots and other forms of automation, it will be more convenient to simply use platforms like Beefy Finance or Rivo.xyz which automatically collect and reinvest earned rewards. Automated protocols can help optimize farming work by reinvesting rewards and managing positions.

Exploring Yield Farming Risks

Using various techniques, you can achieve exorbitant interest rates. For example, using the SOL-DOGS pair ($23 million mixed TVL) brings in 3,078% with the vast majority of rewards paid in DOGS. Yield farming can offer high returns and potentially high returns, but these come with significant risks. This token is a memecoin that does not have real market value, but investing in it is akin to making a bet in a casino. There is a chance that DOGS will become the next DOGE and everyone will become rich overnight.

In reality, many strategies used by professionals in this sector are associated with incredibly high risks and should be used only by experienced investors who also have capital that they can lose without crippling themselves financially. The potential earnings and profit that attract investors to these strategies are often offset by the substantial risks involved. If you believe that using these risky approaches to squeeze out every bit of potential gains from your digital assets, consider the following risks:

• Impermanent loss. One of the most prominent issues in liquidity mining is when the prices of assets diverge from the entry price. If they are lower, the software automatically adjusts your holdings to match the ratio of assets and keep it the same. These corrections incur gas fees and change the value of your locked holdings. The loss is called impermanent because it can be recouped if prices recover. Nonetheless, a study showed that up to 60% of Uniswap stakers lose money due to this issue.

• Smart contract vulnerabilities. All DeFi protocols use smart contracts to conduct their operations in a trustless, permissionless manner. Many projects in this segment of the industry may issue faulty applications that have errors in their code. In some cases, software errors can lead to catastrophic failures. A user simply cannot avoid such issues and has to rely on the expertise of developers and founders. Many protocols run bug bounties and external audits to ensure that their technology is solid.

• Market volatility. Another problem with calculating potential ROI is that prices can vary greatly. One of the reasons why so many stablecoin pairs and stablecoin pools become popular is that users can easily compare the current value of their holdings to a reference like the US dollar, and these pools are considered a safer option for those seeking less volatility. In other cases, gains acquired due to compounding interest can be nullified by price fluctuations. For example, earning 5% on ETH is worthless if it loses 10% of its value during the same period.

• The lack of transparency. Some say that these strategies are a nightmare for newcomers since many novices simply cannot estimate potential profits due to the complicated nature of APRs in the DeFi ecosystem where rates are dynamic and can change depending on market circumstances and throughput as well as user activity. For example, Compound may pay up to 9% APR during some months and less than 1% when utilization drops significantly. Predicting these changes is close to impossible.

When engaging in methods like layering investments or leveraged farming, one has to remember about exponentially increasing exposure with each new layer. For example, if you lock in DAI and use sDAI to borrow USDC to keep stablecoins on the Coinbase wallet, you are relying on three different platforms with each exposing the portfolio to an additional risk of total failure. Some protocols are designed to provide more liquidity to the market, which can benefit both traders and liquidity providers.

Leveraged positions are also burdened with interest payments on debt. Borrow APR varies and is usually higher than lending APR. It is important to calculate investment costs appropriately and take these payments into consideration. Various DeFi protocols offer different features, including low fees and trading fees, which can impact overall profitability. Additionally, some protocols are designed to deliver optimized returns and help users achieve the highest yield possible through automation and compounding strategies.

A Complete Guide for a Newbie

You must select which type of this strategy seems most profitable and reliable. It is crucial to choose a reputable and user-friendly DeFi platform or platform, such as Aave, Uniswap, or PancakeSwap, to maximize returns and minimize risks. Capital holders can supply liquidity to decentralized exchanges, contribute to pools from which others can borrow, or simply toss assets around in the DeFi ecosystem endlessly layering investments on top of each other. With enough dedication and preparation, each method can work well in the long term.

Liquidity Pools and Mining

Liquidity pools are a crucial component of the DeFi ecosystem, serving as the backbone for many decentralized finance activities. In essence, these pools are collections of digital assets locked in smart contracts, which facilitate trading, lending, and borrowing on various DeFi platforms. When users deposit tokens into a liquidity pool, they become liquidity providers—often referred to as yield farmers—who help ensure there is enough liquidity for others to trade or borrow assets efficiently.

By participating in liquidity mining, yield farmers earn rewards in several ways. These can include a share of transaction fees generated by the pool, interest from lending activities, or even governance tokens that grant voting rights in the protocol. The annual percentage yield (APY) that liquidity providers receive depends on factors such as the pool’s performance, the types of assets deposited, and the overall demand for liquidity within the DeFi sector. As more users deposit tokens and provide liquidity, the total value locked in these pools grows, further strengthening the DeFi ecosystem.

Yield farming rewards can fluctuate, so it’s important for yield farmers to monitor their positions and adjust strategies as needed. By engaging in liquidity mining, users not only earn rewards but also play a crucial role in supporting the decentralized finance movement and facilitating trading across DeFi platforms.

Governance and Tokens

Governance tokens are at the heart of many DeFi protocols, giving users a direct say in the future direction of their favorite platforms. These tokens are often distributed as rewards to liquidity providers and yield farmers, incentivizing users to contribute liquidity and participate in the protocol’s ecosystem. By holding governance tokens, users can vote on important proposals, such as changes to transaction fees, protocol upgrades, or the introduction of new features.

Many DeFi protocols issue their own governance tokens, which can be traded on decentralized exchanges, providing an additional source of potential income for yield farmers. Beyond their voting power, governance tokens can also earn holders a share of transaction fees, interest, or even more tokens, depending on the protocol’s reward structure. This system not only empowers users to shape the evolution of DeFi platforms but also aligns their interests with the long-term success of the protocol.

For yield farmers and liquidity providers, accumulating governance tokens can be a strategic way to earn rewards while actively participating in the growth and governance of the DeFi ecosystem.

How to Maximize Yield Farming Returns

An investor can focus on mitigating risks or try to achieve the biggest APY possible. Let’s talk about the latter since it is simply more fun! Liquid staking appears to be the best way to achieve high rates on mainstream and stablecoins. Otherwise, you can look in the general direction of memecoins like DOGS, PEPU, or REVEEL on the ORCA DEX where you can expect 3,078%, 2,100%, and 625% respectively. Whether these numbers translate into real profits is a completely separate issue.

Here are some ways to work with something that actually make sense:

• Get some stETH on LIDO for 3.21% and wrap it to transfer to Merkl where you can use it to receive up to 25.5% in ARB and UNI rewards. These ARB and UNI rewards are examples of token rewards provided by DeFi protocols to incentivize participation. Stake ARB and wETH on Uniswap for 50% (30-day average) while transferring all UNI to Strike for 3.11% base APY and up to 5.24% in STRK priced at $5.97 as of the time of writing. Achieve up to 90% in mixed APY while earning a variety of different assets.

• You can also search for good returns on alternative networks like TON. Here, the biggest decentralized exchange is DeDust offering massive rewards in TON to individual providers supplying stablecoins like USDT (base APY is 1.5% while the rewards rate is over 30%). All TON earnings can be further invested in Storm Trade for an additional 30%.

• Farming native tokens is a good short-term strategy if you can cash out before the inflationary pressure completely demolishes the value. For example, Aerodrom on the Base network is offering 156% in AERO on OVN-USD+ holdings and 72% on USDC-AERO. These are impressive numbers. Investors bet that during the time they will be accumulating AERO its price won’t go down by more than 156% or 72% respectively.

These approaches work. The problem is that you cannot have a practice session by launching a crypto paper trading app and just experimenting with different settings and ideas. Instead, all these platforms require users to test things with real money. Whether you have the stomach for such games is quite important. Having first-hand experience is imperative. If you want to take a shot at becoming a master of passive income, make sure to start small and slowly test different methods and protocols.

Calculating Returns

Understanding how to calculate returns is essential for yield farmers looking to maximize their earnings. The two most common metrics are annual percentage yield (APY) and annual percentage rate (APR). While APR represents the simple interest earned over a year, APY takes compounding interest into account, which can significantly boost overall returns if rewards are regularly reinvested.

To accurately calculate APY, yield farmers should consider the interest rate offered by the pool, how often rewards are compounded, and the initial amount of assets deposited. However, it’s equally important to factor in the risks associated with yield farming, such as impermanent loss, smart contract vulnerabilities, and market volatility. These risks can impact the actual returns realized, sometimes offsetting the gains from high APYs.

Using yield farming calculators and conducting thorough research can help users estimate potential returns and make informed decisions. By understanding both the rewards and the risks, yield farmers can optimize their strategies and achieve more consistent results in the DeFi ecosystem.

Selecting a Pool

Choosing the right liquidity pool is a key step for yield farmers aiming to balance risk and reward. When evaluating a liquidity pool, users should start by researching the pool’s historical performance, the types of assets involved, and the current demand for liquidity. It’s also important to assess the security of the pool’s smart contract, as vulnerabilities can put deposited assets at risk.

Other factors to consider include the reputation of the protocol, the level of transparency provided, and the fees associated with participating in the pool. Yield farmers should also be aware of the potential for impermanent loss, which can affect returns if the value of deposited assets fluctuates significantly. By carefully analyzing these elements and aligning pool selection with their investment goals and risk tolerance, users can optimize their yield farming experience.

Thorough research and regular monitoring are essential for yield farmers to manage risk, maximize returns, and make the most of opportunities in the ever-evolving DeFi landscape.

DeFi Yield Farming Tips

Building a portfolio of positions on various protocols can be extremely challenging even for experienced veterans who have seen it all. Newcomers justifiably feel overwhelmed by the sheer complexity of the DeFi ecosystem and the thousands of different options available to them. If you feel out of the water too, here are some simple pieces of advice to follow:

• Do not chase high numbers. Your main goal is to consistently beat rates that you can get by simply staking BTC or ETH. Aiming at a return higher than what local banks offer is also a valid goal. Trying to ride a wave of hype by joining pools that give exorbitant APRs feels good but these platforms often have increased risks or shady founders.

• Work with time-tested protocols. DeDust and ORCA pay huge percentages on many forms of investments. However, these are still projects that must mature. On the other hand, Compound, Aave, Uniswap, and many other Dapps have been around for over five years. Choose projects with good track records and at least some notable history.

• Avoid memecoins. Incredibly high profitability goals seem lucrative and often attract newcomers who believe that they can make money on DOGS or PEPU. The problem is the rapid depreciation of prices that confidently outpace any interest rate. If you like lotteries and gambling, investing in these projects can scratch the itch. Otherwise, stick to stablecoins and mainstream assets like Ethereum, Bitcoin, and others.

• Use aggregators. Yearn Finance, Harvest Finance, Beefy, Rivo, and other platforms help investors manage their investments easier. These are non-custodial protocols strongly focused on providing valuable services and advice to users interested in funds to DEXes that pay well. Use these platforms for auto-compounding, strategy selection, or other perks.

• Adjust positions frequently. It is important to mix and shake your portfolio when it comes to profitability optimization. The vast majority of investors interact with at least a couple of digital assets throughout their careers. You will be dealing with all sorts of governance, LP, staked, wrapped, and other tokens! Regularly updating the composition of holdings is quite important.

Following these tips is a good starting point for newcomers who are seeking ways to generate passive income. We would like to add that if you like the convenience of working with a centralized exchange and do not oppose custodial services, it is a much better idea to join pools offered by these institutions or simply run a GRID trading bot to generate profits consistently.

The main takeaway

Focusing on earning money passively is a noble goal for any investor. If you are in the business of selling and buying cryptocurrency, you will have endless opportunities to efficiently allocate capital to the DeFi ecosystem and start making gains. However, you should never forget about the risks associated with lending assets or supplying funds to DEXes!