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Yield farming: What is it and how does it work?

An easy to read intro guide on Yield Farming on Solana

Yield Farming on Solana: intro guide

Ever wondered how you can earn passive income with Crypto? Let’s find out.

 

In the world of traditional finance, when you save a particular deposit amount in a bank over a period of time, you earn a certain interest which is typically referred to as the Annual Percentage Yield (APY) on your savings account. Traditional banks offer relatively modest APYs, often hovering around or below 1%, which means that over time, your savings grow slowly.

 

DeFi, on the other hand, presents more opportunities for protocol users to earn passively on their investment in the form of crypto with APYs as high as 100%. Quite remarkable, right? 

This activity of allocating capital to DeFi protocols to earn yield is called Yield Farming.

 

In this introductory guide, the following topics will be covered:

  • What is Yield Farming?

  • Types of Yield Farming.

  • Risks associated with Yield Farming.

What is Yield Farming?

Yield farming, often termed liquidity mining, is the activity of providing liquidity in DeFi protocols to earn rewards or incentives. In other words, yield farming is a way to earn passive income on your cryptocurrency assets by either lending, staking or LPing your assets to earn additional yield on them. By providing liquidity to a DeFi protocol, you become a liquidity provider (LP).

 

In this section, we’ll cover the following types of Yield Farming:

  • Liquidity Providing (LPing) on DEXs

  • Lending

  • Validator Staking

  • Liquid Staking

  • Staking Protocol Tokens

  • Farming Perpetual Funding Rates

 

Types of Yield Farming

Liquidity Providing on DEXs 

Liquidity Providing (LPing) in yield farming is the most basic type of Yield farming. It involves providing liquidity to a liquidity pool on a DEX. Liquidity provision is essential in DeFi for seamless operation and secure transactions which are regulated by smart contracts. 

 

As mentioned earlier, when you provide liquidity in a liquidity pool, you become a liquidity provider and can earn from the trading fees generated on that particular DEX. Liquidity providers are also, in some cases rewarded with Liquidity Provider Tokens (LPTs)  which can be used in various ways in DeFi.

 

To  participate in liquidity farming, you will need to:

 

  • Choose a DeFi protocol: There are a lot of DeFi protocols that offer LP pools and opportunities within the ecosystem. Factors such as already existing liquidity, security, and reputation of the platform, and the reward options offered by the different platforms should be of importance. Some popular options on Solana include Raydium and Orca which operate similarly to Uniswap on Ethereum. 

  • Supply liquidity: To supply liquidity, select a protocol and deposit your crypto assets into a paired pool via your wallet. This liquidity allows users to swap and trade between these assets on the DEX, and in return, liquidity providers earn a portion of the trading fees. Several DEXes, like Kamino Liquidity Vaults and Orca Whirlpools, offer CLMMs on Solana, expanding the options for liquidity provision.

(Read more about how AMMs and CLMMs work here)

  • Claim Rewards: After LPing on a particular DEX, you can now start earning rewards from the fees generated and incentives offered protocol. 

Lending

Lending in DeFi involves the process of loaning out your cryptocurrency assets to borrowers in order to earn interest on the loans paid back. It is basically a way to earn interest on your cryptocurrency by lending it to others. Lenders can earn very high-interest rates, sometimes over 15% per year. 

 

Decentralized lending and borrowing allows anyone to collaterize their digital assets to get loans, or earn interest on their assets by lending them out to lending pools.This is possible without the need for a bank or a credit check.

 

DeFi lending protocols are generally over-collateralized. It involves borrowers depositing more assets as collateral than the value of the loan they intend to borrow. This acts as a safeguard and helps minimize the risk of insolvency. Smart contracts play a pivotal role in managing over-collateralization as they ensure that collateral remains locked until the borrowed funds are repaid. If a borrower defaults, the smart contract can automatically trigger the liquidation of the collateral, protecting the lender's interests.

Staking

Staking is a way to support a blockchain network by locking up your cryptocurrency. This helps to secure the network and validate transactions. In return for staking your crypto, you may be rewarded with additional cryptocurrency. The amount of rewards you receive will vary depending on the network you are Staking on and the amount of crypto you are staking. Staking is only possible on blockchains based on the Proof-of-Stake (PoS) consensus mechanism such as Solana, Ethereum, and Cardano.

 

When you decide to stake your cryptocurrency, the first step is to select a staking pool or a validator. There are numerous validators across various PoS blockchains. Find a list of the different validators under Solana at Staking.kiwi 

 

A staking pool as the name suggests, is a group of investors who pool their cryptocurrency together. The pool is run by an operator who is in charge of managing and allocating the stakes on behalf of the Stakers. This operation and management is the function of a validator. This allows users without an in-depth knowledge of how the blockchain network works to participate and earn rewards. 

 

The investor deposits their crypto into the pool to participate in a staking pool. The cryptocurrency deposited is usually the native token of the blockchain. The validator then stakes the pooled cryptocurrency on the blockchain and the stakers earn rewards proportional to the amount of cryptocurrency they deposit.

 

The amount of rewards earned on staked crypto is determined by a number of factors. One of which is the amount of the particular cryptocurrency you’re staking. Your rewards are also affected by the length of time your assets have been actively staked or locked up in a pool. Other factors like the total number of coins staked on the network and inflation rates affect staking rewards. 

 

For more detailed information on POS Staking and Consensus Mechanisms, read here.

 

In addition to pooled staking and validator staking, there are a few other types of staking in DeFi that are worth exploring and also yielding massive returns such as:

Liquid Staking

One of the limitations of regular staking is that the staked tokens cannot be traded or used as collateral to earn more yield across the DeFi ecosystem. This is the problem liquid staking aims to solve. 

 

Liquid staking is the activity of staking crypto assets in a PoS blockchain while retaining access to liquidity. Compared to traditional staking where your tokens are locked up for a stipulated period, you are issued Liquid Staking Tokens (LSTs) which serve as a receipt or proof of stake of your crypto assets. 

(top ten LSTs on solana)

 

By transforming staked assets into tradeable tokens(LSTs), liquid staking provides users with increased liquidity, flexibility, and composability compared to native staking methods. As a result, users can freely trade, lend, or borrow against their staking derivatives in various DeFi applications to generate additional yield and reward opportunities.

Staking on Solana

Solana uses a delegated Proof-Of-State network which means holders of Solana coins (SOL) can delegate them to a validator to earn rewards. This stake on validators enables them to validate transactions and add new blocks to the blockchain based on the amount of SOL staked. It also contributes to the overall security and efficient operation of the network.

 

Staking your SOL will generate rewards based on the size of your investment. These rewards equate to roughly 8% APY on your staked SOL and differ from validator to validator.

Even though you stake your coins through a validator, they remain securely in your control at all times. You can unstake your coins at any time, but there may be a short delay before you can access them. This delay is called an  Epoch.

 

(Different Validators on Solana and their APYs)

 

While the validation system of Solana itself is fairly complex, the process of staking your SOL is surprisingly simple. Here’s a detailed guide on Staking on Solana.

 

Staking STEP for xSTEP

Staking in DeFi isn’t just limited to securing proof-of-stake networks, it can also be used for other purposes, such as earning rewards from a protocol. For example, staking STEP lets stakers earn rewards generated by the Step Finance protocol. When users stake their STEP, they receive xSTEP which represents their share of the staking vault. The xSTEP tokens are transferable like any other SPL token, so they can be used in other DeFi protocols as a yield bearing asset to earn additional yield.

 

The unique thing about xSTEP is that you don't need to actively claim your rewards. Instead, your rewards are automatically added to your balance when you unstake and you get back more STEP tokens than you initially staked.

 

Click here for a detailed guide on staking STEP for xSTEP.

Farming Perpetual Funding rates

Funding rates are a mechanism used in perpetual contract trading to ensure that the price of a perpetual contract tracks the spot price of the underlying asset as closely as possible. Funding rates are paid between long and short traders, depending on the difference between the perpetual contract price and the spot price.

 

If the perpetual contract price is higher than the spot price, long traders will pay funding rates to short traders. This is because long traders are betting that the price of the underlying asset will go up, and they are willing to pay a fee to short traders to keep the perpetual contract price aligned with the spot price.

 

Conversely, if the perpetual contract price is lower than the spot price, short traders will pay funding rates to long traders. This is because short traders are betting that the price of the underlying asset will go down, and they are willing to pay a fee to long traders to keep the perpetual contract price aligned with the spot price.

 

How to Farm Perpetual Funding Rates

 

There are two main ways to farm perpetual funding rates:

 

Market-making: Market makers provide liquidity to perpetual contract markets by placing both long and short orders at different prices. When the perpetual contract price moves in favor of one of their orders, they make a profit. However, market makers also have to pay funding rates when the perpetual contract price moves against their orders.

 

Directional trading: Directional traders bet on the direction of the perpetual contract price. If they believe that the perpetual contract price will go up, they will open a long position. If they believe that the perpetual contract price will go down, they will open a short position. Directional traders can make money even if the perpetual contract price does not move in their favor, as long as they are able to manage their risk effectively.

 

Risks Associated With Yield Farming

Yield farming is a high-risk, high-reward investment strategy that can offer significantly higher returns than traditional savings accounts or other investment opportunities. However, it is important to know the risks involved before participating in yield farming.

Smart Contract Risks

Yield farming relies on smart contracts, which automate the lending, borrowing, and trading of cryptocurrency assets. However, smart contracts are not immune to vulnerabilities or bugs. If there is a flaw in the smart contract’s code, it can be exploited, leading to substantial financial losses for yield farmers. 

Smart contract risks can be mitigated by properly researching DeFi protocols before depositing in them. It’s also essential to assess the project’s audit reports, the development team, and the security level of the protocol before making a choice.

 

Impermanent Loss

Impermanent loss is a risk associated with LPing on DEXs. It occurs when the price of the assets deposited in a pool changes relative to when they were deposited. The amount of impermanent loss that you experience will depend on the size of the price change and the ratio of the assets in the pool. The greater the price change and the more uneven the ratio of the assets, the greater the impermanent loss will be.

 

There are a few ways to mitigate impermanent loss:

 

  • Choose balanced liquidity pools: Liquidity pools that have a 50/50 deposit ratio of the assets are less prone to impermanent loss.

  • Use a stablecoin: Pairing one of your assets with a stablecoin, such as USDC, can help to reduce your risk of impermanent loss.

  • Rebalance your portfolio regularly: Rebalancing your portfolio means selling some of your assets that have appreciated in value and buying more of the assets that have depreciated in value. This can help to reduce your overall risk of impermanent loss.

 

It is important to note that impermanent loss is only realized when you withdraw your liquidity from the pool. If the prices of the assets in the pool return to their original levels before you withdraw your liquidity, you will not experience any impermanent loss.

 

Market Volatility

Crypto markets are volatile, which can affect the value of your tokens and the rewards you earn from yield farming. Sudden price swings can reduce the value of your deposits and rewards, making your farming strategy less profitable. Investors can manage these risks by diversifying their portfolio and doing adequate research before looking to farm yield from any protocol.

 

Conclusion

DeFi is groundbreaking, and with the advent of yield farming, you can passively earn yield on your cryptocurrency assets by using the right protocols and implementing the right strategies. Yield farming is a powerful tool for earning passive income in the DeFi space. However, it is important to understand the risks involved before getting started.

 

Despite the risks, yield farming can be a great way to earn passive income and support the DeFi ecosystem. If you are considering yield farming, be sure to do your research and choose a strategy that you are comfortable with before participating.