If you’re reading this, you've probably heard of a craze that took the crypto world earlier this year: "DeFi Casino Summer".
At the center of it all was the introduction of "yield farming", a practice that was generating 1000+% APYs at its height.
In this article, I explain what yield farming is, how to do it, and what the risks are. Even if you're not interested in participating in the casino, understanding how to yield farm will teach you the skills you need to participate in DeFi - a permissionless industry that's antifragile and growing at a torrid pace.
What is yield farming and why should you care?
Yield farming is the concept of supplying liquidity to a decentralized exchange, and in turn collecting a small fee.
Additionally, you get a token for supplying this liquidity and if the project you are supplying liquidity to is in a "incentivization" stage, you can "stake" that token and earn rewards from the project.
You make money on both liquidity fees and staking rewards.
These combined earnings are what we typically refer to as yield farming.
Yield farming allows you to acquire a potentially speculative asset, without trading for it.
Here are the hurdles you need clear before you can Yield Farm:
If you've never bought Ether, this is you first hurdle. Thankfully, if you have access to Coinbase, it's pretty easy. That said, it may take DAYS for the ACH transfer from your bank, so you could get stuck at this step if this is the first time you're doing it.
The second thing to note is that Coinbase charges a hefty 3% fee for buying crypto from their primary website.
If you find that fee intolerable (you should), then use Coinbase Pro instead. The Pro version has minimal fees (0.50% or less). The user interface may look intimidating, but if you beeline to trading USD for ETH, it's fairly straightforward. And if you're not too price sensitive, look for a way to place a market order (as opposed to a limit order).
This may take you 30 minutes - 1 hour if you've never done it before.
Once you have bought Ether, you'll need to transfer it to a wallet. I personally use Metamask, so that's what I will focus on.
Metamask is a browser extension available for Chrome, Firefox, and Brave. Install this extension and set up your wallet.
It will ask you to write down a list of recovery words. Find a secure place to save these.
Once you have your Metamask wallet set up, you will be able to see your wallet address. When you click Metamask, you'll see
Account 1 and underneath something like
0x..... When you hover over that, it will say "Copy to Clipboard".
Now, go back to Coinbase Pro and withdraw your Ether. Set the destination address to be your Metamask address that you copied above.
For many of you reading this, steps 1 and 2 are things you might have done a long time ago. Thus, this is where it gets interesting.
Currently, the best place to go to find yield farming opportunities is Coin Gecko. Coin Gecko works hard to curate and list all sorts of investment vehicles in the crypto space. They are reputable and considered good faith actors.
As it pertains to yield farming, we want to focus on their "Farms" tab. You'll see something like this:
Right now, lots of people are providing liquidity to Sushi and receiving yield on the SUSHI token. While I don't personally farm much SUSHI, it is the most popular asset at the moment, so we'll focus on that.
There are many ways to get SUSHI right now. They all involve providing liquidity to the following pairs on SushiSwap. Here are some examples:
If we want to participate in yield farming, we'll need to acquire a pair of those assets, supply them to a SushiSwap liquidity pool, recieve an "LP token" and then stake that "LP token" to start getting a constant trickle of SUSHI token.
Let's focus on the ETH-SUSHI pair because that's giving a good healthy yield right now of over 100% APY.
Alright, so how do we do this?
Our ultimate goal is to acquire liquidity provider tokens, or "LP tokens". For many yield farming opportunities, we need Uniswap LP tokens. In the case of SUSHI, we will need Sushi LP tokens or SLP. It is really important that you're clear on which platform the LP tokens need to be issued by. On Coin Gecko, they help by providing basic instructions.
I've annotated a screenshot below:
But many times, you will need to do your own research and understand which assets you need to acquire. In the image above, I indicated "???" for those yield farming opportunities I could not immediately understand.
In the case of WETH-SUSHI, what we're after are the following assets:
We already have ETH, as we transferred this to our Metamask wallet. Thus, that just leaves us with acquiring SUSHI token. How do we do that?
We go to an exchange. My preference is a decentralized exchange.
Uniswap is the biggest one. SushiSwap is a clone (and smaller - and has a questionable history). Thus, using either Uniswap or SushiSwap, we can trade some ETH for SUSHI token.
There are other decentralized exchanges out there, but these two are by far the easiest to get started with. Plus, you'll need to interact with them anyways to get your LP token.
This is what their interfaces for swapping look like. SushiSwap on the left, Uniswap on the right:
As you can see, it looks very simple. You select the token you want to trade, and the token you want to receive. Then you press swap, accept some Metamask confirmations, wait for the transactions to process, and then you're done!
Make sure to leave some ETH left over! You don't want to trade all of it for SUSHI, because you will need an even amount of both assets to provide liquidity.
If you can't find the SUSHI token, you might need to change the list that SushiSwap and Uniswap are using to find the tokens. When you click the dropdown menu to change your selection, you'll need to try a different list. Here's what I mean:
You might need to try a couple lists to find the token you're looking for. There are other ways to get the token to show up (i.e. pasting the address in the text field), but this is the easiest.
Now that we have SUSHI and ETH, let's go get our ETH-SUSHI LP Token on SushiSwap. This is important that we do this next step on SushiSwap! To do this, go back to the SushiSwap app, but make sure to click on the Pool tab:
When we provide liquidity, we must do so in a 1:1 proportion. That is, if we want to supply $100 of ETH, we must also supply $100 of SUSHI. This is why it's so important to leave some ETH in your wallet.
From this point, we just approve SUSHI, wait for that transaction to go through, and then click Supply - and wait for the second transaction to go through.
For our troubles, we'll now obtained a ETH-SUSHI LP Token!
We can take our ETH-SUSHI LP Token and go to SushiSwap's farm (you can find this from either Coin Gecko, or navigating from SushiSwap's homepage). In our case, the farm is located on this page.
You'll see something like this, where you can start staking:
Your screen might look slightly different from mine because I've already begun staking, but the buttons will be mostly in the same location.
Again, press some buttons, specify how much you want to stake, do some Metamask confirmations, and when the transactions go through, you'll be staking!
The value of the SUSHI that you've farmed will show up on the left. Not to mention, you're earning liquidity provider fees on the funds you placed in SushiSwap too.
Congratulations, you're yield farming!
Now that you know how to yield farm (or have bookmarked this page for later), let's talk about what the yield farming opportunity really is.
At its core, we know that when we're yield farming, we're getting rewarded for providing liquidity, as well as for staking our LP tokens (basically, proof of liquidity).
Let's understand why we should be getting a liquidity fee and the risk we have when we do so (impermanent loss). And then let's talk about why anyone would issue tokens for us to "stake" our LP tokens.
Fundamentally, it makes sense why we should earn liquidity fees. We're providing our assets such that those who are looking to exchange one token for another have a market for this. They don't have to wait to find a buyer, and it's pretty seamless to go from the thought "I want token Y" to the action "I will exchange X for Y".
That requires liquidity. We're providing it. Uniswap is collecting fees on our behalf. When we redeem our LP tokens back for our underlying assets, we'll get a little bit more than we put in.
However, this is not risk free! Due to some rather interesting constraints and details of how Uniswap, SushiSwap, Balancer, and all such "x * y = k" exchanges work, we are subject to an opportunity cost known as impermanent loss.
I won't explain why it happens in this article (maybe later), but the effect is that in certain conditions, a liquidity provider may actually be worse off by providing liquidity to the pool, compared to doing nothing at all. What is that condition?
When the relative price of the two assets they're providing liquidity changes. So in our case, if either SUSHI becomes far more valuable than ETH or ETH becomes far more valuable than SUSHI, we're subject to impermanent loss. It's all about the relative price.
There are lots of calculators that will do this for you, but nothing I've found that monitors the relative prices and alerts you if you're experiencing significant impermanent loss. But it's very important to keep in mind while you're yield farming, otherwise, you put in all this effort and are now worse off than if you did nothing!
One question you might be asking is, why do I even want SUSHI token anyways? Why am I staking my LP tokens to acquire it?
Well, the SUSHI token is a governance token - and when it comes to decentralized exchanges, it's relatively easy to see why that might be valuable. In the future, SUSHI might change the rules such that SUSHI token holders see a small share of the liquidity fee. In such a future, that would be like a dividend on a stock. Or, you might see SUSHI holders vote on other changes to the platform.
Governance tokens are a lot like equity in a company. A share of stock in a company allows you to vote on who the CEO should be, as well as a variety of other decisions. You also get dividends, when the company decides to issue them.
In crypto, there are lots of governance tokens for this reason. It's a model that is somewhat intuitive to those who come from a background in traditional finance. Of course, there are many other things we can do with tokens, but governance is the foundation.
Do I personally believe in the SUSHI token? I have no idea, but I think it's a good idea to have a little of both the SUSHI and UNI tokens.
If we take a moment and step back, we need to properly evaluate risk.
We know there's the risk of impermanent loss.
Let's imagine a scenario where one of the underlying assets starts falling. Those who provided liquidity will start feeling the effects of impermanent loss. LPs will be pressured to exit the pool to get their underlying pair. But because one of the assets are falling in value, LPs may go back to the pool and trade the devalued asset for the more stable asset.
This could cause a massive collapse in the value of the asset experiencing a falling valuation.
Another risk is that the reward token's value plummets. In this case, the reward subsidy is decreasing in value. Now you're providing liquidity to a pool that you wouldn't have otherwise, risking impermanent loss for collecting minimal fees.
Reward tokens can plummet if they give out too many rewards too quickly (causing inflation and encouraging holders to sell), or if the project attracts short term farmers who don't want to hold the reward tokens (and dump the tokens as soon as they recieve it). In both of these cases, farming would put downward pressure on the reward token - it's hard to justify holding a token that's collapsing in value. (Although, for good projects with a clear max supply, this presents a solid buying opportunity).
I hope this was a helpful introduction on how to yield farm. We spent a lot of time talking about how to yield farm on SUSHI, but there are other opportunities out there.
Take the time to do your own research, think through which tokens you want earn via staking, and figure out if there's a path to yield farming that exposes you to risks that you are comfortable taking.
If you do all of these steps, you might realize that DeFi has come a long way. You can now:
And much much more.
I personally had taken a break from crypto for many months and when I returned to the space, I was amazed by the capabilities of these platforms. The pace of innovation is crazy (everything is open source, so everything gets copied and tweaked).
This is just the beginning.