What is Yield Farming and Liquidity Mining?

Welcome to the fourth of PYMNTS eight-part series on decentralized finance (DeFi).

Over the coming days, well be looking at every part of DeFi the biggest, hottest, most rewarding and risky part of the blockchain revolution.

At the end of it, youll know what DeFi is, how it works, and the risks and rewards of investing in it.

See Part 1: What is DeFi?

See Part 2: What Are the Top DeFi Platforms?

See Part 3: What Is a Smart Contract?

So, what is yield farming? Start with this. Its earning passive interest on your crypto holdings generally at rates far higher than you could get from a savings account.

Then move on to this. Its risky. Like any other investment, the higher the reward, the higher the risk. Bank savings accounts now earn a small fraction of 1% APY (annual percentage yield) or APR (annual percentage rate), the difference being that APY plows earnings back into the investment for compound interest. Yield farming rewards start at a couple of percent and can go into the hundreds of percent.

By loaning your crypto holdings on a decentralized finance, or DeFi, project, you can earn far more. However, even with ludicrous interest rates, in yield farming you need money to make money, and need to be able to let it sit for long periods.

One of the bigger DeFi lending projects is Aave, with $24.4 billion locked. On Dec. 13, it was offering 2.87% APY on USD Coin and 5.44% on Binance USD both stablecoins but just 0.01% APY on Ethereum. But the Curve DAO token was offering 12.15%.

For the bigger reward, you loan funds to more obscure DeFi projects, with the higher returns coming from the more obscure projects. Which means the potential for hacks, fraud and outright rug pulls the creator of a project running off with all the funds are substantially higher than with established DeFi lending protocols like Curve, Yearn or Aave.

What are you Doing?

Lets step back and look at how DeFi projects work. One of the biggest forms of DeFi projects are lending protocols. They work like this: Person A locks crypto usually dollar-pegged stablecoins in a liquidity pool on a DApp, which is borrowed by person B, who pays interest. (Yield farming is also called liquidity farming.)

Funds are locked, or staked, into smart contracts that control the liquidity pools DeFi lending protocols rely on. These are simply pooled funds from which borrowers draw funds. Pool members earn a share of the interest received based on how much they have locked. The rules of the pools can get complex, so be sure you know what youre getting into.

Among the many wrinkles is that some projects offer rewards in their own tokens as rewards. This has a number of potential benefits and pitfalls. For one thing, you are essentially investing in that token, hoping it will go up. It also gives access to tokens that are hard to buy due because they are from a new project and have limited availability. And are, therefore very volatile.

In June, billionaire investor and crypto fan Mark Cuban tweeted out that hed lost a fair chunk of money when an obscure DeFi token he owned called Titan crashed, dropping from about $60 to nearly zero.

Another wrinkle of the combination of yield farming and crypto volatility is whats called impermanent loss. Staked crypto can rise and fall in value while its locked in a liquidity pool, creating temporary gains or losses sometimes frightening ones on paper. However, if you pull your crypto from a pool at the wrong time, those losses become permanent.

Where yield farming gets really complex and best left for investors who are experienced and knowledgeable in the workings of DeFi is when you reinvest these rewards tokens into other liquidity pools, earning different tokens. Complex investment chains can be built.

Next up: What is Staking?

Another big area of DeFi is staking, and it is in some ways the most important. Most new blockchains run on proof-of-stake rather than Bitcoins power-hungry proof-of-work even Ethereum is switching over. Staking is how new tokens are minted (rather than Bitcoins mined) and how new information is added to those blockchains. But unlike bitcoin mining, anyone can participate and earn rewards by staking.