What is Yield Farming and how is APY calculated?

During the Defi (Decentralized Finance) Summer of 2020, yield farming gained immense popularity with crypto participants rushing to become “yield farmers.”

While various tokens and platforms came and went, many major DeFi protocols we now know and love launched during this Defi frenzy in mid-2020.

Compound, Yearn and Uniswap are DeFi protocols that rewarded early adopters with retrospective airdrops, giving users free tokens as a thank you for being first to use the protocol, while also encouraging the next phase of the platform’s growth with liquidity mining programs.

If you’re an enterprise or SME wanting to get started in the crypto space or looking to earn a yield on digital assets, yield farming through DeFi platforms can generate substantial APY compared to traditional savings methods. It’s also crucial to identify genuine opportunities available versus those that can turn out to be too good to be true.

This article breaks down the crypto jargon around yield farming, liquidity mining, the differences between APY versus APR and what it means to stake your digital tokens for rewards.

What is liquidity mining?

As projects battle for users and market share, a common launch strategy from many DeFi platforms has been to offer liquidity mining. In a nutshell, liquidity mining encourages users to deposit their crypto onto the platform, rewarding them with a high APY (sometimes >100% per year).

Liquidity mining usually means you will become a liquidity provider (LP), which means you will be helping add liquidity to the various trading pairs available on the new platform.

For example, a popular trading pair may be ETH/USDC. This pair allows anyone to swap ETH for USDC, and vice versa. If the platform doesn’t have many LPs providing liquidity to the pair, there will likely be high slippage, leading to a worse price when trading the pair.

If ETH was currently trading at US$3000 and there was low liquidity (high slippage), this could mean your buy trade could execute for US$3100, meaning you have incurred ~3% slippage, not great.

In order to prevent this issue, platforms will offer “liquidity mining” incentives to LPs who deposit their ETH and/or USDC into the platform, adding liquidity, and reducing slippage in the above scenario. This means traders are more likely to use the platform, as it offers lower slippage for trades. LPs are rewarded with a high APY in the protocol’s tokens as an incentive to continue having their tokens deposited on the platform.

How high is your APY?

Crypto APY is generally an arbitrary number that is just high enough to attract yield farmers and liquidity providers to one platform over another, but not so high that it has a significantly negative impact on the token’s price.

If APY was 500%, depositing tokens worth US$1,000 into the platform would generate $5,000 in the platform’s tokens in rewards over a 12-month period. While this looks incredibly attractive versus the ~2% interest you might get from a savings account, it doesn’t factor in the price volatility the token may experience as rewards are distributed.

Yield farmers and LPs are incentivized to deposit their tokens onto the platform to generate a high yield, but they are equally incentivized to sell these tokens immediately as they receive them.

Speculation drives this game-theory outcome. As token emissions are high at the start to attract as many users as possible, sustained selling pressure may negatively affect the token’s price. However, as token emissions reduce over time, prices usually stabilize, resulting in more subdued selling pressure and more organic platform use.

In this recent interview on Bloomberg, Sam Bankman-Fried (CEO of crypto platform FTX, and founder of Alameda Research) explains how VCs and trading firms utilize high APYs to generate yield.

Are APR and APY the same?

In short, no. When seeing 600% APR, you could be easily mistaken thinking it’s the same as 600% APY, however they do differ slightly. While APY (annual percentage yield) accounts for compounding, APR (annual percentage rate/return) does not.

600% APR means you will receive 600% divided by the number of reward periods. If you receive monthly payouts, this means your 600% is divided by 12 months or 50% per month.

On the other hand, 600% APY is different. As it accounts for compounding, your monthly reward payouts would start off slightly below 50% for the first six months and be slightly more than 50% in the last six months of the year. Ultimately, you will still receive 600% over the 12-month period, just with a variation on the amounts each month versus APR.

It should be noted that a 600% return in 12 months may sound too good to be true (and it might just be. If the underlying token retains its value over the year, you will generate 600% p.a. However, if the token ends up down 80% at the end of the year, your rewards look more like a 20% return — not terrible, but if you bought the underlying token in order to stake it for rewards, it would have generated a negative return.

Impermanent Loss (IL)

Another key component of yield farming is known within the crypto space as “Impermanent Loss” or IL. As a liquidity provider (LP), you may look at staking your digital assets into a two-sided pool that attracts high volume on Uniswap — say ETH/USDC. This means your stake would be 50% ETH and 50% USDC in terms of total value when you deposit funds. For example, at a price of US$2000 per ETH, you would deposit 1 ETH and 2000 USDC.

As a yield provider, you would be rewarded with tokens for providing liquidity to the ETH/USDC market over time. However, as the price of ETH changes, your deposit would need to rebalance ito maintain 50% ETH and 50% USDC. Say the price of ETH increases to US$4000; In this scenario, while the price of ETH has increased, your ETH balance in the pool would have been rebalanced into USDC.

Ultimately you would end up with approximately 2800USDC (a gain of 800USDC), and 0.7ETH (a loss of 0.3ETH). The total value of your liquidity in the pool would be around US$5600. However, if you held your tokens, you would have 2000USDC (each worth US$1) and 1ETH (which would have been worth US$4000) for a total of US$6000.

This example doesn’t include any fees or yield you may have accrued over this period but is a simple example of what IL is and how it can directly affect your crypto yield strategies. If you want to calculate what your IL might be, there are plenty of free calculators and tools you can use to choose what liquidity pools and yield approaches might work for you.

How does Proof of Stake (PoS) compare to Proof of Work?

You may have heard about ETH 2.0 and Proof of Stake (PoS) coming to the Ethereum blockchain over the coming months. Currently, both Ethereum and Bitcoin use a mechanism called Proof of Work (PoW) in order to secure the blockchain and verify transactions. Every block then rewards the miner with a “block reward” denominated in the native token (ETH or BTC) to incentivize mining.

As PoW is quite energy intensive, Ethereum is moving to a PoS blockchain, joining other blockchains such as Solana, Polkadot and Cardano. PoS aims to decrease energy use versus PoW by enabling participants to “stake” their tokens in order to validate transactions on the blockchain, compared to utilizing specialized miners in order to do so. When users stake tokens, they generate a yield, incentivizing more participants to stake tokens, increasing the blockchain’s overall security.

Ready to become a yield farmer?

Hopefully you’re now equipped with some extra knowledge and ready to start yield farming yourself. Crypto yields are volatile, and, as mentioned, if you need to buy a certain token in order to generate a high yield, it may not be worth it.

Various strategies such as yield farming while simultaneously shorting a perpetual contract of the same size in order to “yield harvest” are also popular options for those with slightly more experience and knowledge within the crypto space to generate lower risk returns.

If you’re looking for more information on how you can generate an attractive yield with the Unido Liquidity Mining (ULM) program, read more here.

About Unido EP

Unido EP takes the complexity and expense out of digital asset management for organizations with sophisticated corporate governance needs. Our patented, end-to-end platform seamlessly automates corporate governance and self-custody of crypto assets so you can securely store, manage and invest in crypto without massive overheads.

Unido EP comes with a web-based dashboard and a decentralized application (dApp) featuring a robust set of Defi tools, easy-to-set-up authority regimes and iron-clad security. All of this is inside a complete digital asset management platform, built with financial institutions in mind but tailor-made for any organization or individual’s needs.

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Built on Polkadot and powered by $UDO token, Unido is building enterprise-grade solutions to give institutions better access to DeFi Markets.