Yield farming is the practice of deploying cryptocurrency across various DeFi protocols to maximise returns. At its simplest, it means putting your tokens to work rather than letting them sit idle in a wallet. The returns, or yield, come from a combination of trading fees, lending interest and protocol token rewards.
How yield farming works
- You deposit tokens into a liquidity pool or lending protocol.
- The protocol uses your tokens, for example to facilitate trades on a decentralised exchange or to fund borrower loans.
- You earn rewards in the form of trading fees, interest or newly minted governance tokens.
- Some farmers reinvest (compound) their rewards into the same or different protocols to earn additional yield.
Common yield farming strategies
| Strategy | How it works | Risk level |
|---|---|---|
| Liquidity provision | Deposit token pairs into a DEX pool | Medium to high |
| Lending | Deposit tokens into a lending protocol like Aave | Low to medium |
| Staking | Lock tokens to secure a network | Low to medium |
| Leveraged farming | Borrow additional tokens to farm with more capital | Very high |
Annual Percentage Yield (APY) vs APR
DeFi protocols display returns as APR (annual percentage rate) or APY (annual percentage yield). APY accounts for compounding; APR does not. A 100% APR compounded daily results in an APY of about 171%. High displayed APYs often include unsustainable token incentives that decrease as more farmers join.
Risks of yield farming
- Impermanent loss: when the price ratio of your deposited token pair changes, you can end up with less value than if you had simply held the tokens.
- Smart contract risk: bugs in protocol code can lead to total loss of deposited funds.
- Token depreciation: farming rewards paid in a protocol's own token can lose value rapidly if selling pressure is high.
- Rug pulls: unaudited or anonymous protocols can steal deposited funds.
- Complexity: strategies involving multiple protocols multiply the risks.
Yield farming and Indian tax
All income from yield farming, whether from trading fees, lending interest or token rewards, is classified as VDA income in India. Gains are taxed at 30% under Section 115BBH. Each swap, deposit, and claim of rewards may constitute a separate taxable event. Record-keeping is essential because DeFi protocols do not issue tax certificates.
Is yield farming worth it?
For most retail investors, the risks of yield farming significantly outweigh the potential rewards. The highest advertised APYs are usually the most dangerous, often involving new, unaudited protocols with rapidly depreciating reward tokens. If you explore yield farming, start small, use only well-audited protocols, and never invest more than you can afford to lose entirely.