Yield farming is depositing digital assets into decentralized financial protocols to earn yields in exchange for providing liquidity.

The problem usually starts when someone sees a high APY on the screen and assumes that will be the actual gain. The reality is generally quite different, and understanding why makes the difference between earning real yield and losing capital.

In this article, you will understand how yield farming mechanics work, what real costs are involved, and how to evaluate protocols before depositing.

For those starting to explore the universe of digital assets, the belo app can be a simpler starting point, allowing you to monitor alternatives to receive, convert, and move digital assets according to the functions available for your account and country.

Advertised APY vs. what is actually left over

The mechanics of yield farming have four concrete stages:

1. You need a wallet compatible with the protocol you want to participate in.

2. You acquire the tokens that the pool requires, usually a pair like two stablecoins or one stablecoin and a volatile asset.

3. You deposit these assets into a liquidity pool within an AMM (automated market maker), where your capital allows other users to make swaps, and you receive a share of the fees generated by those transactions.

4. You decide whether to withdraw yields periodically or reinvest in the pool (known as "compound"), a decision that seems small but directly affects the final result.

The numbers that matter

Consider an example with an amount deposited in a pool with a high advertised APY. After a year, the gross return would seem attractive if everything remained stable, but conditions never remain stable.

Network fees (gas) to approve contracts, deposit, compound, and eventually withdraw can represent a significant portion of capital, depending on network congestion, even on layer 2 networks where fees are usually lower than on the mainnet.

If you compound frequently, each transaction has a cost that builds up. Then comes impermanent loss, the concept that generates the most confusion.

When the price of an asset moves significantly relative to the other in the pair, which happens frequently, the protocol automatically rebalances your position and you end up with a different proportion of tokens than what you deposited. 

Combining gas costs with impermanent loss, the actual net yield usually falls below the initially advertised APY.

Comparison: what to consider between DeFi and centralized platforms

Aspect · DeFi Protocols · Centralized Platforms

Operational complexity · High, requires wallet management and paying gas · Low, simpler experience

Custody of funds · You maintain direct control via smart contract · Delegated to the company operating the platform

Main risk · Smart contract failure, impermanent loss · Solvency and security risk of the company

The decision between DeFi and centralized platforms is usually a choice between types of risk, not between options with and without exposure to risk.

How to evaluate an opportunity before depositing

A very high APY on a newly created protocol with low locked volume should generate the same distrust as a promise of easy money. 

Very high yields usually come from inflationary issuances of governance tokens that lose value as more people sell them, turning the "gain" into something temporary.

Four questions to evaluate before depositing

• Where does the yield come from? If the answer is "from the indefinite issuance of the protocol token", sustainability tends to be low.

• What is the total value locked (TVL) in the protocol? Higher values suggest greater market confidence, although they do not guarantee security.

• Are there smart contract audits? It is worth checking if recognized firms have reviewed the code.

• What are the project's tokenomics like? Specifically, if there are emission schedules that dilute the value of the reward token.

Security checklist before depositing

• Verify that the protocol URL is official, since phishing sites are common in DeFi.

• Confirm that contract functions do not allow an administrator to drain the funds.

• Ensure your wallet has only the minimum approvals necessary to operate.

Start small, monitor with discipline

The most frequent mistake among those starting in yield farming is committing capital they cannot afford to lose. 

A reasonable strategy starts with an amount that does not affect your financial stability, enough to become familiar with the mechanics of depositing, compounding, and withdrawing without a mistake being costly.

Distributing capital across different protocols reduces the impact of a specific failure. 

Distributing across different protocols means that if one of them fails, you only lose a fraction of your exposure, not the total, which completely changes the risk equation.

If you want to start accumulating digital assets gradually before exploring DeFi protocols, the belo app can help you monitor options to receive, convert, and move digital assets.

To understand more about cryptocurrencies, check the cryptocurrency guide in the help center. To understand more about cryptocurrencies, check the cryptocurrency guide in the help center.

Frequently asked questions about what yield farming is and how it works in DeFi

Does the advertised APY already include the compound effect?

It depends on the protocol. Some show the APR (without compound) and others the APY (with projected compound). It is worth checking which of the two appears on the screen before calculating expected gains, because the difference can be significant.

What happens if I want to withdraw my capital earlier than expected?

In most liquidity pools you can withdraw at any time without penalty, although you pay gas for it. If the accumulated fees exceed the yield generated up to that moment, early withdrawal may result in a net loss.

Does impermanent loss disappear if I do not withdraw?

Impermanent loss only materializes when you withdraw your position. If the price of the tokens returns to the original proportion before the exit, the loss decreases or disappears. In volatile pairs, this recovery is not guaranteed.

What difference is there between a stablecoin pool and a pool with volatile tokens?

A stablecoin pool almost completely eliminates impermanent loss, since both assets seek to maintain the same reference value. In exchange, APYs are usually lower than in pools with volatile tokens, where the risk of rebalancing is higher.