What Is Yield Farming in Decentralized Finance (DeFi)?
Yield farming is a way to make more crypto with your crypto. It involves you lending your funds to others through the magic of computer programs called smart contracts. In return for your service, you earn fees in the form of crypto. Simple enough, huh? Well, not so fast.
Yield farmers will use very complicated strategies. They move their cryptos around all the time between different lending marketplaces to maximize their returns. They’ll also be very secretive about the best yield farming strategies. Why? The more people know about a strategy, the less effective it may become. Yield farming is the wild west of Decentralized Finance (DeFi), where farmers compete to get a chance to farm the best crops.
The Decentralized Finance (DeFi) movement has been at the forefront of innovation in the blockchain space. What makes DeFi applications unique? They are permissionless, meaning that anyone (or anything, like a smart contract) with an Internet connection and a supported wallet can interact with them. In addition, they typically don’t require trust in any custodians or middlemen. In other words, they are trustless. So, what new use cases do these properties enable?
One of the new concepts that has emerged is yield farming. It’s a new way to earn rewards with cryptocurrency holdings using permissionless liquidity protocols. It allows anyone to earn passive income using the decentralized ecosystem of “money legos” built on Ethereum. As a result, yield farming may change how investors HODL in the future. Why keep your assets idle when you can put them to work?
So, how does a yield farmer tend to their crops? What kind of yields can they expect? And where should you start if you’re thinking of becoming a yield farmer? We’ll explain them all in this article.
What is yield farming?
Yield farming, also referred to as liquidity mining, is a way to generate rewards with cryptocurrency holdings. In simple terms, it means locking up cryptocurrencies and getting rewards.
In some sense, yield farming can be paralleled with staking. However, there’s a lot of complexity going on in the background. In many cases, it works with users called liquidity providers (LP) that add funds to liquidity pools.
What is a liquidity pool? It’s basically a smart contract that contains funds. In return for providing liquidity to the pool, LPs get a reward. That reward may come from fees generated by the underlying DeFi platform, or some other source.
Some liquidity pools pay their rewards in multiple tokens. Those reward tokens then may be deposited to other liquidity pools to earn rewards there, and so on. You can already see how incredibly complex strategies can emerge quite quickly. But the basic idea is that a liquidity provider deposits funds into a liquidity pool and earns rewards in return.
Yield farming is typically done using ERC-20 tokens on Ethereum, and the rewards are usually also a type of ERC-20 token. This, however, may change in the future. Why? For now, much of this activity is happening in the Ethereum ecosystem.
However, cross-chain bridges and other similar advancements may allow DeFi applications to become blockchain-agnostic in the future. This means that they could run on other blockchains that also support smart contract capabilities.
Yield farmers will typically move their funds around quite a lot between different protocols in search of high yields. As a result, DeFi platforms may also provide other economic incentives to attract more capital to their platform. Just like on centralized exchanges, liquidity tends to attract more liquidity.
What started the yield farming boom?
A sudden strong interest in yield farming may be attributed to the launch of the COMP token — the governance token of the Compound Finance ecosystem. Governance tokens grant governance rights to token holders. But how do you distribute these tokens if you want to make the network as decentralized as possible?
A common way to kickstart a decentralized blockchain is distributing these governance tokens algorithmically, with liquidity incentives. This attracts liquidity providers to “farm” the new token by providing liquidity to the protocol.
While it didn’t invent yield farming, the COMP launch gave this type of token distribution model a boost in popularity. Since then, other DeFi projects have come up with innovative schemes to attract liquidity to their ecosystems.
What is Total Value Locked (TVL)?
So, what’s a good way to measure the overall health of the DeFi yield farming scene? Total Value Locked (TVL). It measures how much crypto is locked in DeFi lending and other types of money marketplaces.
In some sense, TVL is the aggregate liquidity in liquidity pools. It’s a useful index to measure the health of the DeFi and yield farming market as a whole. It’s also an effective metric to compare the “market share” of different DeFi protocols.
A good place to track TVL is Defi Pulse. You can check which platforms have the highest amount of ETH or other cryptoassets locked in DeFi. This can give you a general idea about the current state of yield farming.
Naturally, the more value is locked, the more yield farming may be going on. It’s worth noting that you can measure TVL in ETH, USD, or even BTC. Each will give you a different outlook for the state of the DeFi money markets.
How does yield farming work?
Yield farming is closely related to a model called automated market maker (AMM). It typically involves liquidity providers (LPs) and liquidity pools. Let’s see how it works.
Liquidity providers deposit funds into a liquidity pool. This pool powers a marketplace where users can lend, borrow, or exchange tokens. The usage of these platforms incurs fees, which are then paid out to liquidity providers according to their share of the liquidity pool. This is the foundation of how an AMM works.
However, the implementations can be vastly different — not to mention that this is a new technology. It’s beyond doubt that we’re going to see new approaches that improve upon the current implementations.
On top of fees, another incentive to add funds to a liquidity pool could be the distribution of a new token. For example, there may not be a way to buy a token on the open market, only in small amounts. On the other hand, it may be accumulated by providing liquidity to a specific pool.
The rules of distribution will all depend on the unique implementation of the protocol. The bottom line is that liquidity providers get a return based on the amount of liquidity they are providing to the pool.
The funds deposited are commonly stablecoins pegged to the USD — though this isn’t a general requirement. Some of the most common stablecoins used in DeFi are DAI, USDT, USDC, BUSD, and others. Some protocols will mint tokens that represent your deposited coins in the system. For example, if you deposit DAI into Compound, you’ll get cDAI, or Compound DAI. If you deposit ETH to Compound, you’ll get cETH.
As you can imagine, there can be many layers of complexity to this. You could deposit your cDAI to another protocol that mints a third token to represent your cDAI that represents your DAI. And so on, and so on. These chains can become really complex and hard to follow.
How are yield farming returns calculated?
Typically, the estimated yield farming returns are calculated annualized. This estimates the returns that you could expect over the course of a year.
Some commonly used metrics are Annual Percentage Rate (APR) and Annual Percentage Yield (APY). The difference between them is that APR doesn’t take into account the effect of compounding, while APY does. Compounding, in this case, means directly reinvesting profits to generate more returns. However, be aware that APR and APY may be used interchangeably.
It’s also worth keeping in mind that these are only estimations and projections. Even short-terms rewards are quite difficult to estimate accurately. Why? Yield farming is a highly competitive and fast-paced market, and the rewards can fluctuate rapidly. If a yield farming strategy works for a while, many farmers will jump on the opportunity, and it may stop yielding high returns.
As APR and APY come from the legacy markets, DeFi may need to find its own metrics for calculating returns. Due to the fast pace of DeFi, weekly or even daily estimated returns may make more sense.
What is collateralization in DeFi?
Typically, if you’re borrowing assets, you need to put up collateral to cover your loan. This essentially acts as insurance for your loan. How is this relevant? This depends on what protocol you’re supplying your funds to, but you may need to keep a close eye on your collateralization ratio.
If your collateral’s value falls below the threshold required by the protocol, your collateral may be liquidated on the open market. What can you do to avoid liquidation? You can add more collateral.
To reiterate, each platform will have its own set of rules for this, i.e., their own required collateralization ratio. In addition, they commonly work with a concept called overcollateralization. This means that borrowers have to deposit more value than they want to borrow. Why? To reduce the risk of violent market crashes liquidating a large amount of collateral in the system.
So, let’s say that the lending protocol you’re using requires a collateralization ratio of 200%. This means that for every 100 USD of value you put in, you can borrow 50 USD. However, it’s usually safer to add more collateral than required to reduce liquidation risk even more. With that said, many systems will use very high collateralization ratios (such as 750%) to keep the entire platform relatively safe from liquidation risk.
The risks of yield farming
Yield farming isn’t simple. The most profitable yield farming strategies are highly complex and only recommended for advanced users. In addition, yield farming is generally more suited to those that have a lot of capital to deploy (i.e., whales).
Yield farming isn’t as easy as it seems, and if you don’t understand what you’re doing, you’ll likely lose money. We’ve just discussed how your collateral can be liquidated. But what other risks do you need to be aware of?
One obvious risk of yield farming is smart contracts. Due to the nature of DeFi, many protocols are built and developed by small teams with limited budgets. This can increase the risk of smart contract bugs.
Even in the case of bigger protocols that are audited by reputable auditing firms, vulnerabilities and bugs are discovered all the time. Due to the immutable nature of blockchain, this can lead to loss of user funds. You need to take this into account when locking your funds in a smart contract.
In addition, one of the biggest advantages of DeFi is also one of its greatest risks. It’s the idea of composability. Let’s see how it impacts yield farming.
As we’ve discussed before, DeFi protocols are permissionless and can seamlessly integrate with each other. This means that the entire DeFi ecosystem is heavily reliant on each of its building blocks. This is what we refer to when we say that these applications are composable — they can easily work together.
Why is this a risk? Well, if just one of the building blocks doesn’t work as intended, the whole ecosystem may suffer. This is what poses one of the greatest risks to yield farmers and liquidity pools. You not only have to trust the protocol you deposit your funds to but all the others it may be reliant upon.
Yield farming platforms and protocols
How can you earn these yield farming rewards? Well, there isn’t a set way to do yield farming. In fact, yield farming strategies may change by the hour. Each platform and strategy will have its own rules and risks. If you want to get started with yield farming, you must get familiar with how decentralized liquidity protocols work.
We already know the basic idea. You deposit funds into a smart contract and earn rewards in return. But the implementations can vary greatly. As such, it’s generally not a great idea to blindly deposit your hard-earned funds and hope for high returns. As a basic rule of risk management, you need to be able to remain in control of your investment.
So, what are the most popular platforms that yield farmers use? This isn’t an extensive list, just a collection of protocols that are core to yield farming strategies.
Compound is an algorithmic money market that allows users to lend and borrow assets. Anyone with an Ethereum wallet can supply assets to Compound’s liquidity pool and earn rewards that immediately begin compounding. The rates are adjusted algorithmically based on supply and demand.
Compound is one of the core protocols of the yield farming ecosystem.
Maker is a decentralized credit platform that supports the creation of DAI, a stablecoin algorithmically pegged to the value of USD. Anyone can open a Maker Vault where they lock collateral assets, such as ETH, BAT, USDC, or WBTC. They can generate DAI as debt against this collateral that they locked. This debt incurs interest over time called the stability fee — the rate of which is set by MKR token holders.
Yield farmers may use Maker to mint DAI to use in yield farming strategies.
Synthetix is a synthetic asset protocol. It allows anyone to lock up (stake) Synthetix Network Token (SNX) or ETH as collateral and mint synthetic assets against it. What can be a synthetic asset? Practically anything that has a reliable price feed. This allows virtually any financial asset to be added to the Synthetix platform.
Synthetix may allow all sorts of assets to be used for yield farming in the future. Want to use your long-term gold bags in yield farming strategies? Synthetic assets may be the way to go.
Aave is a decentralized protocol for lending and borrowing. Interest rates are adjusted algorithmically, based on current market conditions. Lenders get “aTokens” in return for their funds. These tokens immediately start earning and compounding interest upon depositing. Aave also allows other more advanced functionality, such as flash loans.
As a decentralized lending and borrowing protocol, Aave is heavily used by yield farmers.
Uniswap is a decentralized exchange (DEX) protocol that allows for trustless token swaps. Liquidity providers deposit an equivalent value of two tokens to create a market. Traders can then trade against that liquidity pool. In return for supplying liquidity, liquidity providers earn fees from trades that happen in their pool.
Uniswap has been one of the most popular platforms for trustless token swaps due to its frictionless nature. This can come in handy for yield farming strategies.
Curve Finance is a decentralized exchange protocol specifically designed for efficient stablecoin swaps. Unlike other similar protocols like Uniswap, Curve allows users to make high-value stablecoin swaps with relatively low slippage.
As you’d imagine, due to the abundance of stablecoins in the yield farming scene, Curve pools are a key part of the infrastructure.
Balancer is a liquidity protocol similar to Uniswap and Curve. However, the key difference is that it allows for custom token allocations in a liquidity pool. This allows liquidity providers to create custom Balancer pools instead of the 50/50 allocation required by Uniswap. Just like with Uniswap, LPs earn fees for the trades that happen in their liquidity pool.
Due to the flexibility it brings to liquidity pool creation, Balancer is an important innovation for yield farming strategies.
Yearn.finance is a decentralized ecosystem of aggregators for lending services such as Aave, Compound, and others. It aims to optimize token lending by algorithmically finding the most profitable lending services. Funds are converted to yTokens upon depositing that periodically rebalance to maximize profit.
Yearn.finance is useful for farmers who want a protocol that automatically chooses the best strategies for them.
We’ve taken a look at the latest craze in the cryptocurrency space — yield farming.
What else can this decentralized financial revolution bring? It’s impossible to see what new applications may spring up in the future built on these current components. Nevertheless, trustless liquidity protocols and other DeFi products are certainly at the cutting edge of finance, cryptoeconomics, and computer science.
Undoubtedly, DeFi money markets can help create a more open and accessible financial system available for anyone with an Internet connection.