What Is Yield Farming? The Rocket Fuel of DeFi, Explained

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What Is Yield Farming? The Rocket Fuel of DeFi, Explained
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The globe of decentralized financing (DeFi) is growing and also the numbers are just trending up. According to DeFi Pulse, there is $95.28 billion in crypto possessions secured DeFi now – up from $32 billion the year prior to. Leading the DeFi race is the Ethereum-based Maker procedure, with a 17.8% share of the marketplace.

One of the primary stimulants for this field’s rapid development can be credited to an ROI-optimizing method one-of-a-kind to DeFi called yield farming.

Where it began

Ethereum-based debt market Compound began dispersing compensation to the procedure’s customers in June, 2020. This is a kind of property called a “governance token” which provides owners one-of-a-kind ballot powers over recommended adjustments to the system. Demand for the token (enhanced incidentally its automated circulation was structured) started today fad and also relocated Compound right into the leading placement in DeFi at the time.

The warm brand-new term “yield farming” was birthed; shorthand for brilliant methods where placing crypto momentarily at the disposal of some start-up’s application makes its proprietor a lot more cryptocurrency.

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Another term drifting around is “liquidity mining.”

The buzz around these ideas has actually advanced right into a reduced roar as increasingly more individuals obtain interested.

The laid-back crypto viewer that just stands out right into the marketplace when task warms up may be beginning to obtain pale feelings that something is taking place now. Take our word for it: Yield farming is the resource of those feelings.

We’re mosting likely to start with the extremely essentials and after that relocate to advanced elements of yield farming.

What are symbols?

Tokens resemble the cash video-game gamers make while battling beasts, cash they can utilize to purchase equipment or tools in deep space of their preferred video game.

But with blockchains, symbols aren’t restricted to just one enormously multiplayer online cash video game. They can be made in one and also utilized in great deals of others. They normally stand for either possession in something (like an item of a Uniswap liquidity swimming pool, which we will certainly get involved in later) or accessibility to some solution. For instance, in the Brave internet browser, advertisements can just be acquired making use of standard focus token (BAT).

If symbols deserve cash, after that you can bank with them or a minimum of do points that look quite like financial. Thus: decentralized financing.

Tokens confirmed to be the huge usage situation for Ethereum, the second-biggest blockchain on the planet. The term of art below is “ERC-20 tokens,” which describes a software application requirement that enables token designers to create policies for them. Tokens can be utilized in a couple of means. Often, they are utilized as a type of cash within a collection of applications. So the concept for Kin was to develop a token that internet customers might invest with each various other at such small quantities that it would certainly nearly seem like they weren’t investing anything; that is, cash for the web.

Governance symbols are various. They are not such as a token at a video-game gallery, as numerous symbols were explained in the past. They job a lot more like certifications to offer in an ever-changing legislature because they provide owners the right to elect on adjustments to a procedure.

So on the system that confirmed DeFi might fly, MakerDAO, owners of its administration token, MKR, ballot nearly each week on tiny adjustments to criteria that control just how much it sets you back to obtain and also just how much savers make, and so forth.

Read a lot more: How Yield Farming on Curve Is Quietly Conquering DeFi

One point all crypto symbols share, however, is they are tradable and also they have a cost. So, if symbols deserve cash, after that you can bank with them or a minimum of do points that look quite like financial. Thus: decentralized financing.

What is DeFi?

Fair concern. For people that disregarded awhile in 2018, we utilized to call this “open finance.” That building and construction appears to have actually discolored, however, and also “DeFi” is the brand-new language.

In situation that does not run your memory, DeFi is all the important things that allow you have fun with cash, and also the only recognition you require is a crypto budget.

On the typical internet, you can’t buy a blender without giving the site owner enough data to learn your whole life history. In DeFi, you can borrow money without anyone even asking for your name.

I can explain this but nothing really brings it home like trying one of these applications. If you have an Ethereum wallet that has even $20 worth of crypto in it, go do something on one of these products. Pop over to Uniswap and buy yourself some FUN (a token for gambling apps) or WBTC (wrapped bitcoin). Go to MakerDAO and create $5 worth of DAI (a stablecoin that tends to be worth $1) out of the digital ether. Go to Compound and borrow $10 in USDC.

(Notice the very small amounts I’m suggesting. The old crypto saying “don’t put in more than you can afford to lose” goes double for DeFi. This stuff is uber-complex and a lot can go wrong. These may be “savings” products but they’re not for your retirement savings.)

Immature and experimental though it may be, the technology’s implications are staggering. On the normal web, you can not purchase a blender or food processor without offering the website proprietor sufficient information to discover your entire biography. In DeFi, you can obtain cash without any person also requesting your name.

DeFi applications don’t worry about trusting you because they have the collateral you put up to back your debt (on Compound, for instance, a $10 debt will require around $20 in collateral).

Read more: Which Comes First: DeFi Utility or Yield?

If you do take this advice and try something, note that you can swap all these things back as soon as you’ve taken them out. Open the loan and close it 10 minutes later. It’s fine. Fair warning: It might cost you a tiny bit in fees.

So what’s the point of borrowing for people who already have the money? Most people do it for some kind of trade. The most obvious example, to short a token (the act of profiting if its price falls). It’s also good for someone who wants to hold onto a token but still play the market.

Doesn’t running a bank take a lot of money upfront?

It does, and in DeFi that money is largely provided by strangers on the internet. That’s why the startups behind these decentralized banking applications come up with clever ways to attract HODLers with idle assets.

Liquidity is the chief concern of all these different products. That is: How much money do they have locked in their smart contracts?

“In some types of products, the product experience gets much better if you have liquidity. Instead of borrowing from VCs or debt investors, you borrow from your users,” said Electric Capital managing partner Avichal Garg.

Let’s take Uniswap as an example. Uniswap is an “automated market maker,” or AMM (another DeFi term of art). This means Uniswap is a robot on the internet that is always willing to buy and it’s also always willing to sell any cryptocurrency for which it has a market.

On Uniswap, there is at least one market pair for almost any token on Ethereum. Behind the scenes, this means Uniswap can make it look like it is making a direct trade for any two tokens, which makes it easy for users, but it’s all built around pools of two tokens. And all these market pairs work better with bigger pools.

Why do I keep hearing about ‘pools’?

To illustrate why more money helps, let’s break down how Uniswap works.

Let’s say there was a market for USDC and DAI. These are two tokens (both stablecoins but with different mechanisms for retaining their value) that are meant to be worth $1 each all the time, and that generally tends to be true for both.

The price Uniswap shows for each token in any pooled market pair is based on the balance of each in the pool. So, simplifying this a lot for illustration’s sake, if someone were to set up a USDC/DAI pool, they should deposit equal amounts of both. In a pool with only 2 USDC and 2 DAI it would offer a price of 1 USDC for 1 DAI. But then imagine that someone put in 1 DAI and took out 1 USDC. Then the pool would have 1 USDC and 3 DAI. The pool would be very out of whack. A savvy investor could make an easy $0.50 profit by putting in 1 USDC and receiving 1.5 DAI. That’s a 50% arbitrage profit, and that’s the problem with limited liquidity.

(Incidentally, this is why Uniswap’s prices tend to be accurate, because traders watch it for small discrepancies from the wider market and trade them away for arbitrage profits very quickly.)

Read more: Uniswap V2 Launches With More Token-Swap Pairs, Oracle Service, Flash Loans

However, if there were 500,000 USDC and 500,000 DAI in the pool, a trade of 1 DAI for 1 USDC would have a negligible impact on the relative price. That’s why liquidity is helpful.

You can stick your assets on Compound and earn a little yield. But that’s not very creative. Users who look for angles to maximize that yield: those are the yield farmers.

Similar effects hold across DeFi, so markets want more liquidity. Uniswap solves this by charging a tiny fee on every trade. It does this by shaving off a little bit from each trade and leaving that in the pool (so one DAI would actually trade for 0.997 USDC, after the fee, growing the overall pool by 0.003 USDC). This benefits liquidity providers because when someone puts liquidity in the pool they own a share of the pool. If there has been lots of trading in that pool, it has earned a lot of fees, and the value of each share will grow.

And this brings us back to tokens.

Liquidity added to Uniswap is represented by a token, not an account. So there’s no ledger saying, “Bob owns 0.000000678% of the DAI/USDC pool.” Bob just has a token in his wallet. And Bob doesn’t have to keep that token. He could sell it. Or use it in another product. We’ll circle back to this, but it helps to clarify why people like to talk about DeFi products as “money Legos.”

So how much money do people make by putting money into these products?

It can be a lot more lucrative than putting money in a traditional bank, and that’s before startups started handing out governance tokens.

Let’s use Compound as an illustration. As of January, 2022, a person can put USDC or tether (USDT) into Compound and earn around 3% on it. Most U.S. bank accounts earn less than 0.1% these days, which is close enough to nothing.

However, there are some caveats. First, there’s a reason the interest rates are so much juicier: DeFi is a far riskier place to park your money. There’s no Federal Deposit Insurance Corporation (FDIC) protecting these funds. If there were a run on Compound, users could find themselves unable to withdraw their funds when they wanted.

Plus, the interest is quite variable. You don’t know what you’ll earn over the course of a year. USDC’s rate is high right now yet it used to hover somewhere in the 1% range.

Similarly, a user might get tempted by assets with more lucrative yields like USDT, which typically has a much higher interest rate than USDC. The trade-off here is USDT’s transparency about the real-world dollars it’s supposed to hold in a real-world bank is not nearly up to par with USDC’s. A difference in interest rates is often the market’s way of telling you the one instrument is viewed as dicier than another.

Users making big bets on these products turn to companies Opyn and Nexus Mutual to insure their positions because there’s no government protections in this nascent space – more on the ample risks later on.

So users can stick their assets in Compound or Uniswap and earn a little yield. But that’s not very creative. Users who look for angles to maximize that yield: those are the yield farmers.

OK, I already knew all of that. What is yield farming?

Broadly, yield farming is any effort to put crypto assets to work and generate the most returns possible on those assets.

At the simplest level, a yield farmer might move assets around within Compound, constantly chasing whichever pool is offering the best APY from week to week. This might mean moving into riskier pools from time to time, but a yield farmer can handle risk.

“Farming opens up new price arbs [arbitrage] that can spill over to other protocols whose tokens are in the pool,” said Maya Zehavi, a blockchain consultant.

Because these positions are tokenized, though, they can go further.

This was a brand-new kind of yield on a deposit. In fact, it was a way to earn a yield on a loan. Who has ever heard of a borrower earning a return on a debt from their lender?

In a simple example, a yield farmer might put 100,000 USDT into Compound. They will get a token back for that stake, called cUSDT. Let’s say they get 100,000 cUSDT back (the formula on Compound is crazy so it’s not 1:1 like that but it doesn’t matter for our purposes here).

They can then take that cUSDT and put it into a liquidity pool that takes cUSDT on Balancer, an AMM that allows users to set up self-rebalancing crypto index funds. In normal times, this could earn a small amount more in transaction fees. This is the basic idea of yield farming. The user looks for edge cases in the system to eke out as much yield as they can across as many products as it will work on.

Why is yield farming so hot right now?

Because of liquidity mining. Liquidity mining supercharges yield farming.

Liquidity mining is when a yield farmer gets a new token as well as the usual return (that’s the “mining” part) in exchange for the farmer’s liquidity.

“The idea is that stimulating usage of the platform increases the value of the token, thereby creating a positive usage loop to attract users,” said Richard Ma of smart-contract auditor Quantstamp.

The yield farming examples above are only farming yield off the normal operations of different platforms. Supply liquidity to Compound or Uniswap and get a little cut of the business that runs over the protocols – very vanilla.

But Compound announced in 2020 it wanted to truly decentralize the product and it wanted to give a good amount of ownership to the people who made it popular by using it. That ownership would take the form of the COMP token.

Lest this sound too altruistic, keep in mind that the people who created it (the team and the investors) owned more than half of the equity. By giving away a healthy proportion to users, that was very likely to make it a much more popular place for lending. In turn, that would make everyone’s stake worth much more.

So, Compound announced this four-year period where the protocol would give out COMP tokens to users, a fixed amount every day until it was gone. These COMP tokens control the protocol, just as shareholders ultimately control publicly traded companies.

Every day, the Compound protocol looks at everyone who had lent money to the application and who had borrowed from it and gives them COMP proportional to their share of the day’s total business.

The results were very surprising, even to Compound’s biggest promoters.

COMP’s value will likely go down, and that’s why some investors are rushing to earn as much of it as they can right now.

This was a brand-new kind of yield on a deposit into Compound. In fact, it was a way to earn a yield on a loan, as well, which is very weird: Who’s ever heard of a borrower earning a return on a debt from their lender?

COMP’s value reached a peak of over $900 in 2021. We did the math elsewhere but long story short: investors with fairly deep pockets can make a strong gain maximizing their daily returns in COMP. It is, in a way, free money.

It’s possible to lend to Compound, borrow from it, deposit what you borrowed and so on. This can be done multiple times and DeFi startup Instadapp even built a tool to make it as capital-efficient as possible.

“Yield farmers are extremely creative. They find ways to ‘stack’ yields and even earn multiple governance tokens at once,” said Spencer Noon of DTC Capital.

COMP’s value spike is a temporary situation. The COMP distribution will only last four years and then there won’t be any more. Further, most people agree that the high price now is driven by the low float (that is, how much COMP is actually free to trade on the market – it will never be this low again). So the value will probably gradually go down, and that’s why savvy investors are trying to earn as much as they can now.

Appealing to the speculative instincts of diehard crypto traders has proven to be a great way to increase liquidity on Compound. This fattens some pockets but also improves the user experience for all kinds of Compound users, including those who would use it whether they were going to earn COMP or not.

As usual in crypto, when entrepreneurs see something successful, they imitate it. Balancer was the next protocol to start distributing a governance token, BAL, to liquidity providers. Flash loan provider bZx then followed suit. Ren, Curve and Synthetix have also teamed up to promote a liquidity pool on Curve.

It is a fair bet many of the more well-known DeFi projects will announce some kind of coin that can be mined by providing liquidity.

The case to watch here is Uniswap versus Balancer. Balancer can do the same thing Uniswap does, but most users who want to do a quick token trade through their wallet use Uniswap. It will be interesting to see if Balancer’s BAL token convinces Uniswap’s liquidity providers to defect.

So far, though, more liquidity has gone into Uniswap since the BAL announcement, according to its data site.

Did liquidity mining start with COMP?

No, but it was the most-used protocol with the most carefully designed liquidity mining scheme.

This point is debated but the origins of liquidity mining probably date back to Fcoin, a Chinese exchange that created a token in 2018 that rewarded people for making trades. You won’t believe what happened next! Just kidding, you will: People just started running bots to do pointless trades with themselves to earn the token.

Similarly, EOS is a blockchain where transactions are basically free, but since absolutely nothing is actually free the absence of friction was an invitation for spam. Some malicious hacker who didn’t like EOS created a token called EIDOS on the network in late 2019. It rewarded people for tons of pointless transactions and somehow got an exchange listing.

These initiatives illustrated how quickly crypto users respond to incentives.

Read more: Compound Changes COMP Distribution Rules Following ‘Yield Farming’ Frenzy

Fcoin aside, liquidity mining as we now know it first showed up on Ethereum when the marketplace for synthetic tokens, Synthetix, announced in July 2019 an award in its SNX token for users who helped add liquidity to the sETH/ETH pool on Uniswap. By October, that was one of Uniswap’s biggest pools.

When Compound Labs, the company that launched the Compound protocol, decided to create COMP, the governance token, the firm took months designing just what kind of behavior it wanted and how to incentivize it. Even still, Compound Labs was surprised by the response. It led to unintended consequences such as crowding into a previously unpopular market (lending and borrowing BAT) in order to mine as much COMP as possible.

Just last week, 115 different COMP budget addresses – senators in Compound’s ever-changing legislature – voted to change the distribution mechanism in hopes of spreading liquidity out across the markets again.

Is there DeFi for bitcoin?

Yes, on Ethereum.

Nothing has beaten bitcoin over time for returns, but there’s one thing bitcoin can’t do on its own: create more bitcoin.

A smart trader can get in and out of bitcoin and dollars in a way that will earn them more bitcoin, but this is tedious and risky. It takes a certain kind of person.

DeFi, however, offers ways to grow one’s bitcoin holdings – though somewhat indirectly.

A long HODLer is happy to gain fresh BTC off their counterparty’s short-term win. That’s the game.

For example, a user can create a simulated bitcoin on Ethereum using BitGo’s WBTC system. They put BTC in and get the same amount back out in freshly minted WBTC. WBTC can be traded back for BTC at any time, so it tends to be worth the same as BTC.

Then the user can take that WBTC, stake it on Compound and earn a few percent each year in yield on their BTC. Odds are, the people who borrow that WBTC are probably doing it to short BTC (that is, they will sell it immediately, buy it back when the price goes down, close the loan and keep the difference).

A long HODLer is happy to gain fresh BTC off their counterparty’s short-term win. That’s the game.

How risky is it?

Enough.

“DeFi, with the combination of an assortment of digital funds, automation of key processes, and more complex incentive structures that work across protocols – each with their own rapidly changing tech and governance practices – make for new types of security risks,” said Liz Steininger of Least Authority, a crypto security auditor. “Yet, despite these risks, the high yields are undeniably attractive to draw more users.”

We’ve seen big failures in DeFi products. MakerDAO had one so bad in 2020 it’s called “Black Thursday.” There was also the exploit against flash loan provider bZx. These things do break and when they do money gets taken.

As this sector gets more robust, we could see token holders greenlighting more ways for investors to profit from DeFi niches.

Right now, the deal is too good for certain funds to resist, so they are moving a lot of money into these protocols to liquidity mine all the new governance tokens they can. But the funds – entities that pool the resources of typically well-to-do crypto investors – are also hedging. Nexus Mutual, a DeFi insurance provider of sorts, told CoinDesk it has maxed out its available coverage on these liquidity applications. Opyn, the trustless derivatives maker, created a way to short COMP, just in case this game comes to naught.

And weird things have arisen. At one point, there were more DAI on Compound than have been minted in the world. This makes sense once unpacked but it still feels dicey to everyone.

That said, distributing governance tokens might make things a lot less risky for startups, at least with regard to the money cops.

“Protocols distributing their tokens to the public, meaning that there’s a new secondary listing for SAFT tokens, [gives] plausible deniability from any security accusation,” Zehavi wrote. (The Simple Agreement for Future Tokens was a legal structure favored by many token issuers during the ICO craze.)

Whether a cryptocurrency is adequately decentralized has been a key feature of ICO settlements with the U.S. Securities and Exchange Commission (SEC).

What’s next for yield farming? (A prediction)

COMP turned out to be a bit of a surprise to the DeFi world, in technical ways and others. It has inspired a wave of new thinking.

“Other projects are working on similar things,” said Nexus Mutual founder Hugh Karp. In fact, informed sources tell CoinDesk brand-new projects will launch with these models.

We might soon see more prosaic yield farming applications. For example, forms of profit-sharing that reward certain kinds of behavior.

Imagine if COMP holders decided, for example, that the protocol needed more people to put money in and leave it there longer. The community could create a proposal that shaved off a little of each token’s yield and paid that portion out only to the tokens that were older than six months. It probably wouldn’t be much, but an investor with the right time horizon and risk profile might take it into consideration before making a withdrawal.

(There are precedents for this in traditional finance: A 10-year Treasury bond normally yields more than a one-month T-bill also though they’re both backed by the full faith and also credit of Uncle Sam, a 12-month certificate of deposit pays higher interest than a checking account at the same bank, and also so on.)

As this sector gets more robust, its architects will come up with ever more robust ways to optimize liquidity incentives in increasingly refined ways. We could see token holders greenlighting more ways for investors to profit from DeFi niches.

Whatever happens, crypto’s yield farmers will keep moving fast. Some fresh fields may open and also some may soon bear much less luscious fruit.

But that’s the nice thing about farming in DeFi: It is extremely simple to switch areas.

Learn More: DeFi Crash Course 101



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