Decentralized Finance (DeFi) is at the forefront of blockchain innovation. What makes DeFi applications unique? You don’t need any permission to use them, which means that anyone (or anything, such as a smart contract) with an internet connection and a supported wallet can “interact” with them. Additionally, they typically don’t require a trusted third party or intermediaries.
Those interested in the DeFi space will likely come across the term “Yield Farming.” This is the process of productively using crypto tokens in the decentralized finance (DeFi) market with the aim of earning interest. The difference is that simply holding tokens doesn’t generate interest, whereas Yield Farming does.
So, how does a so-called “yield farmer” — someone who engages in this activity — go about it? What returns can they expect? And where should you start if you’re thinking about becoming a yield farmer? All of this and more will be explained in this article.
What exactly is Yield Farming
Yield Farming is a way of generating returns from cryptocurrency holdings. Simply put, it means locking up cryptocurrencies for a certain period and receiving rewards. In some sense, Yield Farming can be very similar to what happens with “staking.” However, there is much more complexity going on behind the scenes with yield farming. In many cases, Yield Farming works by involving users called liquidity providers (LP), who add funds to liquidity pools.
What does the concept of liquidity actually mean? It refers to the characteristic of an asset or individual parts of an asset that can be quickly exchanged for cash. An asset is therefore liquid if it can be quickly converted into cash to settle other obligations. For example, real estate is not the most liquid form of asset, as the selling process can be lengthy.
What is a liquidity pool? It is a smart contract that holds assets. In exchange for providing liquidity to a so-called liquidity pool, liquidity providers (LP) receive a reward. This reward can come from fees generated by the underlying DeFi platform, a share of trading commissions, or some other source. Some liquidity pools pay out their rewards in multiple tokens, while others pay in the base token you committed to Yield Farming. These reward tokens can then be deposited into other liquidity pools to earn rewards there as well, and so on. At this point, you can already see how incredibly complex strategies can emerge very quickly. But the basic idea is that a liquidity provider deposits funds into a liquidity pool and earns rewards or interest in return.
Yield Farming is mostly carried out using ERC-20 standard tokens, which applies to the Ethereum network, and the rewards are usually also a type of ERC-20 token. Nevertheless, this could change in the future, but for now a large part of this activity still takes place within the Ethereum ecosystem, as it is, after all, the first network to enable smart contracts.
What caused the boom in Yield Farming?
The unusually high interest in Yield Farming can be attributed to the introduction of the COMP token — the Compound Finance ecosystem token. First, it’s important to understand what governance tokens actually are, of which the COMP token is one. These are cryptocurrencies that represent “voting” on the blockchain by distributing the power of making major platform decisions away from a centralized structure to the entire community. Governance tokens thus grant their holders management rights.
A common way to launch a decentralized blockchain is through the algorithmic distribution of these governance tokens as liquidity incentives. This attracts liquidity providers to manage the token in order to provide liquidity to the protocol.
Although this protocol did not invent Yield Farming, the launch of the COMP token gave this type of token distribution increased popularity. Since then, other DeFi projects have devised innovative schemes to attract liquidity into their ecosystems.
What is Total Value Locked (TVL)?
TVL measures how much cryptocurrency is locked in loans across the entire DeFi ecosystem and other types of money markets within such an ecosystem. In a sense, TVL is the total liquidity in liquidity pools. It is a useful index for measuring the “health” of DeFi and the Yield Farming market as a whole.
A good place to track TVL is DeFi Pulse. You can check which platforms have the largest amount of ETH or other crypto assets locked in DeFi. This can give you a general idea of the current state of Yield Farming. It’s also worth knowing that TVL can be measured in ETH, USD, or even BTC. Each will give you different perspectives on the state of DeFi money markets.
How DeFi Yield Farming works
Yield Farming is closely related to a specific model that enables automatic coverage of illiquid value around the current actual currency value (Automated Market Maker – AMM). It typically involves liquidity providers (LP) and liquidity pools. Let’s look at how it works.
Liquidity providers deposit funds into what is known as a liquidity pool. This pool powers a “marketplace” where users can lend, borrow, or exchange tokens. Using these platforms generates fees, which are then paid out to liquidity providers based on their share in the liquidity pool. This is the foundation of how an Automated Market Maker (AMM) works. However, implementations can vary greatly – and let’s not forget, this is new technology. We will undoubtedly see new approaches that will also improve current implementations. Distribution rules depend on the unique implementation of the protocol. The key point is that liquidity providers receive a return based on the amount of liquidity they provide to the pool.
Deposited funds are typically stablecoins pegged to the USD – although this is not a universal 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 will receive cDAI or Compound DAI. If you deposit ETH into Compound, you will receive cETH. As you can imagine, this can get quite complex. For example, you can deposit your cDAI into another protocol that mints a third token representing your cDAI, which in turn represents your DAI. These chains can become really complicated and difficult to track. You will learn more about this later in the article.
In the incredible world of DeFi, you can lend and borrow tokens without having to fill out numerous forms first, as you typically do in the existing banking system. You won’t even get to first base without some intermediary asking for your information and forcing you to spend time filling out all their “necessary” paperwork. DeFi allows you to play with tokens, move them, trade them, lend and borrow them – whatever you want to call it. All you need is a wallet and some tokens to get started.
Yield Farming Platforms
How can you earn Yield Farming rewards? Basically, there is no single defined way. In fact, Yield Farming strategies can change from hour to hour, depending on market conditions. Each platform and strategy will have its own rules and risks. If you want to get started with Yield Farming, you need to familiarize yourself 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 implementations can vary greatly. Therefore, it is generally not a good idea to blindly deposit your hard-earned funds and hope for high returns. As a basic risk management rule, you need to be able to remain in control of your investment.
So what are the most popular platforms used by yield farmers? Here we list just a collection of platforms that are essential for Yield Farming:
– Compound Finance
– MakerDAO
– Synthetix
– Aave
– Uniswap
– Curve Finance
– Balancer
– Yearn.finance
Simple Yield Farming Examples
In the following examples, we will focus on the names of some protocols that you may or may not already be familiar with. If you are encountering these topics for the first time, we recommend first browsing and reading other articles, particularly about what DeFi is and the various wallet options in the world of cryptocurrencies.
Interaction on the COMPOUND protocol
Compound is a decentralized protocol on the Ethereum blockchain that establishes money markets for borrowing and lending assets. These assets are popular cryptocurrencies such as ETH, DAI, and USDT. At the most basic level, a so-called yield farmer can simply shuffle funds within Compound where the best annual percentage yield – APY is offered, while simultaneously weighing potential gains and risks.
As an example, here is a simple strategy that worked (no longer works!) on Compound:
- Lend USDC.
- Borrow USDT against it, i.e. against USDC.
- Swap USDT to get more USDC.
- Lend USDC again.
- Borrow more USDT, etc.
The leading people from Compound closed this loop so it no longer works. However, this kind of thinking is what leads a smart yield farmer to find creative ways to generate more profit. While the average trader would be satisfied earning interest on USDC once, sophisticated yield farmers took it a step further.
STACKING YIELD
Some protocols will issue tokens to yield farmers who provide liquidity to their pool. The yield farmer can then find other platforms to deposit their new token into, which will generate even greater returns. We mentioned this briefly at the beginning of the article.
For example, a yield farmer could become a liquidity provider (LP) by supplying 1,000 USDT to Compound. And let’s say that in return the liquidity provider receives 1,000 cUSDT. Note the small prefix “c“. These c tokens represent Compound’s native tokens.
At this point we will mention Balancer, which is an automated market maker. This means that this same yield farmer could put their new tokens into a Balancer pool that accepts cUSDT tokens. Let’s also say that this yield farmer could earn some yield from transaction fees based on the liquidity they provided to the Balancer pool. In this way, the yield farmer could earn interest on two platforms — first on 1,000 USDT in Compound, and second on 1,000 cUSDT sitting in Balancer.
A smart yield farmer will therefore always be looking for edge cases where they can earn the most profit. The best thing about this is that a yield farmer can generate returns from multiple platforms using a single source of liquidity.
Remember, the purpose of this introductory article is not to provide advice or precise strategies, but rather to show what others have done in the past in order to open your mind to the range of possibilities that may exist for increasing profit. We are not financial advisors. All information regarding cryptocurrencies is accepted at your own risk. Therefore, do your own research as well.
RETURN ON INVESTMENT
Yield farmers can earn returns in several ways, including transaction fees, token rewards, and capital appreciation.
- Transaction fees
Transaction fees vary between protocols and their different pools.
Liquidity providers typically receive a percentage of the fees, but they can also be claimed by holders of so-called governance tokens. It depends on the protocol. For example, on Balancer, users set the fees at the time of pool creation. They can range from 0.001% to 10%. On Uniswap, the fee is a flat 0.03%.
- Token rewards
Token rewards can be used as incentives for liquidity providers. These are typically the aforementioned governance tokens.
- Capital appreciation
When fees, rewards, and assets are available in stablecoins, it is easier to predict future income. Other tokens can complicate this process, as they are more likely to fluctuate in price.
Where to earn yield
The three places to “harvest” yield are money markets, liquidity pools, and incentives.
- MONEY MARKETS (LENDING AND BORROWING)
Lending tokens is the most straightforward way for a yield farmer to earn returns. Two of the better-known decentralized money markets are Compound and Aave. Interest rates are generally better on Aave because it offers both variable and stable interest rates. The stable interest rate typically works better for borrowers, while lenders will be more attracted to the variable rate. Compound, on the other hand, offers its governance token COMP as an additional incentive for both lenders and borrowers. Yield farmers can thus deposit stablecoins and immediately start generating returns.
Keep in mind that DeFi money markets require borrowers to collateralize their loans. This means that yield farmers must deposit more than they can borrow. Why would anyone want to do this? Well, once you add up all the fees, rewards, and incentives, they can be very much worth a yield farmer’s time.
To explain this with a practical example for easier understanding. With lending protocols, collateral worth 20 euros can cost you a loan worth 10 euros. Borrowing causes the most confusion among those from the traditional world of finance. Because DeFi requires overcollateralization, many uninitiated people often ask: “Why on earth would I put in more tokens just to get back fewer?” This is where yield farmers work their magic.
Over-collateralization ensures that lenders do not lose their funds if the borrower fails to meet their obligations. It is important to remember that with over-collateralized loans, the borrower must maintain the collateral ratio to avoid liquidation. These types of loans are never a “set it and forget it” scenario. Borrowers must keep an eye on the collateral ratio, which is affected by market conditions.
- LIQUIDITY POOLS
Liquidity is very important for DeFi protocols. Fees, bid-ask spreads, and the overall user experience improve with greater liquidity. Liquidity allows founders to borrow from their users instead of having to invest in venture capital firms. This is why the DeFi world is often described using the analogy of Lego bricks, as when one platform succeeds, others borrow from it to build something new.
Liquidity pools offer better returns than money markets. However, greater rewards come hand in hand with greater risks. One example of the latter is the previously mentioned Uniswap. It is an automated market maker that offers at least one ERC-20 token pair for trading. Other well-known liquidity providers include the previously mentioned Balancer, Curve, and Synthetix, and so on.
- INCENTIVES
Yield farmers can also be rewarded by locking their assets in a protocol. One example offering such rewards is the aforementioned Synthetix, which offers its SNX token as a reward. Locking assets in a specific protocol gives the protocol greater stability. An experienced yield farmer will therefore carefully monitor various incentives to find the most profitable opportunities for tokens, while avoiding those with low yields.
Yield Farming Risks
It is very easy to make wrong moves while learning how Yield Farming works. Unfortunately, many have had to learn things the hard way in order to truly understand them. As new DeFi projects become more credible and secure, their interest rates should eventually stabilize. Currently, however, interest rates can outperform everything in traditional banking by a wide margin.
Some of the most prominent risks include smart contract exploits, price volatility, and impermanent loss. Mistakes during the learning process can also result in high transaction fees, making liquidity mining inefficient or unprofitable. Yield Farming is never without risk.
You can read more about the risks and how to secure your cryptocurrencies in one of our previously published articles, which you can find here. At this point, it is worth knowing that you can earn higher interest rates with DeFi because it is openly a riskier place to invest money. There is no FDIC (Federal Deposit Insurance Corporation) protection, and interest rates can change from week to week or even day to day, making it difficult to calculate how much interest you will earn in a year.
The Future of Yield Farming
Everyone knows that nothing, neither good nor bad, lasts forever. DeFi is still in its infancy and developers will undoubtedly come up with new and creative ways to optimize liquidity incentives. Token holders in governance positions will undoubtedly give the green light to more projects with new ways to benefit their users. And yield farmers will undoubtedly come up with new and creative ways to increase their returns.
We hope this article has helped you discover what Yield Farming is. If you found this article interesting and would like to learn more about the world of cryptocurrencies, you are welcome to read our other articles and join us at the webinar, which you can access at this link.
