What is DeFi Yield Farming?

What is DeFi Yield Farming?

Table of Contents

While Bitcoin is in the spotlight in November 2020 due to the incredible rally that pushed it closer to the all-time high than ever, DeFi tokens are still making headlines, and many of them are still performing well and are worthy of attention.

In the present article, we’ll discuss the phenomenon of yield farming, which has been growing in the DeFi space for the last few months.

DeFi stands for decentralized finance and represents a new sector within the crypto space that promotes the development and transition of all kinds of financial services to blockchain and decentralized infrastructures. DeFi tokens almost jump-started an altcoin season in the summer, but Bitcoin came stronger in the last quarter to regain dominance and overwhelm the market.

What is Yield Farming?

In a nutshell, yield farming is a new yield generating opportunity in the crypto space, in which investors can stake or lock an amount of cryptocurrency to earn a return in the form of the native token. While this definition is ambiguous, the yield farming conditions are set individually by every DeFi project apart.

Yield farming can be promoted by DeFi projects for various purposes, but there are two main directions: liquidity mining and participation in DeFi applications.

In the first instance, users are locking their cryptocurrency to contribute to liquidity pools used by decentralized trading platforms. An eloquent example would Uniswap or Balancer. This process is also called liquidity mining, and it can be very profitable, especially when the native token increases in price.

In the second case, DeFi projects reward stakers for taking part in their DeFi applications. Such an example would be Compound. In fact, yield farming became super popular last summer, when Compound started to issue its COMP governance tokens to lenders and borrowers who used the Compound application. Compound described itself as

an algorithmic, autonomous interest rate protocol built for developers, to unlock a universe of open financial applications.”

In simple terms, it is a platform where users can lend and borrow cryptocurrency without middlemen. If you use the app actively, you can receive COMP and participate in the governance process by voting various proposals.

In other words, yield farming is a new method to earn more crypto by putting your crypto at stake. You can think about it as a form of lending or depositing money into a bank to earn interest, though the mechanism is surely different.

Crypto investors who are dedicating their time to liquidity mining and staking, as described above, are called yield farmers. They would usually apply complex strategies that involve multiple DeFi projects. Yield farmers move their digital currencies regularly between different lending marketplaces and DeFi applications to get the best return possible.

How Does DeFi Yield Farming Work?

The core idea is that users lock a portion of their funds to get incentivized in the native token. Each DeFi project has its own rules related to the method of staking, the distribution mechanism, and the source of rewards.

For instance, let’s start with the yield farming method called liquidity mining. Today, there are DeFi ecosystems that allow the trading of tokenized assets on their proprietary platforms that have no middlemen. However, how would they ensure liquidity since there is no central authority to match buyers and sellers as in centralized exchanges? To provide liquidity on the platform, the projects rely on so-called automated market makers (AMMs), which I explained in a previous article. This model involves liquidity pools and liquidity providers. They are usually locking equal amounts of two different cryptocurrencies in a liquidity pool that represents a given pair.

Thus, liquidity providers lock their funds into a liquidity pool. The pool eventually supplies a marketplace where users can trade, lend or borrow tokens. The usage of these marketplaces incurs fees, which are ultimately paid to liquidity providers based on their contribution in the pool. This is the basic model of any AMM system.

Still, DeFi projects are very different, and they can innovate the yield farming rules as they wish in order to attract more investors.

Besides the fees, another way to incentivize contributors to liquidity pools may be the distribution of new tokens.

Yield farmers’ deposited funds are usually represented by stablecoins pegged to the USD, such as USDT, USDC, DAI, and BUSD, among others. Other protocols would mint new tokens to back your deposited cryptocurrency. For instance, if you put DAI into Compound, you will get cDAI. If you deposit ETH into the same protocol, you get cETH. Basically, Compound tokenizes the cryptocurrencies that you deposit and creates ERC 20 equivalents that are valid exclusively for internal use. A similar approach is used on Synthetix, which allows the creation of synthetic assets (synths).

All these schemes have the goal to make financial services flexible and lucrative. The DeFi space is rapidly expanding even today when all the focus is on Bitcoin and its surprising rally.

Yield farming is designed in a way to make cryptocurrency work for your benefit. It discourages the philosophy of HODLers, who are keeping their crypto untouched and don’t put it to work.

What is the Total Value Locked Right Now?

Every DeFi project has its own rules about locking the funds, unlocking, and withdrawing or converting them. A great way to assess the health of the DeFi space is to check the so-called total value locked (TVL), which measures the valuation of all cryptocurrencies locked for yield farming purposes.

From another perspective, TVL is the total value in all liquidity pools in a given moment. Investors regularly check this index to understand the growth rate of the entire DeFi sector. The metric is also useful to compare the attractiveness of various DeFi protocols.

The most reputable source to monitor the TVL figure is DeFi Pulse. The latter is for DeFi the same as Coinmarketcap is for cryptocurrencies. DeFi Pulse shows you which platform holds the highest amount of USDT, ETH, or any other digital currency locked in this fast-growing sector.

As of today, there is over $14 billion worth of cryptocurrency locked in DeFi projects, which is a record. In fact, this figure is constantly growing, and the chances are that while you read this, the TVL has updated the all-time high again.

Total USD Value Locked in DeFi Yield Farming
Total USD Value Locked in DeFi Yield Farming

Note that the increase in the valuation of locked crypto funds has to do with the recent surge in the price of Bitcoin and Ethereum, both of which are locked for yield farming purposes. Otherwise, the actual number of BTC and Ethereum tokens is decreasing as of November.

How Are Yield Farming Returns Calculated?

As a rule, the estimated yield farming returns are displayed in annualized terms. Thus, the rate that you get shows the potential return you should expect for keeping the cryptocurrency locked for a year.

The two most popular metrics are Annual Percentage Rate (APR) and Annual Percentage Yield (APY). While the two may be often used interchangeably, the APR generally doesn’t include the effect of compound. In APY, the compound effect occurs when the profits are directly reinvested to generate more passive income.

Still, even if you see an attractive yield farming return advertised by a DeFi project or website, you should know that they are projections and may change, especially if you don’t keep the funds locked for more than several weeks. Rewards can fluctuate based on the interest from users. If there is an attractive DeFi protocol that offers high returns, yield farmers would jump at the opportunity and would cause a reduction in returns.

What is Collateralization in DeFi?

Collateralization is an essential concept in DeFi. As with traditional banking, if you borrow assets, you have to put up some collateral, which acts as insurance for your loan. When you lock your crypto funds in a DeFi protocol, you will get some of its native token based on the collateralization ratio.

If your collateral’s value drops below a certain threshold determined by the project, the collateral may be liquidated. In order to avoid liquidation, you have to add more collateral. For example, if you lock 10 ETH, you may get about $5,000 worth of the native stablecoin, since each ETH is priced at $500. If the price of ETH drops to $400, then you will have to add more collateral to match the $5,000 worth of the stablecoins in your hands. The good news is that when the ETH price is increasing, you will get more stablecoin value for free.

However, not all protocols work with a collateralization ratio. Again, each platform has its own rules, and consequently, the collateralization ratio differs from case to case. Often, the collateralization ratio is much higher than 100%, meaning that you will get less USD value for the locked cryptocurrency. This is done in order to keep the ecosystems safe.

Benefits of DeFi Yield Farming

The main benefit of yield farming is obvious – it’s the profit you can make by simply locking a portion or all of your crypto holdings. If you are lucky and invest in a young DeFi project, the native token may rapidly increase and you can generate generous profits not only from the interest return but also from the price increase.

Another benefit is that yield farming gives you the opportunity to take part in a fast-growing sector that many experts say is here to stay. Thus, if you deal with DeFi projects, you are an early promoter of the blockchain adoption in financial markets and contributing to the decentralization of finance.

Risks of Yield Farming

Any form of investment in the cryptocurrency market carries some form of risk, especially when it comes to newer projects like most DeFi protocols are. It’s worth mentioning that yield farming is working much better with higher initial deposits. Still, if you want to have fun, you can experiment with small amounts that you can afford to lose.

If you ignore the basic risk management techniques, you may end up losing your holdings. Here are the main risks you should consider:

  • Smart contracts – many DeFi protocols are developed by small and sometimes inexperienced teams. As a result, the smart contract might have bugs that can affect the entire ecosystem. For example, bZx suffered several hacks early this year. In the latest hack, it lost about $8 million due to a single line of code that was misplaced. The good news is that the funds were later returned.
  • High volatility – it is no secret that the crypto market is highly volatile, and DeFi tokens are probably the most extreme examples. Because of this, yield farmers may be exposed to liquidation risk if the market unexpectedly drops, and the collateralization ratio is high.
  • Overvaluation – the hype around DeFi tokens might be justified, but that doesn’t mean investors are rational and objective when they buy tokens for speculative purposes, especially when they are so sensitive to the fear of missing out (FOMO). This causes overvaluation in many tokens, and the price would eventually retreat to its fair value. The important thing is to anticipate the trend reversal and close your exposure on time.  

DeFi Projects That Allow Yield Farming

Here are a few platforms and protocols that allow their users to generate profits through yield farming:

Compound Finance

Compound is a decentralized network that relies on an algorithmic money market to let users lend and borrow crypto assets. Any individual with an Ethereum wallet can deposit funds to Compound’s liquidity pool and earn rewards that start compounding right away. The rates are fluctuating based on supply and demand, but yield farmers use complex strategies to boost the effective rate.

MakerDAO

Maker is one of the first DeFi projects out there. It is promoted as a decentralized credit platform that enables the creation of DAI – the proprietary stablecoin that is pegged algorithmically to the value of USD. Users can open a so-called Maker Vault to lock supported cryptocurrencies as collateral, such as ETH, USDC, BAT or WBTC. By locking crypto funds, users generate DAI as debt against their collateral. The debt incurs interest called the stability fee, which is set by MKR token holders. In order to generate yield, users may lock Maker to mint DAI for their yield farming strategies.

Synthetix

Synthetix enables the minting of synthetic assets against the staked Synthetix Network Token (SNX) or ETH, which are used as collateral. Users can contribute to various liquidity pools and earn interest.

Aave

Aave is another decentralized platform for lending and borrowing tokens. Lenders receive “aTokens” in return to their funds. The tokens start earning interest immediately upon depositing.

Uniswap

Uniswap can be regarded as a decentralized exchange (DEX) – it enables real-time swaps between various tokens. Uniswap hosts token pairs supplied by pools, where liquidity providers lock two different tokens based on the pair components. In return, liquidity providers earn from trading fees.

Curve Finance

Another decentralized exchange is Curve, though it was designed specifically for rapid stablecoin swaps. The protocol enables users to conduct large stablecoin swaps with low price slippage. Yield farmers can earn interest by locking funds in Curve’s liquidity pools.

Balancer

Balancer is a decentralized exchange quite similar to Uniswap and Curve. Unlike Curve, it allows users to trade all kinds of tokens, not just stablecoins. The main difference from Uniswap is that it allows liquidity providers to build custom pools that don’t necessarily require 50/50 allocation.



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