Decentralized finance (DeFi) has been the talk of the blockchain town over the past few months. The total value locked in DeFi smart contracts reached the all-time- high of $9.6b on the 2nd of September 2020 before it started to go south. The current total value locked as of today is $7.21b, according to Defipulse. Yield farming plays a significant role in this DeFi craze.
One popular and hot new concept in the DeFi space is yield farming.
Let’s take a closer look at defi yield farming, what it means, and why it has become so popular.
In a nutshell, yield farming is a way to allow token holders to put their cryptocurrencies into DeFi network to earn fixed or variable interest. It works by you lending your cryptocurrencies to others via programmed rules of the so-call smart contracts. Investing in ETH is not considered yield farming; lending out ETH on DeFi networks such as Compound Finance, Aave for a return beyond the ETH price appreciation is yield farming.
Where it starts
Yield farming started to attract strong interest from the cryptocurrency community after the launch of COMP token – the governance token of the Compound Finance ecosystem. COMP 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?
Protocols such as Compound Finance uses governance tokens to make the networks decentralized by rewarding the token holders with new tokens when they deposit their tokens to the network to provide liquidity to the network. This process is called “farming”.
The COMP launch indeed makes this new way of rewarding token holders popular Ever since, many DeFi projects have come up with different innovative schemes to incentivize token holders deposit their tokens to provide liquidity to the ecosystems, and “farm” new tokens.
How it works
Yield farming typically involves automated market makers (AMMs) such as liquidity providers (LPs) and liquidity pools.
Liquidity providers are incentivized to deposit cryptocurrencies 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, the “farmed tokens”.
Apart from fees, another incentive to put cryptocurrencies to a liquidity pool could be the distribution of a new token.
There are two typical ways of farming tokens on DeFi networks, which are earning through money markets and liquidity pools.
Yield farmers use very complicated strategies and move their cryptos around constantly between various DeFi lending marketplaces to maximize their returns. They’ll also be very secretive about the best yield farming strategies.
Yield farming using money market networks
Compound and Aave are top platforms for yield farmers to farm tokens using money market mechanism. Both of these platforms are lending and borrowing protocols.
The easiest way to earn cryptocurrencies is to lend money to open DeFi marketplaces.
Apart from normal interest offered to token holders that lend their cryptocurrencies on Compound protocols, Compound also offer extra incentives for token holders through its governance token COMP.
Yield farming through liquidity pools
Uniswap and Balancer are the two largest liquidity pools in DeFi space, offering liquidity providers (LPs) with fees as a reward for adding their assets to a pool. Liquidity pools are configured between two assets in a 50-50 ratio in Uniswap. Balancer allows for up to eight assets in a liquidity pool with custom allocations across assets.
Yield farming through incentive schemes
A typical example of this is Compound introducing COMP as an incentive for people to use the protocol. It adds extra incentives for token holders to hold and use COMP tokens within its network.
Another example is Synthetix which first introduced an sETH-ETH pool that offers LPs an added incentive of SNX rewards. While this pool has been deprecated, this expanded to other liquidity pools. At the moment, Synthetix has two substantial liquidity incentives: an sBTC pool and an sUSD pool on Curve that give LPs an added reward in SNX.
What are the risks of yield farming?
Smart Contract risk: Smart contracts are prone to exploits, with several examples just this year (bZx, Curve, lendf.me). The surge in DeFi has led to millions in value being slammed into nascent protocols, increasing the incentive for attackers to find exploits.
System design risk: Many protocols are nascent and the incentives can be gamed. (E.g., Balancer, where FTX was able to capture >50% of the yield due to a simple flaw)
Liquidation risk: Collateral is subject to volatility, and debt positions are at risk of becoming undercollateralized in market swings. Liquidation mechanisms may not be efficient and could be subject to further loss.
Market risk: The price dynamics of the underlying network tokens (like $COMP) are reflexive because expected future value follows usage, and usage is incentivized by expected future value.
In general, DeFi protocols with significant capital are honeypots for exploits. In just one week, the Balancer protocol was gamed by an exchange, changed its protocol rules, got hacked, and saw the token price go up 3x! In some ways, DeFi is still the wild west — be careful out there.
DEX Volume explodes, begins to rival Centralized Exchange volumes
DEX volume rocketed upwards over the last months, and has begun to rival some centralized exchanges.
This is a direct result of yield farming, especially when recursively borrowing and lending requires swapping between two different ERC-20 tokens. Stablecoins have been most preferred (as in the example above), which led to Curve’s rise to dominance (a stablecoin-specific DEX).