What is Yield Farming?
DeFi is a general term used for financial products based on open-source smart contracts. Popular DeFi protocols such as Compound, Balancer, Curve, and 0x have opened up a whole world of new opportunities for investors in search of deep liquidity, different risk-return ratios, as well as interesting and affordable modern financial instruments.
In yield farming, cryptocurrency holders contribute funds to liquidity pools to provide liquidity to other users. Thus, these holders become liquidity providers (LPs).
It is worth noting that the liquidity pool is a digital pile of crypto-assets locked in smart contracts. Liquidity providers compensate by adding liquidity to the pool. Compensation can come from the base fees of the DeFi platform, or another source.
Liquidity pools offer different tokens as payment methods. After receiving the reward, the incentive tokens can be placed in additional liquidity pools to continue receiving the reward. However, the basic concept is that a liquidity provider deposits money into the liquidity pool and receives a reward in return.
In the Ethereum blockchain, yield farming is usually carried out using ERC-20 tokens, and some other ERC-20 tokens often serve as returns. In the future, owing to the development of blockchain technology, Ethereum may have competitors. However, to date, the Ethereum ecosystem has been the most popular blockchain for yield farming.
Interchain bridges and other related developments may eventually allow DeFi applications to be blockchain-independent. This implies that they can function in various blockchain networks, facilitating the use of smart contracts.
In pursuit of high income, yield farmers often swap money between different protocols. Consequently, DeFi platforms may offer additional financial benefits to attract more funds to their systems. Liquidity tends to attract even more liquidity, similar to centralized exchanges.
How Does Yield Farming Work?
Yield farming is carried out using automated market makers (AMM), which are protocols used in liquidity pools for automatic asset pricing.
Liquidity providers deposit funds in liquidity pools. Other users can borrow, or trade these deposited tokens on a decentralized exchange that operates based on a specific pool. These platforms charge an additional fee that is then distributed among liquidity providers according to their percentage participation in the liquidity pool.
As this technology is constantly evolving, new approaches are likely to emerge that may even replace existing models.
In addition to the commission, the issue of a new token can play a role in stimulating money deposits into the liquidity pool. For example, a token can only be available in modest quantities in an open market. However, it can be generated by providing a pool with liquidity.
Each protocol implementation has its own allocation rule. The bottom line shows that liquidity providers earn revenue based on the amount of liquidity they provide to the pool.
Main Advantages of Yield Farming
You are not required to agree to a fixed duration of blocking in the yield-farming pools. This means that the amount of liquidity can change, as needed. You can simply withdraw funds immediately if you feel unprotected and at risk from a particular pool. On the other hand, you can invest more tokens if you find that a particular pool for yield farming provides better conditions.
Depending on the trading pair you choose, you can also obtain a significant return that exceeds that offered by the other methods. This depends on how volatile and liquid the pair is. For example, there is a high probability that the pool will offer a three-digit APY to provide liquidity for a completely new and unknown crypto asset. Farming is widespread because it can generate double-digit returns even for very liquid pairs.
Where Does a Yield of Hundreds and Thousands of Percent Come From?
Yield farming is characterized by high profitability. The norm is tens of percent per annum, and there are often hundreds or even thousands of percent. Where does such profitability originate?
High profitability helps protocols to solve their own problems:
- Quick attraction of liquidity. Users bring liquidity, and protocols use it to make money.
- Advertisement. Centralized banks and insurance companies spend money on advertising to attract users. Decentralized banks and insurance companies directly distribute their money to users as advertising.
- Creating a community. Communities play an exceptionally high role in the crypt. For large projects, the community is more important than the team and often merges with it into a single whole. Community members can simultaneously be users, holders of management tokens, developers, and evangelists. The widespread distribution of management tokens is a guarantee of the stability and decentralization of the project.
As a rule, the yield of hundreds and thousands of percent does not last long. The thickest cream was removed by early investors, who came to the protocol in the first few days. Then the yield falls. It does not yield protocols to maintain a high APY forever — a high issue creates an oversupply of tokens, which puts pressure on the price.
Therefore, most hardcore farmers constantly look for new projects. There is a small (several tens of thousands of people) but a very active and super-mobile international community of DeFi-farmers in the world. These people were the first to develop new protocols. Many operate with millions of dollars and constantly shift funds from one project to another in search of the highest profitability.
Risks of Yield Farming
Yield farming has various common risks, including impermanent loss, smart contract risks, volatility, regulatory risks, liquidation risks, unfairness, scam risks, gas fees, bugs in the code, and price risks. Impermanent loss occurs when the value of assets changes while providing liquidity, resulting in a loss of more than holding assets.
The most complex strategies are only suitable for advanced users or whales (owners of large capital).
What other risks are worth knowing about?
Errors and vulnerabilities are constantly being discovered even in large and reputable protocols. Some of these can lead to the loss of user funds, and it is impossible to return them because of the technical features of the blockchain - all transactions are irreversible.
High risk of smart contract errors. In particular, many projects have been developed by small teams with limited budgets.
The entire DeFi ecosystem consists of "building blocks.” This has both advantages and disadvantages at the same time. While the underlying protocol may not have vulnerabilities, it is associated with may have vulnerabilities. Consequently, owing to errors in one block, the user may lose funds.
Earnings variability: The yield changes every few seconds depending on the state of the market. You can never know in advance what it will be and how much you will earn. Today, the rate may be very high, and tomorrow, it may be very low.
From a legal perspective, DeFi platforms are not the safest place to invest money. They are not regulated by anyone and usually do not provide insurance in the case of loss of funds.
It is essential for investors to research assets thoroughly, diversify them, and use risk management tools to mitigate these risks.
How to reduce risks
- The risk of non-permanent losses can be reduced in several ways:
- Invest in stablecoin pools. For example, USDap/USDN, DAI/USDC/USDT, or DAI/BUSD. The rates of popular stablecoins fluctuate in a narrow range, so the risk of non-permanent losses in such pools is small. But for a low risk, you have to pay with a lower yield. A yield above 15% on stablecoins is considered high.
- Invest in pools of correlated assets. Correlated assets are getting more expensive and cheaper synchronously. A strong correlation is characteristic of the network's native coins and the tokens of the largest DEX on this network. For example, BNB-CAKE or AVAX-JOE.
DeFi Platforms for Yield Farming
yearn.finance is an aggregator of credit protocols (Compound, Aave, etc.). In addition, it provides a complete set of other financial services, from trading to insurance. One of the features is profit optimization owing to the automatic search for the most yield credit protocol at any given time. After the deposit, the funds are converted into yTokens, which are redistributed to different pools based on their profitability.
Compound is one of the most extensive and sought–after money markets in the DeFi ecosystem. It is used as an auxiliary tool in many other projects. It helps users to give their cryptocurrency at interest or borrow assets against the security of others. Anyone with an Ethereum wallet can supply liquidity to a pool. Interest rates, as in other similar protocols, are adjusted independently, depending on the supply and demand for specific assets.
Curve Finance is a decentralized exchange protocol developed primarily for stablecoins. This makes it possible to perform exchange operations with stablecoins with much higher yields than on the same Uniswap. In other words, the liquidity providers are rewarded. A native CRV token was used as the reward.
Synthetix is a protocol that is used to create synthetic assets. Any user can block their cryptocurrencies (or other assets from the list of supported assets) in a smart contract and create an equivalent number of synths (synthetic assets). The auxiliary token is the SNX. Synths are convenient because they can be used to tokenize even fiat currencies or precious metals to manage them on a decentralized basis.
The Maker platform allows you to create a DAI stablecoin, the rate of which is algorithmically linked to the US dollar. The user can open their own storage on a decentralized credit platform and then lock assets there as collateral (many ERC-20 tokens are supported, including tokenized bitcoin wBTC). Based on the blocked collateral, the participant generates a DAI, and over time, this debt brings interest. The specific rate is set by the participant-holders of the MKR tokens.
Uniswap is a DEX (Decentralized Exchange protocol). Allows users to exchange tokens without trusting them for storage. A pool for exchange is formed thanks to liquidity providers, and traders trade based on the assets available therein. Liquidity providers receive commissions from all the transactions conducted in the pool in which they invest. Each pool is a trading pair.
Aave is a protocol for decentralizing loans and deposits. Supports automatic correction of interest rates. In exchange for his deposit, the participant receives aTokens, which immediately begin to bring interest income. Aave was also one of the first projects to introduce technology for unsecured flash loans.
Balancer is a protocol similar to Uniswap and is based on the concept of a liquidity pool. It differs in that, with its help, users can manage the distribution of tokens in the pool themselves, while Uniswap independently divides investments on the principle of 50-50. Liquidity providers receive commission fees from exchange operations for their work.