What is Yearn Finance? The secret of the most successful DeFi project
In less than three months, Yearn Finance has evolved from a relatively obscure credit aggregator into one of the main drivers of DeFi market with a $670 million capitalization (over a billion dollars peak) and is at the heart of the hottest trend in the industry today — Yield Farming. Yearn dominated Yield Farming so convincingly that some introduced its token, YFI, as the Yield Farming Index. But with this sudden rise, it is worth thinking about the complex issues of value, impact, risks and opportunities for Yearn in the future.
Birth and Rise of YFI
Until 16 July, Yearn was a simple DeFi credit aggregator designed to optimize user profitability. It had $8 million in assets under management and since its launch in January, it has earned a combined 10.58% per annum on the profits of its liquidity providers. But most importantly, it did not have a token.
Everything changed the next day, 17 July, when yearn.finance founder Andre Cronje published a notorious blog post called “YFI”. In an effort to transfer control of the yearn.finance protocol to his users, Cronje developed a plan for users to manage YFI by providing liquidity to Curve and Balancer pools. This may have been the first truly honest launch in years, when Cronje did not allocate YFI tokens to himself, abandoning any rounds of funding, tokens for a team, premine or anything like that. All YFI tokens were distributed to users of the yearn.finance protocol.
A couple of months later, a supposedly “completely useless token” is worth $670 million and drives an “industrial scale agricultural machine” of $770 million (at a peak of almost a billion dollars). And it prints money for token holders of around 20 million dollars a year.
Industrialization of Yield Farming
A long time ago Compound launched its liquidity mining programme and started a speculative hobby that many people dubbed the DeFi Agricultural Revolution. Simply put, liquidity mining refers to the process of distributing tokens to users to use the protocol. The purpose of liquidity mining is to distribute control over the protocol and encourage its implementation. The Community introduced the term “Yield Farming” because of the analogy of users who invest their capital in the work of the protocol to obtain tokens with farmers working in the fields for the harvest.
In the weeks following the launch of Compound Mining, Yield Farming was quite simple. You invest your capital in one of several protocols that offer incentives in exchange for liquidity and start earning tokens. This first phase of Yield Farming was similar to manual field farmers. Users had to define and understand each strategy before they could manually enter capital. But as more and more protocols were running liquidity mining programs and Yield Farming became more complex, the process became more and more time consuming for many users. In addition, as gas prices rose sharply due to the congestion of the Ethereum blockchain, many small ‘farmers’ stopped being involved in Yield Farming. Everything changed when yearn.finance launched v2 (second version) of its protocol, introducing yVaults.
The most effective way to think about yVaults is to present a two-way market where capital providers are on the one hand and strategy developers on the other. The authors of the strategy distribute the users’ capital, and the providers of capital choose which strategies they want to use. The strategies automate Yield Farming for users. With the launch of yVaults, potential farmers can now simply deposit their funds in yVault and their capital will be automatically allocated to the best strategies available. “Vaults” not only reduce the risk faced by users trying to understand the different possibilities of Yield Farming, but also alleviate their concerns about gas fees by sharing it with other providers of capital in the pool. As a result, Yearn.finance has become the largest Yield Farming enterprise in the industry, doing what used to be a case where only sophisticated users could participate.
Cash flow machine
YFI is a challenging project. It has the main products Earn (loan optimisation) and Vaults (Yield Farming optimisation) as well as many different products in its roadmap in the areas of insurance, exchange trading, leverage, venture capital and liquidation. In addition, this token model is still being developed by the consulting firms Delphi Digital and Gauntlet. However, it is important to understand how YFI currently earns money from its two main products, Earn and Vaults, as they can give an idea of its future (from an economic point of view).
The economy is simple. YFI charges a gas subsidy (productivity) fee of 5% of the capital it manages and a withdrawal fee of 0.5% if users withdraw their capital. Withdrawal fees apply to both Earn and Vaults products, while performance fees apply only to Vaults products. In particular, with storages, performance fees are charged each time a “harvest” takes place (selling the treated asset back for the underlying asset). Following the adoption of YIP-36, which determined that Yearn would use a portion of the system fees as operating capital, 100% of the system fees were sent to its treasury with multi-signatures. The YIP states that the treasury must maintain a buffer of $500 000 equivalent, with all surplus rewards allocated to YFI placed in the management pool.
Within a week of implementation, the Treasury has already accumulated over US$463 000 in revenue, which is just over $21 million per year. With a market capitalization of $390 million at the time, this implies a price to sales ratio of around 20 times, which for all intents and purposes can also be seen as a price to profit ratio, given that the protocol has no costs beyond what it receives from its treasury.
The inverse price/profit ratio of YFI means that if all YFI holders had made a stake, they would have received ~ 5% of annual returns (only YFI holders participating in the corporate governance pool receive cash flow). Since around 12% of YFI is currently placed in the pool (a large percentage of YFI is placed in other pools), YFI participants receive ~ 40% of annual returns, which implies a PE ratio of 2.4 times. It is best to understand these ratios as a range. Currently, YFI holders participating in the management pool receive ~ 40% of the annual return, but if everyone makes a stake, they will receive ~ 5% of the annual return. 5 % can be seen as a limit based on the current price and profit per token.
Yearn’s Yield Farming strategies have been so successful that they have started to drive the markets seriously. It is important to understand that Yearn’s Vaults not only automates users’ strategies, but also harmonises these strategies. Thus, instead of some users selling tokens when they are processing them and some users holding tokens because they prefer to hold on to or not pay for gas, all yVault users do one thing. And when this one thing is the systematic sale of tokens, it can have a significant impact on basic fermented tokens, given the token assets under management. The most recent example is CREAM, a decentralised lending protocol based on Compound, which has recently launched a liquidity mining plan. Since the launch of the YFI vault, the vault has systematically grown CREAM and sold profits for additional YFI. Essentially, the strategy benefits from CREAM speculators, who auction newly received CREAM tokens and redirect them to YFI.
The yCRV warehouse below shows how this process looks from the inside. There are some differences from this repository, but the general logic is the same. Replace yCRV with YFI and YFII with CREAM, and the picture will be very similar.
As the implementation of yVaults grows, the Yearn system will collect an increasing percentage of total profits from all the most profitable “agricultural opportunities” as long as the trend continues. The question then arises as to whether this is sustainable.
The main reason why Yearn can generate such high cash flow right now is because profitability is very high. The yields are high for a reason. It is high because it is supported by a speculative enthusiasm for protocols with liquidity mining programmes. The reason why “farmers” can get “yields” in three-digit and higher percentages is because speculators continue to buy new tokens on exchanges. Simply put, speculators pay for the “yields” that “farmers” get.
It is not clear how long the passion for Yield Farming will last. It may well continue beyond next year, or it may end overnight. However, as soon as interest diminishes, token holders will need to find more sources of money. This may be due to either an increase in AUM to compensate for lower ‘yields’, or additional products to provide alternative sources of income for the Yearn system. Equally important for YFI token holders is the current rate of use of Yearn. A performance fee of 5% of Yearn means the highest utilization rate among all DeFi protocols. The fee may well be justified given the value that Yearn provides to capital providers, but it is not a guarantee. Even Cronje himself believes that YFI token holders will not simply be able to get rent from capital providers.
Furthermore, under the current system, Yearn does not pay for the work of strategy authors. It is as if the asset management company does not pay its portfolio managers. To the extent that Yearn acts as a decentralised asset management platform (which some compare to an untargeted / arbitrage-oriented automatic management platform), it will eventually have to compensate strategy developers, resulting in higher costs.
There may not be a single project that is more suitable for reflecting Yield Farming’s growth than YFI. YFI is the short term common available market for Yield Farming, which currently provides USD 7.3 million in daily liquidity rewards. This entails an annual rate of $2.6 billion and the strongest tailwind for YFI.
However, although YFI is currently the leader in Yield Farming, it is not the only one fighting for the “yield pie”. Not only have several (often questionable) YFI forks appeared on the market, but new Yield Farming aggregators such as APY.Finance and asset management platforms such as Set V2 will increase competition. Furthermore, as mentioned earlier, the current returns from Yield Farming will not last forever. Speculators will eventually stop buying as many new tokens as possible, which will lead to lower returns. Although the successful launch of Yearn’s planned insurance, exchange, leverage and liquidation products may diversify YFI revenue streams and provide option value for YFI holders.
At present, YFI remains one of the most exciting experiments in decentralized management. The fair launch of YFI has created a large, diverse and enthusiastic community of people who are very interested in the success of the protocol. Thanks to Cronje’s professionalism and leadership, the pace at which Yearn’s products are released is impressive. There are very few protocols that launch new products as quickly as Yearn. However, although things are relatively smooth for now at Yearn, challengers are entering the market and Yearn is going to launch many new products, the risk is far from zero. The coming months will show whether this nascent community can continue its magic and benefit all stakeholders.
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