Yield Farming in DeFi — A Beginner’s Guide
Decentralized Finance, also popularly known as DeFi, throwing vibes that may put the 2017 ICO craze to shame. The crypto community is going crazy over it. Google trends show the highest search request for DeFi was in the week ending September 5.
And yet many are baffled with it and are unaware of what they can do or how to participate in the next revolution.
DeFi is turning heads with Yield farming. Early users made thousands of percent in profit by simply understanding the concepts before the masses can learn about it. A huge population is still not participating in Yield farming and DeFi in general because they don’t really understand it that well. Hence, let us understand Decentralised Finance and Yield Farming today with this article.
Decentralized Finance
Decentralized finance refers to the shift from traditional, centralized financial systems to peer-to-peer finance enabled by decentralized technologies built on Blockchains like Ethereum. Financial services like lending and borrowing platforms to stablecoins and tokenization of other assets, can all be done with smart contracts and require no middleman. The DeFi ecosystem continues to build financial instruments and push the boundaries of possibilities.
According to DeFi Pulse, there is $7.1 billion in crypto assets locked in DeFi right now.
Some of the advantages of DeFi include immutability, transparency, permissionless, programmability with smart contracts, and more. Most importantly, all the funds are actually in self-custody instead of a cryptocurrency exchange.
Adding spice to DeFi, the sector started receiving prominent recognition after Ethereum based credit market Compound started practically giving away COMP — the governance token, to the protocol’s users.
The term “Yield Farming” became popular since, and it is simply used to describe how users can temporarily put their crypto holdings in such protocols and earn their tokens rapidly. Another term less used for this is “Liquidity Mining”.
What is Yield Farming?
To put it simply, farming means being rewarded by new crypto assets by putting your existing crypto assets to work with lending or staking.
When you put your money in the bank, you get interested. In the cryptocurrency world, when you stake your assets, you may receive interest or fees as a reward. This depends from project to project. When a protocol gives you high amounts of newly generated cryptocurrencies in return, and users keep switching from protocol to protocol to maximize the return, this is broadly known as yield farming. These tokens can rapidly appreciate in value and make the early investors rich.
So imagine someone asks you to deposit Rupees and Dollars with them, in return they will give you thousands of little coins every few minutes as a reward. Maybe these little coins have no value in the beginning, but if someone starts accepting it as a valid payment or they can be used for some service, thereby creating a use case for them, these little coins can make you very wealthy and your original rupee and dollar is safe in a smart contract that you can extract anytime you want.
Different Types of Yield Farming?
Well, there are many ways users can start farming new protocol tokens. The craze started with Compound when users could simply convert their USDT to cUSDT and then put it on Balancer to support the Automatic Market Maker for traders. However, in the past few months, protocols are innovating new ways to maximize yield for their users. You are currently part of a massive experiment that aims to remove the middlemen from financial transactions.
Liquidity Mining:
Liquidity mining derives its name from the fact that users can use their own crypto assets to provide liquidity to Decentralised Exchanges for other traders to quickly swap tokens.
If a trader wishes to convert ETH to MATIC, on a centralized exchange like Binance, there are both buyers and sellers matched to each other. However, for decentralized exchanges of 2020, to offer immediate swaps with the highest possible value, the protocols allow users like us to provide our tokens as liquidity on these protocols.
When a user tries to swap ETH to MATIC on a DEX like Uniswap, the protocol simply deposits ETH and withdraws MATIC from the vast liquidity it has acquired from liquidity providers.
These Liquidity providers earn the trading fees paid by the traders swapping tokens.
Some examples of platforms offering Liquidity mining are Curve Finance and Balancer.
Token Farming:
While certain protocols incentivize liquidity providers with fees, some add a new flavor to the equation by adding a giveaway of protocol tokens as well.
Users can earn native tokens from Protocols like yEarn and Compound after providing liquidity to the pools. When the pool has less quantity, the reward rate tends to be higher and hence attracts more and more “farmers”.
Protocols like Ampleforth, BNS Finance leverage liquidity pools from other platforms like Uniswap to distribute rewards. Users are required to add a set of tokens to pools on Uniswap and then stake the Uniswap tokens on the platform to start farming the protocol’s tokens.
Each protocol uses a different strategy to reward its users. Many have various use cases for their platform tokens as well.
Yield Farming is Complex by Design
Unlike ICOs of 2017, the analogy used for comparing Yield farming in 2020, the latter is much more complicated. Users simply tried to buy the tokens in ICOs early on. For yield farmings, users need to lock their crypto assets early on to maximize gains and have to continually monitor the platforms to maximize the rewards from farmed tokens.
The end game in Decentralised Finance is the ability to replicate the speed and efficiency of transactions in traditional finance.
Building such an ambitious project to be fully decentralized requires all stakeholders to be rewarded well enough to be part of the ecosystem.
It begins with having enough tokens in the vaults of the protocols to always be able to fulfil the requirement of the trader/customer. Thereby, liquidity providers become quintessential to the ecosystem. To keep liquidity providers, they need to be incentivized with rewards, and just the right amount. Too much and the token value can be diluted, too little and LPs can jump ship.
A lot of computation goes into the formulae built to make these protocols sustain and remain trustworthy without truly required to be trusted.
With over 7 Billion USD locked in DeFi, the race is on for who will survive the test of time and emerge a true winner.
Until then, you and I could try to farm some tokens and increase the size of our portfolio.
How are Yield Farming returns calculated?
Calculating the estimated yield farming returns are generally annualized. This estimates the returns that you could expect over the course of a year.
Some commonly used metrics are Annual Percentage Rate (APR) and Annual Percentage Yield (APY). The difference between them is that APR doesn’t take into account the effect of compounding, while APY does. Compounding, in this case, means directly reinvesting profits to generate more returns.
However, be aware that APR and APY may be used interchangeably. It’s also worth keeping in mind that these are only estimations and projections. Even short-terms rewards are quite difficult to estimate accurately. Why? Yield farming is a highly competitive and fast-paced market, and the rewards can fluctuate rapidly.
If a yield farming strategy works for a while, many farmers will jump on the opportunity, and it may stop yielding high returns.
Yield Farming Platforms:
There are many existing and upcoming platforms for Yield Farming. But there are no rules to determine these rewards and farming strategies. Farming strategies may even change by the hour. Each platform will have its own rules and users can gain the most rewards by managing their risks and strategies.
The basic idea is to deposit funds in a smart contract and earn rewards. But it shouldn’t be done blindly.
So let’s look at a few popular Yield Farming platforms used worldwide.
Compound Finance:
Compound allows users to lend and borrow assets. It is an algorithmic Money Market. Users can supply ETH and ERC20 assets to Compound’s liquidity pool and earn rewards that keep on compounding. The compound is one of the first platforms to introduce Yield Farming.
Curve Finance:
Curve Finance is a decentralized exchange for efficiently swapping stable coins. On the Curve, users can swap stablecoins in high volume without much slippage. Users can add stable coins to the Curve Pools and start earning rewards from it.
MakerDao:
MakerDao is a credit platform where DAI — a stable coin algorithmically pegged to USD is created in a decentralized manner by users locking their assets like ETH, BAT. USDC or WBTC as collateral. DAI is generated as a debt against the collateral locked. Yield farmers may use Maker to mint DAI to use in yield farming strategies.
Synthetix
Synthetix is a synthetic asset protocol. It allows anyone to lock up (stake) Synthetix Network Token (SNX) or ETH as collateral and mint synthetic assets against it.
What is a synthetic asset? Practically anything that has a reliable price feed. This allows virtually any financial asset to be added to the Synthetix platform. Virtually anything can be used as an asset for yield farming.
Uniswap
Uniswap is a decentralized exchange (DEX) allowing any token swaps. Liquidity providers deposit an equivalent value of two tokens to create a market. Traders can then trade against that liquidity pool. In return for supplying liquidity, liquidity providers earn fees from trades that happen in their pool.
Many platforms have yield farming strategies designed to work require users to add liquidity to the pools and then stake those LP tokens for yield farming.
Aave
Aave is another decentralized protocol for lending and borrowing tokens. The interest rates are adjusted algorithmically depending on the market condition. The tokens lent immediately start earning interest. One other functionality of Aave is flash loans, that allows users to borrow any amount of capital, provided it is returned within the same transaction — this helps in capturing huge arbitrage opportunities.
Aave is used by yield farmers extensively.
Yearn. Finance
Yearn.finance is a decentralized ecosystem of aggregators for lending services such as Aave, Compound, and others. It aims to optimize token lending by algorithmically finding the most profitable lending services. Funds are converted to yTokens upon depositing that periodically rebalance to maximize profit.
Yearn.finance is useful for farmers who want a protocol that automatically chooses the best strategies for them.
There are many other Decentralised protocols that allow users to continue to improve their Yield farming strategies.
Drawbacks and Future Solutions
Despite all the good things with DeFi mentioned earlier, there are some drawbacks to DeFi. The most important one is the network congestion on Ethereum Blockchain. Users have to cough up huge fees to make transactions for yield farming. As the number of pending transactions increase, the fees required to get your transaction confirmed to go up significantly.
This leads to another problem where it makes it impossible for traders to start farming with low capital. A minimum of $1000 is required to see some earning in almost all the protocols.
However, there is a solution. Several projects are now aiming at layer two solutions to move the DeFi market. Layer two solutions like Matic use side chains to speed up transactions and only send a transaction on the mainnet at certain intervals aka checkpoints.
Use of layer two protocols can easily take the load off the mainnet, speed up transactions, reduce fees and make DeFi, and yield farming more accessible to everyone.
Many projects have started building DeFi protocols on Layer two, one of them is EasyFi. EasyFi wants to bring yield farming to everyone. It will be built on top of the Matic network because of the aforementioned drawbacks of the Ethereum network.
EasyFi will offer micro-lending, Credit default swaps, under collateralized loans with credit delegation — one of a kind trust-based loans, something currently unavailable in the market.
Farmers can earn rewards in “EASY” tokens by adding their assets to the liquidity pools and enjoy gas-less transactions.
Decentralized Finance is both exciting and adventurous. DeFi can help create a more open and accessible financial system available to everyone. Ironically, before DeFi became a buzzword, the concept was actually being thrown around as Open Finance.
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