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From lending to Yield Farming

DeFi’s take on the traditional lending sector

The traditional financial system as we know it has developed over centuries and once one really tries to understand all the financial instruments and institutions that come with it, you’re facing a lot of complexity. Nevertheless, one big criticism surrounding centralized finance has always been its centralization as well as the danger of contagion — the risk that the failure of one major player will bring the whole system out of balance.

Decentralized Finance, DeFi, is proposing an alternative system to the one we’re all too familiar with. A financial system not run by institutions but governed and executed by code and decentralized technologies. We’ve already seen the rise of decentralized exchanges and decentralized lending platforms, but one trend has really taken off more recently: Yield Farming.

Today we’ll dive into what yield farming is. But before that, let’s talk about lending first as it’s highly related.

Quick History of Lending

Amazingly enough, the first example of lending was recorded over 4000 years ago in Mesopotamia where farmers could borrow seeds that were issued against the promise of later payment. Then several centuries later in ancient Greece pawnbrokers would start lending out money against collateral. Collateral could be anything of value that borrowers would deposit with the pawnbroker. This greatly reduced the risk of default and left pawnbrokers at least with a part of the loan even if the borrower defaulted. This concept would survive the centuries and find it’s way into the world of DeFi.

Fast forward to the 20th centuries where we’ve seen loans become a lot more accessible thanks to peer to peer-to-peer lending platforms that circumvent traditional banks completely and let individuals borrow from each other. These platforms have tremendously benefitted from the developments in technology which allowed them to operate with high-profit margins as they don’t have to pay expensive staff nor maintain physical locations. The global peer to peer lending market was valued at $67.93 billion and is projected to reach $558.92 Billion by 2027 — and these estimates were made before the pandemic.

Wondering what this has to do with Blockchain and DeFi?

Blockchain x Lending

Blockchain as a transparent, permissionless database is the perfect technology for lending. Anyone interacting on the blockchain can see the transaction history of other addresses making it a great choice for accurate credit ratings.

However, currently, several challenges remain with blockchain lending platforms, mainly due to the volatility of most cryptocurrencies. This means that you might have to deposit twice as much in collateral as you want to take out. Therefore, many crypto lending platforms are more attractive for trading purpose than for, let’s say financing a big purchase. On the lender’s side though, blockchain lending platforms can pay quite a decent amount of interest that goes well beyond the APR you’d expect on your bank account.

When lending out crypto on a lending platform traders will most frequently deposit stablecoins. As these are in high demand by institutional investors and other big traders who use them to increase leverage or benefit from arbitrage, lenders can earn good interest rates.

That’s “traditional” crypto-lending.

Yield-Farming is a special way of lending crypto assets that don’t involve a person that takes on those assets as a loan. Another term for yield farming that expresses better what really happens is “liquidity mining”.

Liquidity is essential for any financial asset to be tradeable. Liquidity simply refers to the ability of how fast one can turn something into cash. In general, major market cap cryptocurrencies trading on centralized exchanges are fairly liquid. They’ve high trading volumes which indicate that they can indeed be bought and sold — hence are liquid — and on order books the buy and sell orders are balanced. Exchanges often work together with market makers as well as liquidity providers to ensure that traders can trade at any point in time with minimal divergence.

In decentralized finance, exchanges run on top of smart contracts that connect traders with each other. Considering that decentralized exchanges (DEX) can be quite intimidating at first for less technology-savvy traders liquidity is a major challenge to overcome as it’s not guaranteed that coincidentally 2 traders will fill in buy and sell orders that match. In particular when it comes to less known assets.

This is where liquidity mining changes the game. Instead of just having a smart contract that connects traders with each other, decentralized exchanges tap into so-called liquidity pools. Liquidity pools are smart contracts that pool different cryptocurrencies and make them available for trading. Traders, also referred to as liquidity providers when they deposit in pools, lock the funds they don’t need or plan to hold on to long-term into such liquidity pools. In return they receive rewards. While it sounds similar to the way Staking works, there is a lot more going on in the back-end than mere confirmation of blocks.

Liquidity protocols power not only exchanges but can also provide their services to other platforms on which users buy, sell, lend and borrow tokens. For providing liquidity, liquidity protocols usually earn fees which they partly distribute to the liquidity providers — the traders that have locked up their assets. These traders are now “farming yield”. The higher the stake invested in a liquidity protocol is, the higher the yield one can earn.

While yield farming typically happens on Ethereum platforms, with more and more interoperability and cross-chain bridges, that might change in the future.

As of today, several liquidity pools are trying to attract yield farmers with a combination of different incentives, as traders tend to go to wherever they can earn the highest reward or yield. One additional benefit of picking a specific liquidity pool to lock one’s assets in is receiving a new token that can’t be bought easily elsewhere.

It’s complicated…

To name an example of a platform that has tremendously well: Compound finance. Compound finance “is an algorithmic, autonomous interest rate protocol built for developers, to unlock a universe of open financial applications.” Developers can access compound to add liquidity to their platforms or applications while investors can deposit their cryptocurrency to earn interest on it. Compound Finance has done extremely well and has at the time of writing locked in more than $ 6 billion worth of cryptocurrency. Liquidity providers earn interest rates ranging from 0.8% annually to more than 5% on certain stable coins. On top of that, those rewarded with the COMP token were in for a nice surprise, as COMP itself has appreciated strongly in value since the beginning of the year.

Compound is partnering with several well-known crypto platforms and hardware wallets allowing investors to even farm yield from the safety of their ledger.

While it might sound very enticing, one should be aware that many high yield strategies involve a lot more than just locking your coins into one protocol. Many include taking loans to leverage one’s position in pursuit of the highest rewards. Another potential risk to consider is the safety of smart contracts. As a relatively nascent field, a number of teams building liquidity pools start out with a low budget and might not be able to finance a security audit. And even after an audit, it’s quite common in the world of blockchain to still encounter bugs.

With those risks in mind and after having done your own research on the platforms you intend to use happy harvesting!

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Naomi Oba

Naomi Oba

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Writer in Crypto — passionate about financial education, blockchain, books, and food.