How Has Yield Farming Changed DeFi?
An HBR review of studies on incentives leaves the redemptive power of rewards theory dead on the water. Psychologists say that rewards are an inferior motivation mechanism. Incentives rarely create lasting commitment. They only temporarily alter the attitudes that guide behavior.
The study, for instance, reveals that people that expect rewards for completing a task do not perform them well. On the other hand, those who get down to business due to motivations such as teamwork, continuous improvement, or participative management satisfaction perform better.
Rewards, therefore, do not create a long-lasting commitment to an idea, action, or value. Vitalik Buterin, the crypto god behind the powerful Ethereum network, could not agree more. In August 2020, Vitalik tweeted that he would steer clear of the rising yield farming movement till it had a sustainable source of value.
“I am steering clear of the yield farming space completely until it settles down into something more sustainable. But I’m not particularly a “smart mind in DeFi,” Vitalik wrote.
Vitalik was not the only Ethereum visionary to take a stance against the wild yield farming bushfire that had set the Ethereum network ablaze. Other skeptics include John Lim, aka Weeb Mcgee, one of Ethereum’s prominent developers and community members.
In August 2020, Weeb tweeted, “Yep. I’m on the record saying yield farming meta is an unsustainable zero-sum game. The big winners here are protocols benefitting by capturing permanent value via inflated prices / sudden movements of funds. @AaveAave @compoundfinance @iearnfinance”.
The yield farming craze first lit up the DeFi sector in early 2020. At the start of that year, the total DeFi project TVL or total value locked was under $630 million. Half of this value was locked in MakerDAO, Ethereum’s decentralized crypto lending platform.
MakerDAO’s premise was simple, but its utility was complex. Bank your ether via your MetaMask wallet and access crypto loans in non-volatile DAI stablecoin form. MakerDAO’s smart contracts would create a Collateralized Debt Position (CDP) and lock user ETH in its protocols.
It would then mint some DAI in return. To get back their ETH, users would pay off their DAI loan and a preset interest rate. The Maker Protocol offered lots of value to the nascent DeFi ecosystem. Its MCD or Multi-Collateral DAI system gives the larger Ethereum developer community access to innovative financial tools.
DAI and Maker support functions such as community-focused fundraising. Uniswap leverages the Multi-Collateral Dai system for efficient and fast trading processes. In addition, DAI supports in-game asset tokenization and rewards systems in blockchain games such as Axie Infinity.
It also plays a huge role in the NFT market and is an excellent alternative to volatile fiat currencies in regions that suffer hyperinflation. MakerDAO is Vitalik approved because its use case gives it healthy sustainability metrics. Today MakerDao has a total value-locked volume of $17.32 billion.
The rise of the yield farmers
By the Q2 of 2020, the total value locked in DeFi platforms had risen to $1 billion. A month later, that figure tripled to $4.5 billion. Much of this value arose from yield farming protocols such as Aave, Curve, and Balancer.
Yield farming is one of decentralized finance’s most lucrative reward systems. To earn juicy yields, yield farmers only need to deposit and lock up their crypto assets into a yield farming protocol of choice. The protocol will then lend out these assets and earn variable interest. It will then distribute this interest to every farmer as per their stake.
Compound unofficially set off the yield farming boom. The Compound Finance ecosystem was original, like MakerDAO, a lending and borrowing platform. It was Ethereum’s second-largest crypto assets lending protocol in 2020.
While it leveraged peer to peer lending mechanisms, Compound was governed by a team based in San Francisco. To change its governance system and adopt a community-led approach, the team decided to mint COMP, its governance token, and issue it to borrowers and lenders.
COMP holders would have governance rights such as voting on supported assets and protocol upgrades. The team issued the first batch of unvalued COMP on June 16, 2020. After that, the market would determine the token’s value.
At the end of that day, COMP was worth $175 per token. Over time, the team would distribute over 4.2 million COMP to Compound’s users. The token’s supply of 10 million would go to early adopters and Compound investors.
Vitalik and other yield farming skeptics had cause to worry. Soon various yield farming protocols were printing tokens round the clock to incentivize their users.
That first wave of yield farming platforms seemed to provide little to no utility for the larger DeFi ecosystem. In contrast, Vitalik and his fellow thinkers had built Ethereum as a value network. Therefore, they would only show support to platforms that pursue utility rather than price. Price should only come as a result of deep utility.
These platforms would market and onboard users through their liquidity pools. Their users would entrust their crypto assets at times to unaudited protocols. The fortunate user would earn yield from platform transaction fees and highly speculative liquidity provider tokens.
Platforms such as Compound and Yearn finance would award their user’s governance tokens to give them a front seat in protocol governance.
The non-stop printing of tokens alarmed Vitalik. He called out these platforms’ actions, drawing parallels between them and central bank fiat currency printing.
“Seriously, the sheer volume of coins that needs to be printed non-stop to pay liquidity providers in these 50–100%/year yield farming regimes makes major national central banks look like they’re all run by Ron Paul,” tweeted Vitalik.
Vitalik warned that these high-yield promises were unstainable. More, so in a bid to outdo each other and attract larger users to their liquidity pools, yield farming protocols were constantly playing a game of music chairs. Each platform would raise its yield rates to stay competitive and give users high royalty rewards.
Changpeng Zhao (CZ), the Binance CEO, was also skeptical of the yield farming craze. However, he did agree that automated market lenders were doing a great service to the ecosystem. They brought in much-needed liquidity and rewarded liquidity providers a fraction of their transaction fees.
That said, CZ cautioned the market that competition would lead to higher rewards in annualized returns and create a bubble. Vitalik also slammed these protocols because their teams seemed to turn a blind eye to smart contract risks.
Some platforms were vulnerable to hackers and rug pull risks. He felt that the DeFi community was grossly underestimating smart contract risk.
Yield farming protocol’s impact on Defi
Yield farming may have many flaws, but it is a brilliant decentralized finance protocol. It is a DeFi feature that supports decentralized applications’ business ideals. Before the advent of yield farming, Ethereum developers invented the ERC-20 token protocol.
The ERC-20 token standard was designed for use on the Ethereum network. Ethereum based tokens have had a profound effect on the cryptocurrency world. They brought about the 2017 ICO billion-dollar era because ERC 20 tokens and smart contracts support complex transactions. The 2017 ICO token sale was a developer-friendly form of IPO.
Startups often find it difficult to access funding and support in real-world setups. Not so for blockchain-based businesses. While legacy-based centralized companies have to raise massive funds to build their networks, decentralized competitors lower their operational costs through peer-to-peer networks.
Any person with computational power can access the Ethereum platform and innovate with the support of the larger decentralized community. Furthermore, any person could invest in the project they believed in by simply purchasing ERC-20 tokens.
Tokens have become the blockchain technology sector’s return on investment. They also support value exchange governance, are toll systems to dApp use and enhance user experience.
As a result, the decentralized business platforms will not fork our large amounts of initial capital to pay for expensive operational and cloud computing costs. Instead, a project’s peer-to-peer network of data validators puts down capital and provides network computing resources.
These believers receive tokens in return for data validation, computing resources, and network security. These tokens will eventually gain much value if their project solves a crucial challenge.
As an illustration, MakerDAO would perhaps never have seen the light of day had Andreessen Horowitz not provided liquidity to the tune of $15 million as a capital boost. He received 6% of Maker tokens that were in circulation at the time as a reward.
Yield farming protocols will also allow users to earn more yield from their assets. For example, a liquidity provider will make more interest as a yield farmer than in a traditional bank savings account. This is because these tokens have near-zero minting costs.
On top of that, they turn over governance to the community. Essentially, they are a zero operational cost business setup. Consequently, yield farming apps provide the same services as the legacy financial banking industry, but they are cheap to operate.
All their functions are smart contract managed, running 24/7, and are open to all users across the globe. These financial services platforms earn fees from token swaps and, unlike traditional finance institutions, distribute all that profit back to the protocol’s users.
In addition, liquidity providers provide sufficient financial depth to hedge price volatility risks between assets. Finally, stability in yield draws in more yield farmers, creating a symbiotic loop between the yield farming protocols and the DeFi user.
MIMO and PAR’s sustainable yield farming system
Like MakerDao, Mimo Protocol users can access the PAR stablecoin by simply depositing their ETH or wBTC onto Mimo’s liquidity pools.
The protocol will mint crypto-backed PAR, a stablecoin that algorithmically tracks the value of the Euro. PAR holders can lend their stablecoins to the larger DeFi market by depositing their non-volatile assets in Balancer’s yield farming protocols.
They will then receive MIMO tokens that they can stake on the Mimo Protocol and earn staking rewards, governance rights, and more MIMO.
In essence, Mimo’s yield farming protocols are permissionless, KYC less, and automated financially inclusive services. They draw much-needed liquidity into the ecosystem, protecting the DeFi vision of a decentralized personal banking future.
Despite the naysayer’s alarm that DeFi was a bubble waiting to burst, by 2020’s end, DeFi’s total value locked had risen to $20 billion. That figure now stands at $76.66 billion.
So, were the skeptics wrong to call out yield farming protocols?
In 2020, speculators fell head over heels with COMP, and by September 2021, it had an $850 per token value. In September 2021, Compound was the 5th largest DeFi Protocol, largely riding high on yield farming interest.
On September 30, 2021, “napgener,” a Twitter user, warned that some fishy business was going on in Compound’s algorithm. He warned the user of a possible rug pull. The community later came to learn that Compound had smart contract bugs.
Its algorithms had erroneously paid out massive amounts of yield sums to some users. As a result, while Compound user funds were safe, some got away with 91,000 free COMP worth over $27 million in a single transaction. This user had a $0 asset stake in the protocol and paid a measly $154.77 in gas fees. COMP has since slumped back to the $136 range after Vitalik’s warning came true.
As per the HBR review, the rewards system fails because they often cover up flaws. Doubling rewards does not fix a broken system. More so, rewards and punishment are two sides of a coin. They are manipulative. Desirable rewards can demoralize those that desire them and miss out.
As an illustration, copycat yield farming token rises most benefit the speculator, rather than the dApp community. Additionally, rewards systems could disrupt harmonious relationships and change mindsets from collective gain to individual gain.
In truth, community-based networks can only succeed via the power of teamwork. Incentivization mechanisms could undermine network interest because exceptional DeFi supporters have a genuine interest in the future of blockchain ideals.
A rewards system could break down the intrinsic motivation that has led to massive blockchain technology development.
The final word
Rewarding value can be a fool’s errand unless yield farming applications embrace the DeFi sector’s motto of sustainability over price. Should they continue to build tokens with little utility, they could cause the eventual collapse of the DeFi ecosystem.
However, if they learn from their mistakes, responsible yield farming protocols that offer value-based tokens will elevate the entire ecosystem’s efficiency. As an illustration, the Mimo Protocol issues its liquidity providers with PAR, a non-volatile asset with the properties of money.
Consequently, PAR and MIMO are sustainable, unlike tokens that lack utility and only trap users via yield enticements. This is because PAR is the only decentralized stablecoin that tracks the value of the Euro. PAR, therefore, has a massive digital payment use case and is vital to the Web 3.0 environment.