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Understanding DeFi: yield farming explained

The decentralised finance space has grown at a staggering rate. Widely considered the main use case for the Ethereum blockchain alongside the burgeoning NFT movement, DeFi has brought almost $100 billion of value locked on the network. Without a doubt the biggest catalyst for DeFi’s growth has been the emergence of yield farming. In this feature, we’ll explore how yield farmers are profiting from putting their assets to work on Ethereum applications, our plans to leverage yield farming with token.com, and the risks associated with this experimental technological innovation.

What is yield farming?

Put simply, yield farming is a way to earn on your crypto assets. It involves locking funds in smart contracts through blockchain-based applications.

Yield farming is one of the core activities of the burgeoning DeFi sector. As such, it’s most commonly associated with Ethereum, DeFi’s main hub.

Ethereum’s DeFi ecosystem allows users to lend, borrow, swap, and stake their assets across a variety of applications. DeFi is permissionless — anyone with an Internet connection can use an application like Uniswap or Aave as long as they download an Ethereum wallet. DeFi applications are also trustless, meaning they don’t rely on centralised intermediaries like banks.

Ethereum’s DeFi applications are sometimes described as “money legos” because users can stack activities across multiple applications in limitless combinations, almost like lego bricks.

Ethereum’s money legos provide a way to earn passive income by putting crypto assets to work in the application’s smart contracts.

Yield farming is typically associated with lending — users can lock up their assets in a liquidity pool and earn a small percentage of yield on their holdings. But it’s worth noting, in some instances it’s possible to earn yield for borrowing assets.

Yield farming is also most frequently associated with stablecoins, though the activity is not limited to dollar-pegged assets. The yield tends to be paid in ERC-20 tokens.

One of the keys to Ethereum’s DeFi ecosystem is composability: the money legos can be used interchangeably in very quick succession. Thanks to composability, yield farmers develop complex strategies for optimizing the returns on their assets.

For example, someone might deposit DAI into Aave in exchange for aDAI, then lock that aDAI in another application to earn another token.

The top yield farmers are protective of their strategies, because they can become less effective when more people know about them. And because the space moves so fast, the optimal strategies often change.

As DeFi has evolved, protocols have emerged to help farmers optimize their yield. The current market leader among the yield optimization protocols is Yearn.Finance.

Yearn.Finance’s Vaults feature

So where does all this yield come from?

DeFi protocols charge fees for activities like borrowing and swapping. When liquidity providers deposit assets into a liquidity pool, they can expect to earn a small portion of the fee paid to the protocol.

Moreover, there is high demand for leverage in DeFi. Many DeFi users borrow assets to take advantage of opportunities to profit, meaning there is high demand for stablecoins. As a result, lending them out can yield high returns.

DeFi users also earn yield in the form of native tokens (more on that later).

DeFi protocols incentivize users with token rewards, because this helps attract liquidity. The higher the liquidity, the more effective the liquidity pools will be.

Yields are typically measured in terms of annual percentage yield (APY), which compounds the interest rate paid over the course of a year.

The interest rates vary, though they often range from 5 to 15% (and sometimes significantly higher). As the space is so young, it’s worth noting that the rates could decrease over time as more people enter the market.

Nonetheless, for now, yield farmers can benefit from interest rates that far surpass those paid by traditional banking services.

What is liquidity mining?

Yield farming is often discussed alongside liquidity mining, which is another form of earning passive income in DeFi. Liquidity mining is essentially the same as yield farming, only it involves earning a protocol’s native token.

Many DeFi projects issue tokens to decentralise their governance process — token holders vote on key decisions affecting the project such as supported assets or treasury allocations. These tokens can often be earned by providing liquidity to a pool.

In many cases, it’s only possible to get hold of a token when it launches by farming it, i.e. providing liquidity.

Compound pioneered liquidity mining with the launch of COMP in May 2020, and it helped the space explode. It was the arguable starting point for what’s now referred to as “DeFi summer,” a period during which yield farming flourished as hungry DeFi users deposited their assets across a range of projects in search of high returns.

Where are the best places to farm yield?

Yield farming runs across many projects in the Ethereum ecosystem, with some liquidity pools offering far higher returns than others. Some of the most popular applications for farming yield include:

Aave, a decentralised liquidity protocol for lending and borrowing assets. Aave pioneered innovations like flash loans and credit delegation. It also currently holds the most liquidity of every application on Ethereum.

Balancer, an automated market maker for creating multiple asset liquidity pools. Unlike other AMMs, Balancer offers flexible staking, meaning users can provide liquidity for tokens at differing ratios.

Compound, a decentralised money market for lending and borrowing assets. Compound pays an algorithmic autonomous interest rate, and users can earn its COMP token.

MakerDAO, the creator of the leading decentralised stablecoin DAI. Users can lock up their assets to mint DAI, which is pegged to the US dollar. They earn interest through what’s known as a “stability fee.”

Uniswap, Ethereum’s most popular decentralised exchange. Uniswap is an automated market maker that lets users swap ERC-20 tokens in liquidity pools. Liquidity providers deposit tokens to pools in a 50/50 ratio to earn a portion of the transaction fees the protocol earns.

Yearn.Finance, a yield optimization aggregator for depositing assets cross various protocols in the Ethereum ecosystem. When yield farmers deposit assets — either stablecoins or volatile assets — Yearn calculates the most profitable strategy for farmers, deposits the assets to a protocol to earn a yield, then pays a return in the form of the asset they deposited.

Aave’s V2 market

What are the risks?

While yield farming can be lucrative, there are many risks. The most profitable strategies involve multiple complicated steps and are generally only recommended to DeFi experts. Yield farming is also more profitable for those with a higher amount of capital, since the returns are paid as a percentage of the assets deposited. As Ethereum’s gas fees can be high, the cost of moving assets across the network can often outweigh the returns for those with smaller holdings.

Moreover, the interest rate paid on deposited assets often changes, and volatility in the market can lead to impermanent loss and price slippage.

As the technology is still in its infancy, smart contract bugs are common — especially with newer, unaudited protocols. A bug can lead to losses of funds when pools are exploited, and hacks are common. DeFi is composable, so if one money lego stops working, it can cause problems across multiple parts of the ecosystem.

To date, hundreds of millions of dollars have been lost in DeFi hacks, often affecting yield farmers. Once funds are lost in an attack, they can be lost forever. One of the most common ways yield farmers lose their assets is through “rug pulls,” when the rogue developers behind a project withdraw liquidity from a pool and make off with the funds. It’s for this reason that yield farming is considered a risky endeavour in newer pools promising extremely high returns.

As the space has developed, solutions have surfaced to alleviate the risks of yield farming. Nexus Mutual is a popular decentralised alternative to insurance that allows yield farmers to purchase cover on their deposited assets. It offers cover for all of Ethereum’s top DeFi protocols.

Yield farming and token.com

Our new product, token.com, will leverage yield farming by accessing the outsized returns offered in DeFi. However, we will simplify the experience for our users by farming the yield when they deposit assets. For our first product, they’ll be able to deposit in Brazilian real, which we’ll convert to stablecoins to put to work in DeFi. The returns will then be converted and paid back to the user minus a small fee, so they can experience the money growth without needing to interact with complex applications in the ecosystem. We will only farm yield from established “blue chip” protocols to ensure that we reduce the risk.

Conclusion

In conclusion, yield farming has quickly become one of the core activities of the burgeoning DeFi sector. It’s accelerated the growth of the space and helped attract billions of dollars in liquidity. Yield farming is the key that will allow our token.com users to experience turbocharged money growth as we’ll leverage DeFi to pay outsized returns directly to their wallet.

Nonetheless, yield farming comes with several risks. While farming yield can beat the returns paid by any bank, it often requires higher sums of capital to be worthwhile. Moreover, the risk of smart contract bugs, hacks, and rug pulls means that caution should always be exercised.

But it’s safe to say that those who are engaging with yield farming today are experimenting with the bleeding edge of financial innovation. DeFi is here to stay, and yield farming is sure to be a big part of it for years to come.

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