DeFi “yield farming” — a new trend in Crypto
Decentralized finance (DeFi) has become a hot topic in the past few weeks, and some people are speculating that we see something akin to 2017 ICO rally. The DeFi market is seeing rapid growth in users and volume, especially the lending/borrowing segment. A new trend has appeared — “yield farming”- lending out tokens on DeFi lending protocols or becoming a part of a market-making pool to earn a high rate of return, often many times higher than the typical commercial bank savings account. This movement attracted so much attention that there are already several guides on how to “farm” different assets on different platforms: Maker, Compound, Curve, Ren Protocol, Curve, Synthetix, Balancer and so on. DeFi yield farming compounds returns by utilizing leverage across multiple protocols and getting rewards in platform-native tokens for both borrowing and lending.
With such rapid growth in some of the projects’ tokens, the interest rates in the DeFi sector are looking very attractive, and there are cases where users can participate in several DeFi platforms to increase their APY further. Naturally, rates that we see right now are the result of an immature market, and they will decline over time as the market grows in size and volume.
The DeFi rapid market growth we see right now can be attributed to several factors:
- DeFi market’s steady growth since mid-March;
- Coinbase announced future support for quite a few DeFi projects;
- Compound (COMP) token launch.
Market growth
Decentralized Finance (DeFi) has become a significant and highly valued movement in the blockchain community over the last few years. According to the DeFi pulse, the Total Value Locked (TVL) in DeFi projects passed $1 billion for the first time in February, but following the bitcoin crash, the value pulled back the next month. However, in the past month, DeFi TVL has beaten the previous record and now equals $1.67 billion. While this is a relatively modest amount by both the conventional financial sector and the crypto market standards, it clearly shows that the market sees the potential of the DeFi sector.
The Ethereum blockchain continues to dominate the DeFi sector, most major DeFi protocols are built on the Ethereum blockchain, and new projects are launched all the time. Moreover, complex transactions associated with DeFi have increased five-fold in the last two years. Ethereum analysis firm Covalent forecasts a “flippening” event, where DeFi transactions overtake simple ETH transfers.
Market performance
As can be seen in the table above, DeFi projects such as Kyber Network, 0x, Synthetix, Aave, Loopring, Bancor have substantially outperformed both Ethereum and Bitcoin on weekly, monthly and 3 months timeframes.
DeFi has been a rapidly growing sector in the crypto space, and although the market share of the DeFi ecosystem is nowhere near that of the general crypto market, the new way of lending and earning has put them in the spotlight. Interest reflected in the explosive growth of several projects in this sector, both old and new.
Coinbase announcement
On June 10th, Coinbase revealed that they are exploring the possibility of adding 18 new cryptocurrencies. Aave (LEND), Bancor (BNT), Compound (COMP), Numeraire (NMR), Keep Network (KEEP), Ren (REN), and Synthetix (SNX), which are all a part of the decentralized finance sector.
While the exchange’s post does say that they are only evaluating whether or not the tokens should and could be added, the assets above have experienced rallies after that announcement. On the day of the announcement alone, some of the tokens gained 10% and saw rapid growth in trading volume.
These tokens benefited from a well-known “Coinbase Effect” — coins mentioned or listed by the exchange, temporarily pump as listings on Coinbase often lead to an increase in trading volume and mirrors the “mood” of investors on the market. Though coin listings or mentions by Coinbase often retrace once the hype dies down and the trading lines up with the rest of the industry, it is still one of the markets’ stimulating factors.
Compound token launch
A few days later, after Coinbase gave DeFi a small boost, Ethereum-based protocols Compound and Balancer publicly launched their native tokens. And those launch events generated considerable trading volumes and further developed the hype around DeFi projects. Investors have actively onboarded the hype train and begun participating in the protocols, trying to squeeze as much profit as possible out of the booming market.
The Compound became the most popular DeFi lending protocol and overtook MakerDAO in Total Value Locked by over $100 million (Compound has $624.5 mil and Maker $510.4 mil TVL on 03.07.20). The Compound had a sharp rise in TVL by the time of the launch of the protocol’s governance and rewards token, COMP on June 16th. The token price quickly exploded from $90 to over $400 on Coinbase Pro on June 23nd, though it has already retraced to around $180. Compound’s circulating supply is ~25% of its total supply, and even that is already enough to overtake MakerDAO in market capitalization as well ($464 mil and $450 mil respectively).
Differences from 2017
A large number of people in the industry are now voicing their concerns that this DeFi hype is following the same tracks as the 2017 “ICO bubble.” We think that it is essential to outline some significant differences:
- Most DeFi projects are decentralized counterparts of the traditional businesses, the markets they are catering existed for a long time, and they are massive in proportion to Crypto. It is reasonable to assume that DeFi projects could seize a part of that existing market as they provide similar services (that simply work on different principals). Many ICOs, on the other hand, were trying to create new markets, and their use cases were not as straightforward.
- There are real assets involved in DeFi protocols, though they are digital, they are still locked in smart contracts and represent collateral for the loans, same with assets locked to provide liquidity. They are not generating yield purely on speculative incentives, but they are a necessary cog for the project to work.
- DeFi products usually don’t attract non-qualified investors, as most of them have utility tokens which are not generally seen as a speculative type of asset.*
*This doesn’t include situations like listings, as it is the current “norm” to expect a pre-listing and listing pumps on certain exchanges
Aftermath
- Ethereum
What can we learn from the current situation? The more DeFi projects are launched on the Ethereum, the more we understand that PoW may become a barrier for such projects.
In the past month, we have seen a sharp rise in transaction costs, the condition native to the blockchain industry. With the growth of users and their transactions, the transaction costs grow, which may considerably slow the adoption. Low-value transactions become simply too expensive. As can be seen on the graph below, 10th and 11th June were exceptionally pricey days.
And once again, the limitations of Ethereum’s ~13 second block times, which disallows blockchain developers from building DApps that require high tps. A potential bottleneck for financial DApps.
Ethereum 2.0 will be able to solve those issues and make financially oriented DApps more capable, erasing the limitations of block time and high gas prices.
The overall use of gas on the network has been steadily rising since the beginning of 2020, with a sharp jump in June.
The number of transactions has been steadily growing as well, though it still has not reached its ATH of 1,349,890, even though DeFi hype mostly involves ETH-based projects. A sharp jump in the number of transactions in June is highly attributed to the growth in the number of DeFi users.
- Crypto magic
There are some unusual use cases on the market: it is possible to borrow one asset using another as collateral, swap it and once again borrow the asset and have a negative yield, but at the same time earn positive yield simply because COMP was growing sharply in price. It is quite a weird situation where users can create risky sophisticated schemes to earn money, as the global mentality of “high-risk high reward” is persistently connected to the crypto industry. This wouldn’t work in any traditional banking context. It only worked because the speculation on COMP was so high.
- Financial attractiveness
If the trend with crypto adoption continues and fiat-to-crypto gateways will develop even further, DeFi projects will be extremely attractive compared to the traditional financial market. Lending platforms like Compound are putting much higher interest rates than most top tier banks while offering the same services (even better in some way, considering that borrowers are over-collateralized).
- Balancer exploit
According to Coindesk, DeFi liquidity provider Balancer Pool admitted early June 29th morning it had fallen victim to a sophisticated hack that exploited a loophole, tricking the protocol into releasing $500,000 worth of tokens.
In a blog post, Balancer CTO Mike McDonald said the attacker had borrowed $23 million worth of WETH tokens, an ether-backed token suitable for DeFi trading, in a flash loan from dYdX. They then traded, against themselves, with Statera (STA), an investment token that uses a transfer fee model and burns 1% of its value every time it’s traded.
The attacker went between WETH and STA 24 times, draining the STA liquidity pool until the balance was next to nothing. Because Balancer thought it had the same amount of STA, it released WETH that equated to the original balance, giving the attacker a larger margin for every trade completed.
As well as WETH, the attacker performed the same attack using WBTC, LINK, and SNX, all against Statera tokens.
The hacker’s identity remains a mystery, but analysts at 1inch exchange, a decentralized exchange aggregator, said the hacker had covered their tracks well: The ether used to pay transaction fees and deploy smart contracts was laundered through Tornado Cash, an Ethereum-based mixer service.
“The person behind this attack was [a] very sophisticated smart contract engineer with extensive knowledge and understanding of the leading DeFi protocols,” 1inch said in its blog post on the breach
What is next?
It will be interesting to see how the DeFi hype will develop, how much will the DeFi market retrace after the hype cycle ends. It is hard to say how this period will affect the global crypto market exactly. Will it cause developers to create DeFi projects just for the sake of it as in the case of the “ICO bubble”?
Will we see some negative consequences of DeFi “yield farming”? The threat of systemic risk of hack is higher than ever, and we could see a situation akin to the DAO devastating effect. A significant hack or exploit of smart-contract on one the lending platform may trigger a chain reaction and cause a series of position liquidations across different DeFi protocols, causing market sentiment to become highly cynical and cautious of DeFi.
Another interesting topic is how the DeFi sector will fare against the Staking sector, as part of DeFi is centered on passive yield, it mainly concerns Ethereum 2.0 plans, as most projects are ETH based. It will all depend on the incentives offered by the projects, as most investors will follow higher APY, and it makes me wonder if DeFi “yield farming” will affect the economic model of ETH 2.0.
It is also intriguing if there will be major DeFi projects built on networks other than Ethereum.
