DeFi 101 : Yield Farming and Liquidity
Yield farming is a new DeFi term that has recently gained traction in the crypto industry. In simple terms, it means staking or locking up cryptocurrencies within a blockchain protocol to “farm” reward tokens. The practice began around 2020 when Compound, a decentralized lending platform launched their governance token COMP. Most DeFi tokens follow this model, helping to establish the decentralized nature of the platform.
Many decentralized finance (DeFi) projects rely on yield farming to incentivize users to contribute to the network’s liquidity and stability since these projects do not rely on a centralized market maker.
Much of the hype in yield farming comes from the idea of depositing tokens across several and different DeFi apps to maximize earnings. With the recent DeFi explosion, yield farming and LP tokens are slowly fusing into being used together. In many cases, users may deposit a token, borrow against it, swap for the original deposit token, and then re-deposit. This process “compounds” the rewards as a user may deposit and then borrow many times, maximizing the “farming rate” of a governance token.
For example, we can look at the steps of farming UBQ tokens on the Curve protocol using USDC.
- Deposit USDC to Ubiquity’s crypto liquidity pool
- Receive LP tokens
- Deposit received LP tokens to the Ubiquity staking pool
- Farm the UBQ token
In this scenario, your USDC would earn interest and fees in Curve’s crypto liquidity pool. In addition, your LP tokens from the liquidity pool also earn you UBQ tokens as a reward for staking. Thus, by using LP tokens, your liquidity works double-time — earning fees and farming yields.
What are LP Tokens
Liquidity is a crucial factor in DeFi. It is a fundamental concept which means to easily convert an asset without causing sharp changes in the asset’s price. If you add a token to a crypto liquidity pool, the platform (in this case, the Curve platform) generates a receipt that shows you have a share in the pool. This receipt is your liquidity provider (LP) token. This LP token is the magic behind DeFi and allows owners to use it for a lot of functions, whether in its own platform or other DeFi apps.
The liquidity available in the DeFi ecosystem is effectively multiplied. Before the invention of liquidity tokens, assets on the Ethereum ecosystem were locked when in use or staked. Like in Ethereum 2.0’s Proof-of-Stake (PoS) mechanism, your ETH is locked up for it to be validated and for new blocks to be added to Ethereum’s blockchain. In these cases, there is less liquidity in the system.
In DeFi, the creation of readily convertible derivative assets such as LP tokens has solved the problem of locked crypto liquidity. It’s like an indirect form of staking where you prove you own the tokens, with the LPs acting as receipt, which you can then use instead of staking the tokens themselves.
