Reap the Harvest of Yield Farming on Blockchain II.
This article is the second part of a concise summary of the paper ‘Reap the Harvest on Blockchain: A Survey of Yield Farming Protocols’ by Dr Jiahua Xu and Yebo Feng. Dr Xu is a researcher at UCL Centre for Blockchain Technology and the programme manager of M.Sc. Emerging Digital Technologies at UCL. Yebo Feng is a Ph.D. candidate of the Computer and Information Science Department at University of Oregon, USA.
Following up on the previous article, this article expands on yield farming revenue models, as well as the potential risks of user participation.
A Brief Introduction
The decentralised finance (DeFi) ecosystem provides an alternative to traditional finance by creating new markets and revenue models. As great opportunities lie in the fragments in DeFi, lack of high technically knowledgeable users, and poor user experience, highly innovative protocols, products and services can be developed.
In general, revenue models in DeFi can be classified by protocol, with yield aggregators, protocols of loanable funds (PLFs) and decentralised exchanges (DEXs) have distinct revenue models, with the former focused on interest rates and the latter transaction fees.
- PLF Revenue Model: The purpose of PLFs is to enable users lend or borrow crypto assets through an automated smart contract. When borrowers return funds at an interest rate. The rate is split between the protocols and lenders, therefore, providing a revenue generation avenue.
- DEX Revenue Model: DEXs with smart contract enabled automated market makers create a mutually beneficial environment for liquidity providers, buyers, sellers and traders. The revenue model works by a percentage of the fee paid by traders sent to the protocol’s treasury.
Yield Farming Revenue Models
Through a combination of methods, yield farming maximises the interest of investors in crypto-assets by interacting with DeFi protocols on behalf of the user. Smart contracts known as “vaults” play a pivotal role in achieving compatibility between yield farming protocols and a number of different protocols. Users deposit funds into vaults which interacts with other third-party protocols via smart contracts known as strategies.
A number of different uses-cases for strategies exist in yield farming. In some cases, strategies discover the best interest rates among a number of PLFs. In other cases, funds received from borrowing on one protocol are used to exploit another protocol’s benefits through different strategies.
The revenue of yield aggregators is generally directly proportional to the vault performance, with most yield farming protocols charging performance fees. By charging a fee on each independent strategy, revenue is generated by the protocol.
Examples of Existing Yield Farming Revenue Models
Revenue models of existing yield farming protocols are mostly fee based. It's important to define the types of fees charged to better understand varying revenue models
- Performance Fees: These are deductions from vault profit every time yield is earned by a strategy.
- Management Fees: This is a fixed charge taken from the total funds deposited in the vault over a year.
- Deposit Fees: These are fees charged upon the deposit of an asset into a vault.
- Withdrawal Fees: These are fees charged following the withdrawal of assets from a vault or pool.
A. Yield Aggregator Model
As yield aggregators combine interest gained on a number of different protocols, performance fees are the main sources of revenue with protocols such as Yearn Finance only charge performance fees. Some protocols include mangement, withdrawal and/or deposit fees to gain additional revenue. For instance, Beefy charges an additional withdrawal fees on some vaults and Enzyme charges a combination of performance, management and withdrawal fees.
B. Yield-bearing Stablecoin Model
Yield-bearing stablecoin protocols often use a number of strategies to generate yield on fiat-pegged tokens deposited such as USDC, USDT & DAI. The strategies generate yield by lending, market making and receiving rewards. In general, the protocol withholds some of the profits gained by the users to generate revenue, by charging fees. Revenue models differ by the type of fees charged. For instance, Origin Dollar charges performance and withdrawal fees, and Bank of Chain currently charges no fees, with performance and management fees scheduled for implementation in the future.
C. Lottery Protocol Model
In this model, the protocol interacts with DeFi protocols to generate revenue on users funds deposited. Following this, the interest gained is shared between the protocol and a few users. PoolTogether, a no-loss lottery protocol, is the pioneer of this revenue model. It enables returns of original deposits to all users and rewards a few with the interest gained from the pooled funds.
Yield Farming Risks
Although yield farming generates high, certain risks exist. The risks associated with yield farming are two-fold, security risks and economic risks. While security risks exploit the nature of yield farming protocols which are smart contracts, economic risks are common when investments are made.
A. Security Risk
- Flash Loan Attack: Flash loan attacks exploit the lack of collateral requirements in flash loan protocols to borrow large amounts of assets. After borrowing assets, the attacker manipulates the asset’s price for a short period before selling it for profit. This process is repeated multiple times, causing losses for investors and yield aggregators. To prevent such attacks, measures such as improved smart contract auditing and preventing the simultaneous withdrawal and deposit of funds should be implemented.
- Rug Pull: A rug pull is a tactic employed by project owners in which they collect funds from investors and then abandon the project, rendering the investors’ assets worthless. One common way of executing this is through deceiving yield farming protocols by swapping fake assets for real ones such as ETH. To avoid falling victim to this type of scam, investors should thoroughly research and perform due diligence on projects prior to investing.
- Reentrancy Attack: A reentrancy attack is a highly destructive type of attack that can occur when multiple smart contracts interact with each other. It happens when a smart contract makes an external call to another contract, and that second contract makes recursive calls back to the original, allowing an attacker to repeatedly withdraw funds from the first contract without updating its state. This vulnerability can be exploited to continuously drain the funds from the original contract.
- Key Exploit: Yield farming protocols are also under the risk of wallet or API key exploitation, as access of these keys to attacks can result in stolen funds or tampered smart contracts. The solution to this attack is reducing a single point of failure in the security architecture of these protocols. This can be achieved by utilising multi-sig wallets, effective defense mechanisms against private keys theft and employing software development best practices.
- Other Attacks: Other attacks may target other network layers which interact with DeFi protocols including the blockchain infrastructure, user interface or network connection.
B. Economic Risk
- Yield Dilution Risk: Yield farming pools can promise high returns without the ability to deliver on that promise. When a yield farming pool is started, the pool owner sets a target annual percentage yield (APY) based on the interest rate they can earn by lending out or borrowing the deposited funds. However, as more investors deposit funds into the pool, the pool’s assets may become diluted, which means that the pool administrator needs to spread the interest earned over a larger pool of assets, resulting in a lower APY for each individual investor.
- Conversion Risk: As yield farming protocols typically require the conversion of funds or other tokens into native tokens, in order to use them, they can be susceptible to conversion risk. Following the conversion of tokens, the yield farming tokens may devalue against the original assets held by the user prior to the conversion, leading to an impermanent loss.
- Exchange Risk: Exchange risk is when the value of the assets in a yield farming pool might change because of changes in the value of the currency they are measured in, such as the US dollar. Because yield farming relies on high returns, and the value of the assets can be unpredictable, this can make it risky for investors. If the price of the token drops, it can lead to loss for investors who have them.
- Counter-party Risk: These risks occur in farming protocols that incorporate lending, where due to certain market conditions, loans may not be able to be repaid. For instance, when the value of the asset that was lent out compared to the collateral increases sharply, this results in the loan being insufficiently secured, leading to losses.
- Liquidation Risk: This risk is associated with DeFi borrowing with overcollateralized loans. Due to the volatility of asset price movements, the loan position maybe be not sufficiently collateralized which results in liquidation. The borrower loses money when the value of the asset deposited as collateral is worth more than the payable loan at the time of liquidation. Therefore, yield farming protocols that do not properly manage liquidation risk can put users’ funds at risk.
To Conclude
As the DeFi space evolves at a rapid pace, more unique protocol revenue models are likely to emerge in the future. Specifically, with interoperability protocol and cross-chain smart contract development, the strongest benefits of individual blockchain networks will be infused into yield farming and other DeFi protocols. This multi-chain blockchain ecosystem will significantly benefit investors, users and protocols. Regardless of this, security risks of operating highly interoperable protocols will equally increase, due to the vulnerability of smart contracts.
