The Decentralized Financial Movement (DeFi) is one of the forces at the forefront of blockchain innovation. But what makes DeFi apps unique? It’s permissionless, which means that anyone (or anything, like a smart contract) with an Internet connection and a supported wallet can interact with them. In addition, DeFi applications will save users from having to fret about their trust in any custody organization or middleman. In other words, they don’t need trust. So, what new use cases do these properties get enabled?
One of the new concepts that has emerged is yield farming, which is a new way of earning rewards from existing crypto assets using unauthorized liquidity protocols. Accordingly, anyone can earn passive income using the decentralized ecosystem built on top of Ethereum. Therefore, yield farming can change the HODLing way of investors in the future. Why keep your assets idle while being able to operate them?
What is Yield farming?
Yield farming is also known as liquidity mining, which generates rewards from crypto assets. In simple terms, it means locking in a cryptocurrency and getting a reward.
In a sense, yield farming can be done in parallel with staking. However, there are many complications. In many cases, it works with users called liquidity providers (LP) to add funds to liquidity pools.
What is a liquidity pool? Basically, a smart contract contains money. In return for providing liquidity to the pool, LP will receive a reward. That reward could come from fees generated by the basic DeFi platform or some other source.
Some liquidity pools pay rewards in multiple tokens. After that, the bonus tokens can be deposited into another liquidity pool to earn the next bonus, … You can see a lot of extremely complex strategies but basically LP depositing money into a liquidity pool. and in return a reward is earned, seen as a profit.
Yield farming is usually done using an ERC-20 token on Ethereum and the reward is usually an ERC-20 token. However, this could change in the future as most of this activity is happening in the Ethereum ecosystem now but is expected to be different.
Besides, cross-chain bridges and similar advances could allow DeFi application to become blockchain agnostic in the future. This means they can be run on other blockchains that also support the smart contract feature.
Yield farmers (profit farmers) will usually move their money pretty much between different protocols in search of high returns. Therefore, DeFi platforms can also provide another economic incentive to attract more capital to the platform. Just like on centralized exchanges, liquidity tends to attract more liquidity.
What makes yield farming explosion?
The sudden strong interest in yield farming could be due to the launch of the COMP token – the governance token of the Compound Finance ecosystem. An administrative token grants administrative rights to the token holder. But how to distribute these tokens if you want to make the network as decentralized as possible?
A popular way to start a decentralized blockchain is by distributing algorithmic governance tokens, with liquidity incentives. This attracts the liquidity provider to “mine” the new token by providing the protocol’s liquidity.
Although the yield farming invented, but the COMP launch event helped this type of token distribution model become more popular. Since then, other DeFi projects have come up with innovative plans to lure liquidity to their ecosystems.
What is Total Locked Value (TVL)?
So, what is a good way to measure the overall yield of yield farming on DeFi? The current most effective answer is the total locked value (TVL). The index measures the amount of crypto locked in DeFi lending and other currency market types.
In a sense, TVL is total liquidity in liquidity pools, so it is a useful indicator to measure the state of DeFi and yield farming market in general. It is also an effective metric for comparing the “market share” of different DeFi protocols.
A pretty good destination to monitor TVL is the Defi Pulse. Here, you can check which platform has the highest amount of ETH or other cryptocurrencies locked in DeFi. Accordingly, it can give you an overview of the current yield farming state.
Of course, the more values that are locked, the more it proves that yield farming continues to grow. It is worth noting that TVL can be measured in ETH, USD or even BTC. Each will give you a different perspective on the state of the DeFi money market.
How does Yield farming work?
Yield farming is closely related to a model known as automatic market maker (AMM). It typically involves liquidity providers and liquidity pools.
The liquidity providers deposit money into the liquidity pool. This pool powers the marketplace where users can lend, borrow or trade tokens. The process of using the platforms incurs fees, which are then paid out to the liquidity providers according to their market share in the liquidity pool. This is the working foundation of AMM.
However, implementations can be very different, not to mention a new technology. More than that, we will see new approaches that are refined from current implementation practices.
In addition to fees, another incentive to add money to the liquidity pool could be the distribution of new tokens. Example: When there is no way to buy tokens on the open market in small amounts. On the other hand, can accumulate by providing liquidity for a particular pool.
All distribution rules will depend solely on the protocol implementation. The bottom line is that liquidity providers receive profits based on the amount of liquidity they are providing to the pool.
Funds deposited are usually stablecoins pegged in USD although this is not a general requirement. Some of the most popular stablecoins used in DeFi are DAI, USDT, USDC, BUSD, … Some protocols will mint tokens representing the amount of money you have deposited into the system. For example, if you send DAI to Compound, you will get cDAI (Compound DAI). If you deposit ETH into Compound, you will get cETH.
As such, many complex problems will arise. You can send your cDAI to another protocol that mints a third token to represent cDAI and cDAI represents your DAI… These chains can get really messy and difficult to track.
How is yield farming profit calculated?
Usually, the estimated yield yield for yield farming is calculated annually. Accordingly, estimate the profit you can expect over the course of a year.
Some of the commonly used metrics are Annual Percentage (APR) and Annual Percentage Rate (APY). The difference between them is that APR does not take into account the effect of compound interest, while APY does. In this case, compounding means directly reinvesting profits to make more profits. Note, however, that APR and APY can be used interchangeably.
Emphasize that these are only estimates and projections. Even short-term rewards can be difficult to accurately quantify. Why? Yield farming is a highly competitive and fast-paced market, and the rewards can fluctuate quickly. If the yield farming strategy is effective in a while, many farmers will take advantage of the opportunity, limiting high profits.
Since APR and APY come from legacy markets, DeFi may need to find its own metrics to calculate profitability. Due to DeFi’s rapid growth, estimated profit weekly or even daily will make more sense.
What is Mortgage in DeFi?
Usually, if you are borrowing property, you will need to have collateral to cover your loan. This is basically the same as securing the loan.
If the value of the collateral falls below the threshold required by the protocol, it can be liquidated on the open market. So what should be done to avoid being liquidated? That is to continue adding more collateral.
Again, each platform will have its own set of rules for this, i.e. their own required mortgage rates. In addition, they often operate with a concept known as over-mortgage, which means borrowers have to put in more value than they want to borrow. Why? To minimize the risk of market collapse, liquidation of a large amount of collateral in the system.
So let’s say the loan protocol you are using requires a mortgage rate of 200%. This means that for every $ 100 of value you put in, you can borrow $ 50. However, usually it is safer to add more collateral than necessary to reduce the risk of liquidation. With that said, many systems will use a very high mortgage rate (say 750%) to keep the entire platform relatively safe from the risk of liquidation.
Risk of yield farming
Yes, actually, yield farming is not simple. The yield farming strategies that yield the highest returns are complex and are recommended only for savvy users. In addition, yield farming is usually more suitable for entities with a lot of capital to implement (ie whales).
Yield farming is not as easy as you imagine and if you do not understand what you are doing, you can lose money. We just discussed the risks of collateral liquidation. But are there other risks that need attention?
One obvious risk of yield farming is a smart contract. Due to the nature of DeFi, many protocols are built and developed by small groups on a limited budget. This can increase the risk of smart contract errors.
Even in the case of larger protocols tested by many reputable auditing firms, vulnerabilities and errors are discovered continuously. Due to the immutability of the blockchain, it can lead to the loss of users’ money. You need to take this risk into account when locking your money in a smart contract.
In addition, one of DeFi’s greatest strengths is also one of its biggest risks. That is the idea of association. Let’s see how it affects yield farming.
DeFi protocols need no permission and can be seamlessly integrated with each other. This means that the entire DeFi ecosystem is heavily dependent on each building block. As such, applications can be combined and easily work together.
But why is this a risk? Well, if just one of the building blocks doesn’t work as expected, the entire ecosystem could be affected. This is what causes one of the biggest risks to yield farmer and liquidity pool. Not only do you have to trust the protocol you send money to, you also have to trust all other protocols.
Typical yield farming platforms and protocols
How to earn this yield farming reward? Sadly, there is no specific way to implement yield farming. In fact, yield farming strategy can be changed hourly. Each platform and strategy will have its own rules and risks. If you want to start yield farming, you must be familiar with how decentralized liquidity protocols work.
Basically, users deposit money into a smart contract and earn rewards in return. But implementations can vary greatly. As a result, it is generally not a good idea to send money blindly and hope to get a high return. Following the fundamentals of risk management, you need to be able to be in control of your investments.
So, what are the most common platforms the yield farmer uses? Below are a few of the core protocols that users can create in order to create the appropriate profit farming strategies.
Compound is a cryptocurrency marketplace that allows users to lend and borrow property. Anyone with an Ethereum wallet can supply assets to Compound’s liquidity pool and earn rewards that immediately start calculating compound interest. The interest rate is adjusted algorithmically based on supply and demand.
Compound is one of the core protocols of the yield farming ecosystem.
Maker is a decentralized credit platform that supports creating DAI, algorithmically fixed stablecoins with value in USD. Anyone can open Maker Vault where collateral is locked, such as ETH, BAT, USDC, or WBTC. They can create DAI as a liability on the collateral they have locked in. This debt is subject to interest over time known as a stability fee – the rate set by the MKR token holder.
Yield farmer can use MKR to cast DAI and be used in yield farming strategies.
Synthetix is an aggregated asset protocol that allows anyone to lock (stake) SNX or ETH as collateral and mint aggregate assets. What is aggregate assets? The fact that anything has a reliable price feed allows virtually any financial asset to be added to the Synthetix platform.
Synthetix can allow all property types to be used to make yield farming in the future. Do you want to use your long-term Bitcoin in yield farming strategies? Synthetic assets can be the effective path.
Aave is a decentralized protocol for lending and borrowing. The interest rate is adjusted algorithmically, based on current market conditions. Lenders receive “aTokens” in exchange for their money. These tokens immediately start making money and calculate compound interest based on the deposit. Aave also enables other advanced functions, such as quick loan.
As a decentralized lending and borrowing protocol, Aave gets the farmer yield used a lot.
Uniswap is a decentralized exchange (DEX) protocol that allows trustless token swaps. Liquidity providers deposit the equivalent value of two tokens to create the market. The traders can then trade in the liquidity pool. In return for providing liquidity, providers earn fees from the transactions that occur in their pool.
Uniswap is one of the most popular platforms for trustless token swaps due to its frictionless nature. This can be useful for yield farming strategies.
Curve Finance is a decentralized exchange protocol specifically designed for efficient stablecoins swaps. Unlike other similar protocols like Uniswap, Curve allows users to perform high-value stablecoin swaps with a relatively low reduction (spread).
As you can imagine, due to the abundance of stablecoins in the yield farming context, the Curve pool is an important part of the infrastructure.
Balancer is a liquidity protocol similar to Uniswap and Curve. However, the main difference is that it allows the allocation of custom tokens in the liquidity pool. Accordingly, liquidity providers create custom Balancer pools instead of allocating 50/50 as required by Uniswap. Just like with Uniswap, liquidity providers earn fees for the transactions that occur in their liquidity pool.
Thanks to the flexibility that the protocol provides for liquid pool creation, Balancer is an important innovation for yield farming strategies.
Yearn.finance is a decentralized ecosystem that aggregates lending services like Aave, Compound, … It aims to optimize token lending by finding the most profitable loan services algorithmically. Funds are converted to yTokens upon deposit for periodic rebalancing to maximize profits.
Yearn.finance is useful for farmers who want a protocol to automatically choose the strategies that are best for them.
After yield farming, what else can the decentralized financial revolution bring about? It is not possible to predict what new applications may emerge in the future built on these existing components. However, trustless liquidity protocols and other DeFi products are undoubtedly at the forefront in the fields of finance, cryptocurrency economics and computer science.
Without a doubt, the DeFi money market can help create a more open and accessible financial system for anyone with an Internet connection.