Yield farming has been one of the most trending terms in the DeFi industry recently. Despite being considered risky and volatile, yield farming has gained huge popularity thanks to innovations such as liquidity mining. Yield farming is now the most important development in the still-developing DeFi industry, allowing it to expand from $500 million in market capitalization to $10 billion by 2020.
What is yield farming?
Basically, yield farming, also known as liquidity mining, is a process in which cryptocurrency holders stake or lend their crypto assets to earn rewards. Specifically, cryptocurrency holders will be able to lend funds to other people through smart contracts. In return, they get compensated in the form of cryptocurrency for the services.
Yield farmers that want to increase their yield will employ more complex techniques. To optimize their earnings, they constantly transfer their cryptos between multiple loan platforms. They’ll also keep the top yield farming methods confidential since the more individuals who are aware of a method, the less effective it is likely to be.
In some ways, yield farming and staking are similar. However, there is a great deal of intricacy going on behind the scenes. It frequently collaborates with liquidity providers (LPs), who provide funds to liquidity pools. Liquidity pool is essentially a smart contract with funds. LPs are compensated for supplying liquidity to the pool. This incentive might come from the underlying DeFi platform’s fees or from another source. Some liquidity pools payout in a variety of tokens, which can then be transferred into other liquidity pools to receive more rewards, and so on. You can see how extremely complicated methods may arise very rapidly. However, the core concept is that a liquidity provider puts cash into a liquidity pool in exchange for incentives.
Read more: Yield Farming vs. Staking – Which is Better?
Since most of the yield farming activities are occurring in the Ethereum ecosystem, it’s mainly done with ERC-20 tokens, and the rewards are usually ERC-20 tokens. However, this may change in the future.
In order to get high yields, yield farmers would generally shift their cash around a lot. Therefore, DeFi platforms may provide additional financial incentives in order to entice more money to their platform. Indeed, liquidity tends to attract additional liquidity, just as it does on centralized exchanges.
What is Total Value Locked (TVL)?
Total Value Locked (TVL) is a way to measure the state of the DeFi yield farming industry. TVL calculates the amount of cryptocurrency locked in DeFi lending and other forms of money markets.
TVL, in some ways, is the total liquidity in liquidity pools. It’s a helpful metric for gauging the overall health of the DeFi and yield farming markets. It’s also a good way to compare the “market share” between various DeFi protocols.
Defi Pulse is a common platform to track TVL. You can be able to see which platforms in DeFi have the most ETH or other crypto assets locked up, which offer you a broad sense of where yield farming stands right now.
Obviously, the more value is locked, the more yield farming is likely to take place. It’s important to note that TVL can be measured in ETH, USD, or even BTC. Each will provide you with a unique perspective on the condition of the DeFi money markets.
How does yield farming work?
Yield farming works with a liquidity provider and a liquidity pool. An investor that puts money into a smart contract is known as a liquidity provider. The liquidity pool is a smart contract that contains money. The automated market maker (AMM) model is the foundation of yield farming. Liquidity providers (LPs), who deposit cash into liquidity pools, are a big part of the AMM concept. Most DeFi markets rely on these pools to let users borrow, lend, and trade tokens. DeFi customers pay the marketplace trading costs, which then are distributed to LPs based on their portion of the pool’s liquidity.
However, because this is a new technology, the implementations might be drastically diverse. There’s little question that new techniques will emerge that will improve on the current implementations.
Apart from fees, the distribution of a new token is another reward to incentivize LPs to add funds to a liquidity pool. For example, a token may only be available for purchase in small amounts on the open market. It may be accumulated, on the other hand, by supplying liquidity to a certain pool. The way tokens are distributed will depend on the implementation of the protocol. The important thing is that liquidity providers are compensated based on the amount of liquidity they provide to the pool.
The deposited money are usually stablecoins pegged to USD, however, this is not a necessity. DAI, USDT, USDC, BUSD, and other stablecoins are among the most often utilized in DeFi. With some protocols, they will mint tokens to represent the coins you’ve put in the system. For instance, you’ll get cDAI (Compound DAI) if you put DAI into Compound. Or, if you put ETH to Compound, you’ll get cETH in return.
As you may expect, there are several layers of intricacy to this. You may transfer your cDAI to a system that creates a third token to represent your cDAI and your DAI. And so on, and so on.
How to calculate yield farming returns?
Usually, estimated yield farming returns are calculated on an annualized model. This shows the possible returns that you could earn for a year.
Annual Percentage Rate (APR) and Annual Percentage Yield (APY) are the two popular metrics to calculate yield farming returns. The difference between APR and APY is that APR does not take compounding into account, which means reinvesting profits to increase your returns. However, keep in mind that APR and APY are sometimes used interchangeably.
Also, most calculation models are just estimates. Moreover, even short-term gains are hard to predict since yield farming is a dynamic market with high competition. A yield farming strategy could provide high returns for a while, however, lots of other farmers will jump on the train later and make yield returns decrease.
DeFi may need to develop its own criteria for calculating profits because APR and APY are traditional market measurements. Weekly or even daily anticipated returns may make more sense due to the rapid change of DeFi.
The risks of yield farming
Although yield farming provides lots of benefits to farmers, it also comes with risks. These include:
- Smart contracts: Many protocols are designed and developed by small teams with minimal resources, which increases the possibility of smart contract bugs. Even with larger protocols that are reviewed by renowned auditing companies, vulnerabilities and bugs are found all the time. This can result in the loss of user funds due to the immutable nature of blockchain. For example, users of well-known DeFi protocols like Uniswap and Akropolis have been affected by smart contract scams.
- Composability risk: Composability is a biggest advantage and biggest risk at the same time. Since DeFi protocols are permissionless and seamlessly communicate together, the whole DeFi ecosystem relies heavily on its building blocks. Imagine if one of the blocks doesn’t function as it should, it may affect the whole ecosystem. This is one of the biggest risks to yield farmers as well as liquidity pools. Apart from the trust you place in the protocol when depositing your funds, you have to care about other factors which may make you suffer losses.
- Liquidation risks: If you’re borrowing assets, you will need collateral to guarantee your loan. However, if the price of the collateral falls below the amount of the loan, your collateral will be automatically liquidated. Therefore, there are many lending protocols using very high collateralization ratios to keep the platform safe from liquidation risk.
Yield Farming platforms
There is no one-size-fits-all approach to yield farming. Yield farming strategies can change hourly. There will be regulations and risks specific to each platform and approach. Let’s look at some common yield farming platforms that yield farmers are currently using.
- Compound Finance: Compound Finance allows users to lend and borrow assets. Anyone with an Ethereum wallet may put assets to Compound’s liquidity pool and start earning rewards. Based on supply and demand, the rates are changed algorithmically. Compound is one of the core protocols in the yield farming ecosystem.
- MakerDAO: This is a decentralized credit platform that allows users to create DAI, a stablecoin that is algorithmically pegged to the US dollar. Anyone may create a Maker Vault and lock collateral assets like ETH, BAT, USDC, or WBTC in it. They can use DAI as debt against the collateral they’ve secured.
- Aave: A decentralized protocol, allowing users to lend and borrow. The interest rates on Aava are adjusted algorithmically according to the current market conditions. Lenders who lend their funds will get “aTokens” in return, which are used to earn and compound interest. Aava is used commonly by yield farmers since it offers vast functionality.
- Uniswap: A decentralized exchange protocol that allows trustless token swaps. To create a market, liquidity providers on Uniswap deposit the equivalent value of two tokens into the liquidity pool. After that, traders can trade against that pool. Liquidity providers get fees from trades that take place in their pool in exchange for providing liquidity.
- Curve Finance: A decentralized exchange protocol specialized in efficient stablecoin swaps. Different from Uniswap, Curve lets users swap high-value stablecoins with low slippage.
- Balancer: This is a liquidity protocol just like Uniswap and Curve. The main difference is that Balancer allows liquidity providers to create custom liquidity pools instead of the 50/50 allocation rule by Uniswap. LPs gain fees for trades that occur in their liquidity pool, just like they do with Uniswap. Balancer is a vital development for yield farming strategies thanks to its flexibility.
- Yearn.finance: Yearn.finance is a decentralized aggregators ecosystem for lending services such as Aave, Compound, etc. Its goal is to maximize token lending by identifying the most lucrative lending services using an algorithm. Upon deposit, funds are converted to yTokens, which are rebalanced on a regular basis to optimize profit.
The revolutions in decentralized finance are unpredictable. We aren’t able to forecast what revolution will come up in the future, however, we do know that trustless liquidity protocols and other DeFi products are significant revolutions in the world of finance, crypto economics and computer science. Without a doubt, DeFi money markets can contribute to the development of a more open and accessible financial system that is available to anybody.