Catching Up: What’s Yield Farming and How its Revolutionizing the DeFi World Today

Decentralized Finance’s focus on yield farming cannot be overstated. With the industry boasting an almost triple increase in frozen assets this year when compared to the year before, yield farming is becoming a more prominent source of passive income by the day.

Data, collected by DeFi Pulse, tells us an optimistic story. Around $95 billion assets are locked and yield farmed today. An almost triple increase when compared to the $32 billion we saw last year.

The Advent

June 2020, Compound, an Ethereum-based credit market, rolled out COMP to all protocol users. This was a revolutionary step in the company’s future as it was meant to serve as a voting mechanism of sorts. Holders of COMP were treated as shareholders with swaying powers when considering future developments. Soon after, the company skyrocketed due to the newly created demand for their native token.

At the time 2 new terms emerged: “yield farming” and “liquidity mining”. Both referred to the same thing — a strategy where crypto holders would lend their assets to companies at an interest rate.

DeFi and Banking

For those who may have lost track of the crypto space around 2018, the term “open finance” was once in vogue. However, this terminology has since evolved, with “DeFi” becoming the new buzzword.

To clarify, DeFi encompasses all financial services that can be accessed using only a crypto wallet as identification. While explanations are helpful, nothing beats hands-on experience with these applications.

If you possess an Ethereum wallet containing even a modest $20 in crypto, I encourage you to explore some DeFi platforms. For instance, visit Uniswap to acquire FUN tokens (used in gambling apps) or WBTC (wrapped bitcoin). Alternatively, try MakerDAO to generate $5 worth of DAI (a stablecoin typically valued at $1) from thin air. Or head to Compound and borrow $10 in USDC.

Note the intentionally small amounts suggested here. The crypto adage “don’t invest more than you can afford to lose” is particularly relevant in DeFi. These systems are intricate and prone to unexpected issues. While they may offer “savings” products, they’re not suitable for your retirement fund.

Despite its experimental nature, DeFi’s potential impact is profound. In the traditional web, purchasing a simple appliance often requires divulging extensive personal information. Conversely, DeFi allows you to borrow funds without even providing your name.

DeFi platforms don’t need to trust users because they hold collateral against debts. For example, on Compound, a $10 loan typically requires about $20 in collateral.

This paradigm shift in financial services represents a significant departure from conventional systems, offering unprecedented levels of privacy and accessibility. However, it’s crucial to approach these platforms with caution and thorough understanding.

Launching a decentralized financial (DeFi) platform requires substantial initial capital, much like traditional banking. However, in the DeFi space, this funding often comes from anonymous internet users rather than institutional investors. To attract these potential backers, known as HODLers, who possess idle digital assets, DeFi startups devise innovative strategies.

The primary focus for these diverse DeFi products is liquidity – essentially, the amount of funds locked within their smart contracts. This metric is crucial for their functionality and success.

Avichal Garg, managing partner at Electric Capital, explains, “Certain DeFi products significantly enhance their user experience with increased liquidity. Instead of relying on venture capitalists or debt financing, these platforms leverage their user base for funding.”

Consider Uniswap, a prime example of an automated market maker (AMM) in the DeFi ecosystem. This digital entity operates as an internet-based robot, constantly prepared to buy or sell any cryptocurrency for which it maintains a market.

Uniswap offers trading pairs for nearly every token on the Ethereum network. Behind the scenes, this system creates the illusion of direct token-to-token trades, simplifying the user experience. However, the mechanism actually relies on pools of paired tokens. The efficiency of these market pairs improves as the pool sizes increase.

This approach to liquidity provision represents a paradigm shift in financial services, allowing DeFi platforms to bootstrap their operations using community-driven funding rather than traditional capital sources.

So What is Yield Farming?

Yield farming, in essence, is the practice of strategically deploying cryptocurrency assets to maximize returns. At its most basic level, a yield farmer might shift assets between different pools within platforms like Compound, pursuing the highest Annual Percentage Yield (APY) available each week. This approach may occasionally involve venturing into riskier pools, but seasoned yield farmers are typically prepared to manage such risks.

Maya Zehavi, a blockchain consultant, notes, “Farming creates new arbitrage opportunities that can ripple through to other protocols whose tokens are part of the pool.”

The tokenization of these positions allows for more advanced strategies. For instance, a yield farmer could deposit 100,000 USDT into Compound, receiving cUSDT tokens in return. While the exact conversion rate is complex, let’s assume they receive 100,000 cUSDT. The farmer could then utilize these cUSDT tokens in a Balancer liquidity pool, potentially earning additional transaction fees. This exemplifies the core concept of yield farming: identifying and exploiting inefficiencies across multiple platforms to maximize yields.

Liquidity mining has significantly amplified the potential of yield farming. This process involves yield farmers receiving new tokens in addition to standard returns, incentivizing them to provide liquidity. Richard Ma of Quantstamp explains, “The concept aims to boost platform usage, thereby increasing token value and creating a positive feedback loop to attract users.”

Traditional yield farming focuses on returns from normal platform operations, such as supplying liquidity to Compound or Uniswap. However, when Compound announced its plan to decentralize in 2020, it introduced the COMP token as a means of distributing ownership to active users. This move, while partially altruistic, also served to enhance the platform’s popularity and potentially increase the value of all stakeholders’ positions.

Compound implemented a four-year distribution period for COMP tokens, allocating a fixed daily amount to users based on their proportional contribution to the platform’s lending and borrowing activities. This governance token grants holders control over the protocol, similar to how shareholders influence publicly traded companies.

The outcome of this initiative surpassed expectations, even among Compound’s staunchest supporters, demonstrating the powerful impact of aligning user incentives with platform growth.