What is yield farming in decentralized finance (DeFi)?

TL;DR
Yield farming is a way to earn more crypto using your crypto funds. This involves you lending your funds to other people through the magic of computer programs called smart contracts. In exchange for this service, you earn fees in the form of crypto. Pretty simple, huh? Well, not so fast.

Yield farmers use complex strategies. They move their cryptocurrencies all the time between different lending markets to maximize their returns. They will also be very discreet about which strategies offer the best returns. For what ? The more people who know about a strategy, the less effective it can be. Yield farming is the Wild West of decentralized finance (DeFi), where farmers compete for the chance to benefit from the best returns.

You are interested ? Read more below.

Contents

• Introduction

• What is yield farming?

  • What caused the explosion of yield farming?

• What is Total Locked Value (TVL)?

• How does yield farming work?

• How are yield farming returns calculated?

• What is a Collateral in DeFi

• The risks of yield farming

• Yield farming platforms and protocols

  • Compound Finance

  • MakerDAO

  • Synthetix

  • Ghost

  • Uniswap

  • Curve Finance

  • Balancer

  • Yearn.finance

• To conclude

Introduction

The decentralized finance (DeFi) movement has placed itself at the forefront of innovation in the blockchain space. What makes DeFi applications unique? They are permissionless, meaning that anyone (or anything, like a smart contract) with an internet connection and a supported wallet can interact with them. In addition, they generally do not need to trust intermediaries or trusted third parties. In other words, they are “trustless”, that is to say they do not need to be trusted. What new use cases do these features offer?

One of the new concepts that has emerged is yield farming. This is a new way to earn rewards with your cryptocurrency holdings using permissionless liquidity protocols. Yield farming allows anyone to generate passive income through the decentralized “money legos” ecosystem based on Ethereum. Therefore, yield farming may change the way investors HODL in the future. Why keep your assets idle when you can put them to work?

So how does a yield farmer take care of his crops? What kind of returns can he expect? And where do you start if you're thinking of becoming a yield farmer? We will explain everything in this article.

What is yield farming?

Yield farming, also called liquidity mining, is a way of generating rewards with the cryptocurrencies held. In other words, it involves locking cryptocurrencies and getting rewards.

In a certain sense, yield farming can be compared to staking. However, there is a lot of complexity in the background. In many cases, it partners with users called liquidity providers (LPs) who add funds to liquidity funds.

What is a liquidity pool? It is essentially a smart contract containing funds. In return for the liquidity provided, LPs obtain a reward. This reward may come from fees generated by the underlying DeFi platform, or from another source.

Some liquidity pools pay their rewards in multiple tokens. These reward tokens can then be deposited into other liquidity pools to earn rewards there, and so on. You can already see how incredibly complex strategies can emerge quite quickly. But the basic idea is that a liquidity provider deposits funds into a liquidity pool and gets rewards in return.

Yield farming is usually done using ERC-20 tokens on Ethereum, and the rewards are usually also an ERC-20 token. However, this may change in the future. For what ? For now, much of this activity is happening in the Ethereum ecosystem.

However, cross-chain gateways and other similar advancements could enable DeFi applications to become independent of a single blockchain in the future. This means they could run on other blockchains that also support smart contracts.

Yield farmers tend to move their funds a lot to where the best returns are found. Therefore, deFi platforms can also provide other economic incentives to attract more capital to their platform. Just like on centralized exchanges, liquidity tends to attract more liquidity.

What caused the explosion of yield farming?

Sudden and strong interest in yield farming can be attributed to the launch of the COMP token – the governance token of the Compound Finance ecosystem. Governance tokens grant governance rights to their holders. But how do you distribute these tokens if you want to make the network as decentralized as possible?

A common way to launch a decentralized blockchain is to distribute these governance tokens algorithmically, with liquidity incentives. This attracts liquidity providers to farm the new token by providing liquidity to the protocol.

Even though the launch of COMP is not the invention of yield farming, it has caused an increase in the popularity of this model. Since then, other DeFi projects have implemented innovative devices to attract liquidity into their ecosystems.

What is Total Locked Value (TVL)?

So what is a good way to measure the overall health of the DeFi yield farming environment? Total Blocked Value (TBV). It measures the amount of crypto locked in DeFi lending protocols and other types of money markets.

In a certain sense, VTB represents the overall liquidity of liquidity pools. This is a useful index for measuring the health of the DeFi and yield farming market as a whole. It is also an effective metric for comparing the “market shares” of different DeFi players.

Defi Pulse is a good place to compare TVBs. You can check which platforms have the highest amount of ETH or other cryptocurrencies locked in DeFi. This can give you a general idea of ​​the current state of yield farming.

Naturally, the higher the value locked, the higher the yield farming activity. It's worth noting that you can measure total value locked (TVL) in ETH, USD, or even BTC. Each denomination will give you a different perspective on the state of the DeFi protocol.

How does yield farming work?

Yield farming is closely related to a model called automated market maker (AMM). It usually involves liquidity providers (LPs) and liquidity pools. Let's see how it works.

Liquidity providers deposit funds into a liquidity pool. This pool powers a marketplace where users can lend, borrow or trade tokens. Using these platforms incurs fees, which are then paid to liquidity providers based on their share of the liquidity pool. This is the basis for the operation of an AMM.

However, the implementations can be very different, not to mention that it is a new technology. There is no doubt that we will see new approaches emerge that improve current implementations.

In addition to fees, another incentive for adding funds to a liquidity pool could come in the form of distributing a new token. For example, it may not be possible to purchase a token on the open market, but only in small quantities. Furthermore, it can be accumulated by providing liquidity to a specific pool.

The distribution rules will depend on the unique implementation of the protocol. The bottom line is that liquidity providers earn a return based on the amount of liquidity they provide to the pool.

The funds deposited are usually US dollar-backed stablecoins, but this is not always the case. Some of the most common stablecoins used in DeFi include DAI, USDT, USDC, BUSD, etc. Some protocols allow you to create tokens that represent the tokens you have deposited into the system. For example, if you deposit DAI into Compound, you will get cDAI, or Compound DAI. If you deposit ETH on Compound, you will receive cETH.

As you can imagine, there can be many layers of complexity in this area. You can deposit your cDAI to another protocol that issues a third-party token to represent your cDAI that represents your DAI. And so on... These strings can become very complex and difficult to follow.

How are yield farming returns calculated?

In general, the estimated yields of yield farmers are expressed annually. This gives an overview of the expected return over a year.

Annualized percentage rate (APR) and annual percentage yield (APY) are commonly used metrics. The difference between them is that APR does not take into account the effect of reinvestment, while APY does. Reinvestment here means putting profits back into the protocol to generate more profits. Be aware that there is often a confusion between APR and APY.

It is also worth keeping in mind that these are only estimates and projections. Even short-term rewards are quite difficult to estimate accurately. For what ? Yield farming is a highly competitive and dynamic market, and rewards can fluctuate quickly. If a yield farming strategy works for a while, many farmers will seize the opportunity and risk lowering the yield of that strategy.

As APR and APY come from traditional markets, DeFi must find its own metric to calculate returns. Due to the rapid pace of growth of DeFi, estimated weekly or even daily returns may be more attractive.

What is a collateral in DeFi?

Typically, if you borrow assets, you must post collateral to cover your loan. This is essentially insurance for your loan. How is this relevant? It depends on the protocol you provide your funds to, but you may need to monitor your collateral rate closely.

If the value of your collateral falls below the threshold required by the protocol, it may be liquidated on the market. What can be done to avoid this liquidation? You can add guarantees.

To summarize, each platform defines its rules, and therefore its guarantee ratio. In addition, they generally use a concept called overcollateralization. This means borrowers must deposit more than they want to borrow. For what ? To reduce the risk of violent market crashes, causing a large amount of your collateral to be liquidated.

Let's say the lending protocol you're using requires a 200% collateral ratio. This means that for every $100 of value you put in, you can borrow $50. However, it is generally safer to add more collateral than necessary to further reduce liquidation risk. That said, many systems use very high collateralization ratios (750% for example) in order to protect the entire platform against the risk of liquidation.

The risks of yield farming

Yield farming is not simple. The most profitable strategies are highly complex and recommended only for the most experienced users. In addition, yield farming is generally better suited to those who have significant capital (whales for example).

Yield farming is not as simple as it seems and if you don't understand what you are doing, you are likely to lose money. We have only discussed how your guarantees can be liquidated. What other risks do you need to be aware of?

One of the obvious risks of yield farming is that of smart contracts. Due to the nature of DeFi, many protocols are built and developed by small teams with limited budgets. This increases the risk of bugs or flaws in smart contracts.

Even in the case of larger protocols that are monitored by reputable auditing companies, vulnerabilities and bugs are discovered all the time. Due to the immutable nature of blockchain, this may result in loss of user funds. You must take this into account when blocking your funds in a smart contract.

Furthermore, one of DeFi's biggest benefits is also one of its biggest risks. This is the idea of ​​composability. Let’s see how this affects yield farming.

As we've already discussed, DeFi protocols are permissionless and can seamlessly integrate with each other. This means that the entire DeFi ecosystem is highly dependent on each of its fundamental elements. This is what we mean when we say these applications are composable, it means they can easily work together.

Why is this a risk? Well, it only takes one of the fundamental elements not working as expected and the entire ecosystem suffers. This poses one of the biggest risks for yield farmers and liquidity pools. You not only have to trust the protocol you deposit your funds into, but also any others it may depend on.

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Yield farming platforms and protocols

How to get these yield farming rewards? Well, there is no specific way to do yield farming. In fact, yield farming strategies can change from hour to hour. Each platform and strategy will have its own rules and risks. If you want to get familiar with yield farming, you need to familiarize yourself with how decentralized liquidity protocols work.

Now you understand the basic operation. You deposit funds into a smart contract and earn rewards in exchange. But implementations can vary widely. As a result, it is generally not wise to blindly deposit your hard-earned funds and hope for high returns. The basic rule of risk management is that you must be able to maintain control of your investment.

So what are the platforms most used by yield farmers? This is not an exhaustive list, but simply a set of protocols essential to yield farming strategies.

Compound Finance

Compound is an algorithmic money market that allows users to lend and borrow assets. Anyone with an Ethereum wallet can contribute assets to Compound's liquidity pool and earn rewards that are immediately reinvested. Rates are adjusted algorithmically based on supply and demand.

Compound is one of the key protocols in the yield farming ecosystem.

MakerDAO

Maker is a decentralized lending platform that supports the issuance of DAI, a stablecoin algorithmically linked to the value of USD. Anyone can open a Maker Vault where they lock collateral assets, such as ETH, BAT, USDC or WBTC. They can issue DAI as debt against this collateral that they have blocked. This debt accrues interest over time, called a “stability fee,” the rate of which is set by MKR token holders.

Yield farmers use Maker to issue DAI and use it in various yield farming strategies.

Synthetix

Synthetix is ​​a synthetic assets protocol. It allows anyone to stake Synthetix Network Token (SNX) or ETH as collateral assets to issue synthetic assets. What is a synthetic asset? Pretty much anything that has a reliable price source. This makes it possible to add virtually any financial asset to the Synthetix platform.

Synthetix could allow the use of all kinds of assets for yield farming in the future. Do you want to use your gold reserve for your yield farming strategies? Synthetic active ingredients are probably what you need!

Ghost

Aave is a decentralized protocol for lending and borrowing. Interest rates are adjusted algorithmically, based on current market conditions. Lenders receive “aTokens” in return for their funds. These tokens immediately start earning and reinvesting interest after deposit. Aave also offers other, more advanced features, such as Flash Loans.

As a decentralized lending and borrowing protocol, Aave is widely used by yield farmers.

Uniswap

Uniswap is a decentralized exchange (DEX) protocol that allows tokens to be exchanged without a trusted third party. Liquidity providers deposit an equivalent value of two tokens to create a market. Traders can then trade through this liquidity pool. In return for providing liquidity, liquidity providers earn commissions on transactions that take place in their pool.

Uniswap has been one of the most popular platforms for trustless token trading due to its ease of use. This can be useful for yield farming strategies.

Curve Finance

Curve Finance is a decentralized exchange protocol specifically designed to efficiently trade stablecoins. Unlike other similar protocols like Uniswap, Curve allows users to perform swaps of high-value stablecoins with relatively low slippage.

As you would imagine, due to the abundance of stablecoins in yield farming, Curve pools are a key piece of infrastructure.

Balancer

Balancer is a liquidity protocol similar to Uniswap and Curve. However, its main difference is that it allows custom tokens to be allocated into a liquidity pool. This allows liquidity providers to create custom Balancer pools instead of the 50/50 allocation required by Uniswap. As in the case of Uniswap, LPs earn fees for transactions that take place in their liquidity pool.

Due to the flexibility it brings to creating a liquidity pool, Balancer represents an important innovation for yield farming strategies.

Yearn.finance

Yearn.finance is a decentralized ecosystem of aggregators for lending services such as Aave, Compound and others. It aims to optimize token lending by algorithmically finding the most profitable lending services. Funds are converted into yTokens upon deposit which rebalance periodically to maximize profit.

Yearn.finance is useful for farmers who want a protocol that automatically chooses the best strategies for them.

To conclude

We looked at the latest craze in the world of cryptocurrencies - yield farming.

What can this decentralized financial revolution bring us? It is impossible to predict what new applications might emerge in the future on these current components. Nonetheless, trustless liquidity protocols and other DeFi products are certainly at the forefront of finance, cryptoeconomics, and computing.

DeFi financial markets can help create a more open and accessible financial system available to anyone with an internet connection.