DeFi (decentralized finance) has been at the forefront of innovation in the blockchain ecosystem, spawning several applications and use cases. DeFi applications are unique because anyone with access to an internet connection and a compatible wallet can interact with them. They are also trustless, meaning they do not require trust in intermediaries. One of the concepts to emerge from DeFi is yield farming. Often called the rocket fuel of DeFi, it gives users a new avenue to earn rewards through their crypto assets by earning passive income.
This article will take a closer look at yield farming, how it works, its benefits, and some of the most prominent yield farming protocols.
- Yield farming allows users to lock their funds and earn rewards.
- Users can lend their assets via various DeFi protocols and earn a fixed or variable interest.
- Yield farming often gives users far greater returns than traditional investments. However, higher returns also mean higher risks.
What Is Yield Farming?
Also called liquidity mining, yield farming is a method through which crypto holders can lock or lend their assets and generate rewards (yield) in the form of additional crypto assets. Yield farming has seen its popularity surge and was one of the driving forces of the DeFi space, helping it rocket to a market cap of $10 billion in 2020. Now, yield farming often draws parallels with staking. However, there are subtle differences to keep in mind. Staking involves users locking up their assets in a designated wallet, earning rewards in the same cryptocurrency staked or other crypto assets.
On the other hand, yield farming involves users locking up their crypto assets in liquidity pools and earning rewards in the form of crypto assets, governance tokens, or interest. These liquidity pools are essentially smart contracts that contain funds. Those providing liquidity to these pools, also called liquidity providers, stand to earn rewards. These rewards are sourced from fees generated by the underlying DeFi protocol. Initially, yield farmers only staked well-known stablecoins such as USDC, and DAI. However, with the Ethereum network seeing an influx of DeFi protocols, the scope of assets locked into liquidity pools has expanded exponentially.
Liquidity pools also have different reward mechanisms where some reward liquidity providers in multiple tokens. The reward tokens can be deposited into other liquidity pools to earn further rewards. Yield farming primarily uses ERC-20 tokens, with rewards also paid out in ERC-20 tokens. However, this is already changing thanks to the advent of cross-chain bridges and other advancements that enable DeFi protocols to become blockchain-agnostic. This means these applications can easily run on other blockchains supporting smart contracts, making it easier for yield farmers to move between different protocols in search of higher returns.
History Of Yield Farming
Let’s rewind a little and look at the history of yield farming. Now, the origins of liquidity farming are still debated. Some attribute it to the launch of the COMP token, while others put its origin back to Fcoin, which created a token in 2018 to reward users for making trades. As a result, users started running bots, trading amongst themselves to earn the reward token. Another example of just how effective incentives are is EOS, a blockchain protocol where transactions are practically free. However, this caught the attention of a malicious entity that created a token EIDOS on the EOS network, rewarding users for pointless transactions and even managing to get an exchange listing.
Liquidity mining on Ethereum first showed up when Synthetix announced a reward in SNX tokens for users helping to add liquidity to the sETH/ETH pool on Uniswap in July 2019. By October 2019, that pool ranked among the biggest pools on Uniswap. Later, when launching the Compound Protocol, Compound Labs created the COMP token. The COMP token was the governance token of the protocol, and the Compound team spent months working on how it wanted to incentivize the token. Despite the preparations, Compound Labs was overwhelmed by the response, which even led to the crowding of a previously unpopular marketplace as users tried to mine more COMP tokens.
How Does Yield Farming Work?
As mentioned earlier, yield farming involves liquidity providers who provide liquidity to liquidity pools. Let’s understand how this works. The first step involves liquidity providers adding funds to a liquidity pool. A liquidity pool is essentially a smart contract containing funds pooled into it. These liquidity pools lie at the heart of a marketplace that facilitates the exchanging, borrowing, and lending of tokens. Once users add their funds to a liquidity pool, they become liquidity providers or yield farmers.
But what do these users get in return for locking up their assets in these pools? Well, they’re rewarded with the fees generated by the underlying DeFi platform. One important point to remember is that directly investing in a token, such as ETH, cannot be defined as yield farming. However, lending ETH out on a non-custodial, decentralized protocol, and receiving a reward, is yield farming. Once users receive their reward tokens, they can deposit them into liquidity pools and earn even more rewards. Additionally, liquidity providers also shift their funds between different DeFi protocols, chasing the highest yields.
A lot of users think yield farming is easy money, but it is far from it. The yield earned by liquidity providers is directly proportional to the amount of liquidity they provide. So if a user is reaping exceptionally high rewards, it means they have a correspondingly large amount of capital locked to earn such a high yield. Funds are generally deposited using stablecoins, most commonly being USDT, USDC, DAI, and BUSD.
What’s So Special About Yield Farming?
The main benefit yield farming gives liquidity providers is that of profit. If a user becomes an early adopter of a particular project, they could generate token rewards that could significantly appreciate in value. They could then sell their rewards for a profit or reinvest them and earn even more rewards. Yield farming also gives users a substantially higher return than traditional institutions such as banks. However, the higher return comes at the cost of an increased amount of risk. Interest rates can also be highly volatile, making it difficult for users to predict their rewards. Add to this that DeFi is traditionally a riskier environment to invest money in.
So how does one gauge the yield farming ecosystem? One way of doing so is through the Total Value Locked (TVL), which measures how much crypto is locked in DeFi lending. TVL refers to the aggregate liquidity present in liquidity pools and is a good indicator of the health of the yield farming and DeFi ecosystem as a whole. It can also help users compare the market share of different DeFi protocols.
Yield Farming Protocols
Let’s look at some of the most popular yield farming protocols.
Maker is the decentralized protocol behind the DAI stablecoin, an algorithmic stablecoin pegged to the value of the USD. Users on Maker can open a Maker Vault and lock their assets. Once they have locked their assets, they can generate DAI against the collateral locked. The debt accrues interest over time and is called the stability fee. Yield farmers often use Maker to mint DAI for use in their farming strategies.
One of the most popular decentralized exchanges and AMM, Uniswap allows users to swap pretty much any ERC20 token pair. Liquidity providers on Uniswap must stake both sides of the liquidity pool in a 50/50 ratio. In return, they receive a proportion of the transaction fees and the UNI governance token.
Sushiswap is a fork of Uniswap and caused quite an upheaval in the DeFi community when it mounted a vampire attack on Uniswap, siphoning billions. Today, the protocol has a well-established DeFi ecosystem featuring a multi-chain AMM, launchpad, dApps, and lending and leverage markets.
Yearn.finance allows yield farmers to utilize other lending protocols, such as Aave and Compound, to earn the highest yield. The protocol seeks out the most profitable yield farming services and strategies and utilizes rebasing to maximize profits. The protocol made waves in 2021 when its YFI token reached a staggering $77,611. Yearn allows users to potentially earn up to 80% APY.
Curve Finance allows users and other DeFi protocols to exchange stablecoins at extremely low fees and low slippage. It achieves this through its unique market-making algorithm. Currently, the protocol has around $4.5 billion in total value locked, according to data from DefiLlama. Curve’s stablecoin pools are considered safe as they generally do not lose their peg, with users potentially earning up to 40% in rewards.
In Closing: Not Without Risks
Yield farming is a highly lucrative way for holders to earn a passive income from their crypto assets. That being said, risks are involved, and it is only sustainable when a high amount of capital is locked. Users also risk impermanent loss and price slippages, especially during phases of high volatility. Yield farming is also susceptible to hacks due to potential vulnerabilities in smart contracts. The Yield farming space is littered with examples where vulnerabilities have caused severe financial losses.
Another point to remember is that because blockchains are immutable, DeFi losses are often permanent and cannot be reversed. Those users who are interested in yield farming should conduct their research thoroughly and familiarize themselves with the risks involved.
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