An emerging and rapidly growing financial technology branch of the cryptocurrency industry is decentralized finance (DeFi), which is based on distributed ledgers where transactions are verified and approved by the decentralized network without the need for third parties such as banks.
DeFi was designed to challenge the limitations of the traditional financial system, known as centralized finance (CeFi), which relies on intermediaries to function. In 2022, the total value (TVL) for DeFi worldwide reached almost $2 billion, rising from $400 million in the previous two years. Aside from DeFi’s permissionless and decentralized nature, the main driver of the industry’s growth has been its flexibility with a variety of platforms combining services such as exchange, lending and yield farming to thrive on this network of economic forces.
This article will help users understand the importance, rewards and risks of this new DeFi branch known as Yield Aggregators. We begin by familiarizing ourselves with the concept of yield farming.
yield farming
Yield farming is an area of DeFi that allows crypto investors to earn rewards by moving their tokens into yield-generating smart contracts. In this process, the investor is the liquidity provider (LP) and the liquidity pool is a cash-filled smart contract. The automated market maker is another key network component in yield farming that allows users to trade through an automated system across pools of liquidity instead of the traditional buyer and seller market.
The concept gained popularity with the creation of COMP, the governance token of DeFi lending protocol Compound. One such protocol rewards participating users with newly minted COMP tokens as they leverage lending and borrowing services in a process called “liquidity mining.”
In addition to being rewarded with interest on lending and fees on providing liquidity, yield farming participants were rewarded with governance tokens to increase their participation in the platform’s early adoption. Such various rewards in the form of interest, fees, and token distribution formed the basis for DeFi yield aggregators.
What is a DeFi yield aggregator?
Yield aggregators, also known as “autocompounders” or “yield optimizers”, play a crucial role in yield economics, combining various DeFi (smart contracts) protocols and strategies to maximize investor profits.
Yield aggregators are a set of smart contracts that pool investors’ crypto assets (tokens) and invest them into a portfolio of yield-producing products and services through pre-programmed and automatically executed strategies.
It’s almost as if a fund manager takes care of an investor’s portfolio and provides the best DeFi crypto staking opportunities to maximize profits. Various yield aggregators are available and they are all similar except in the blockchain they support and the relevant DeFi smart contracts they use, so the difference is mainly technical. However, their fees and interest rates may differ, so crypto investors should check their offers before signing up.
How do yield aggregators work?
The yield farming process typically expects participants to lock or stake their funds, and yield aggregators work by automating the farming process to produce the highest yields possible. Let’s see how this system works in detail.
Real terms like “farm” are not used randomly. On a farm, crops are grown to produce a crop. The same concept applies to yield farming in DeFi, where “farmers” use their investment (crop) to generate profit (return).
Yield aggregators combine the investments of different farmers (crypto investors) to make it easier to generate profits using different strategies while they remain idle and waiting to accumulate passive income, since the automated service provided by yield aggregators does everything for them completed.
These strategies allow investors to move tokens across platforms and optimize returns through auto-compounding. This process allows players to claim and reset their rewards without having to do it manually.
Some of the tokens used in yield farming are governance tokens, allowing participants to influence management decisions through voting. Protocols issue governance tokens to incentivize network activity and to propose and vote on changes. Such incentives generate more fees, resulting in higher deposited token returns.
revenue strategies
A popular yield strategy is to provide liquidity to a decentralized exchange (DEX). Liquidity is an integral part of DeFi, and DEXs replace the traditional order book with a liquidity pool where participants provide the crypto assets to be traded. This way, the liquidity is good enough to allow instant trades, and LPs can get a share of the transaction fee in return.
However, investors should typically be manually claiming those dividends and paying a gas fee each time, impacting their profits and lowering their annual percentage return (APY). APY and Annual Percentage Return (APR) are the leading indicators of revenue generated by depositing tokens on a platform in a year. While the APY includes the compound interest of the asset, the APR does not.
They are variable indicators based on the trading volume that generates fees in a liquidity pool and the TVL of the vault (smart contract) under consideration. When more people participate in a vault, it means the APY is lower as the rewarded tokens are distributed more.
Transaction fees may not be sufficient incentives for LPs. Another strategy to earn rewards in yield farming is staking LP tokens in a farm that pays participants the rewards in their native LP or single tokens.
In this case, yield aggregators allow users to automate this process and save on gas fees by depositing their LP or individual tokens in vaults. You will automatically claim them, convert them into interest-bearing assets, and deposit them back into the farm for maximum profit.
The value of the token increases thanks to the redistribution of accumulated vault fees and the sharing of earned vault rewards by staking the aggregator protocol token. Unlike farms, vault deposits are automatically compounded at specified intervals, such as every five minutes. With auto-compounding, vaults automatically harvest rewards, which are then reinvested into the pool, so the yield is calculated over the new total.
Using yield aggregators automates the process of staking, collecting and reinvesting the generated profits on behalf of users. Maximum profits are achieved by doing this process in batches and dividing gas fees among all participants, making such costs negligible.
Yield Aggregator Platforms
Technological innovations are happening so fast in DeFi that it is difficult to keep up with all the new protocols and services available. However, competition between the different platforms allows for a broader offering with higher interest rates and lower fees for investors.
Most DeFi yield aggregators are deployed on Ethereum, followed by Polygon. Investors should ensure that the network chosen for yield optimization is compatible with the blockchain hosting their assets.
Yearn.finance is one of the top yield aggregators based on Ethereum and accessible via Fantom and Arbitrum. It is a versatile platform as it allows users to optimize yield by combining liquidity pool staking, crypto lending, yield farming pools and the recently added Ethereum staking to create the optimal APY rate for staking from crypto assets.
Convex Finance differs from Yearn.finance as it only offers liquidity stakes. However, Convex uses Curve (CRV) staking to give LPs access to yield increases on its platform. CRV is an automated market maker and by using it, Convex LPs can earn trading fees and claim an increased CRV without having to lock it.
Harvest Finance is an automated yield farming protocol that offers compound interest yield through its farm liquidity mining program. It’s easy for beginners and non-techies who aim for the highest passive income as it automates capital collection from various yield builders, saving participants money and time.
Are DeFi Yield Aggregators Risky?
Yield farming and aggregators exist primarily to allow crypto investors to earn rewards and increase their token holdings, rather than having their wealth slumber in a wallet while waiting for the token value to surge.
However, along with great potential gains, yield strategies could also pose some risks. Due to the composability of the system, different protocol layers are involved in the yielding process, which facilitates the proliferation of threats like fraud and bugs that could drive the token price to zero.
Temporary loss and liquidation risks should be considered when deciding to yield farm with yield aggregators as returns or assets may be lost if such events occur.
A temporary loss could reduce returns if the prices of the underlying assets start to change. On the other hand, liquidation risk arises when investors borrow funds and the value of the asset provided as collateral falls below a predetermined liquidation threshold.
These risks are exacerbated for retail investors when we consider that farmers with large funds have far more control over the protocol and can manipulate an asset’s price. In addition, retail investors could be less likely to repay a loan if the price of the security falls below a certain level and could be more easily liquidated than prominent investors.
To avoid these risks, users should adequately review the platform they intend to use. Yield aggregator tools facilitate passive income for crypto farmers, allowing them to get on with life while earning potential returns. However, investors should regularly monitor the performance of their assets in order to be able to exit one pool and invest in another if necessary.
Yield farming and aggregators are already fully-functional investment vehicles in DeFi; However, there is still a lot to experiment with. In a fast-growing environment like cryptocurrency, we don’t yet know where the development will take us in the future.
As tempting as some returns may seem, crypto investors should always be aware that money can be lost because the networks are not secure. There are many instances of hacks, bugs and security issues that have lost investors money in the past.
It would be wise to follow best practices for safeguarding assets and never invest more than can be lost.
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