Yearn Finance played a leading role in the summer 2020 decentralized finance (DeFi) boom. Running on the Ethereum blockchain, Yearn Finance used smart contracts to maximize returns on deposits and generate high interest rates.
This process is called yield farming and Yearn Finance pioneered this business. Let’s start with the origin of the protocol.
Yearn Finance origin and purpose
Yearn Finance owes its existence to Andre Cronje, a South African programmer who has created and contributed to more than 25 DeFi projects. Many in the community call him the “Godfather of DeFi”.
In early 2020, Cronje pioneered two DeFi projects – yEarn Finance and iEarn. The latter was the first decentralized application (dApp) to use smart contracts for revenue aggregation. The concept was simple:
- Users deposit crypto funds in a smart contract vault.
- The smart contract algorithm automatically allocates these funds to other smart contracts (DeFi platforms) with the highest interest rates (yields).
- Interest is paid by borrowers tapping into these vaults, just as customers go to banks to lend.
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In traditional finance, this approach would mean moving money between accounts to pocket interest income. There are no banks in the DeFi world. Instead, smart contracts hosted on blockchain networks serve as liquidity depositories for lenders and sources of liquidity for borrowers.
On each side of the equation, borrowers and lenders interface with smart contracts. After iEarn found success in yield aggregation, Cronje renamed it YEarn, as in Yield Earn, which eventually morphed into Yearn Finance (YFI) in July 2020.
At its TVL peak in December 2021, Yearn Finance was holding $6.91 billion worth of cryptocurrency, a whopping 103.034% growth since July 2020.
Yearn Finance’s popularity reflects its primary mission. The platform’s goal is to simplify the DeFi experience so crypto investors don’t have to search for yields across dozens of lending dApps.
Interestingly, Yearn Finance is one of the rare projects not funded by venture capital firms. Furthermore, Cronje has not even raised private or public funds through YFI token sales. To keep up with the spirit of decentralized finance, Cronje chose not to reserve YFI tokens for itself.
Main benefit of Yearn Finance
Without Yearn Finance, investors would have to manually move their liquidity to the protocol with the highest yield. As a talented programmer, Andre Cronje has automated this process and scaled it for public use in the form of Yearn Finance.
In addition to making DeFi accessible to the average online adventurer, Yearn Finance deployed a suite of custom tools to serve as a yield aggregator for the largest lending platforms: Aave, Curve, Balancer, and Compound.
Of course, liquidity providers (LPs) are not just limited to lending platforms to do yield farming. Decentralized exchanges (DEXs) like Uniswap require liquidity for token pair exchanges, which also generates interest rates for liquidity providers.
Thanks to these YF tools, investors can search for the best interest rates available. To fund the further development of the protocol, Yearn Finance charges 0.5% withdrawal fees.
Inner workings of Yearn Finance
Yearn Finance is a collection of smart contracts that work together to simplify yield farming. Each provides revenue aggregation:
- APY: marks annual percentage returns from lending logs across the Ethereum dApp ecosystem
- Deserve: is one of the highest interest rates available
- vault: a bundle of trading strategies within staking pools
- Zap: Executing the vault’s bundle of trading strategies
The end user sees these four YF columns arranged like an intuitive news page. Once the account portfolio is connected to the Yearn Finance platform with the MetaMask wallet, it resides in the front-end center and displays holdings, earnings, and Estimated Annual Revenue (APY).
Just below the user’s portfolio, Yearn Finance displays the top three APY opportunities as a version of the “trending” midsection. Below these high earners is the listing of all yield farming opportunities in dozens of vaults, filterable by total assets and vault’s APY.
Vault is the cornerstone of the Yearn Finance model. Yearn Vault is a smart contract that collects investor’s liquidity but from other platforms. To enable this inter-dApp connectivity, yTokens represent liquidity pools (tokens themselves are smart contracts).
Remember, when depositing liquidity into a liquidity pool like ETH/USDC on Aave, the liquidity provider (LP) deposits those tokens as they are intended to generate returns. A Yearn Vault is also such a revenue-generating staking pool, but yTokens convert deposited assets into yTokens.
In other words, they will be packaged as yTokens, allowing other smart contracts on other platforms to be accessed from a single aggregating source – Yearn Finance. Likewise, when withdrawing funds, they are returned as yTokens. A case in point is Curve Finance’s Curve stETH vault with 6.56% APY, which represents the Curve liquidity pool holding Ethereum (stETH).
Depositing liquidity into a vault gives the user return benefits as if accessing the Curve Finance platform. That’s because Yearn Vaults does this for the user by routing deposited funds to the other platform, in this case Curve Finance.
In addition, Yearn Finance employs trading strategies to generate maximum returns. Depending on the type of staking pool represented by yTokens, these returns can come from LP rewards, trading fees, or interest rates.
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Additionally, these strategies run as batch transactions rather than single sequential transactions, which significantly reduces ETH gas fees. Each yToken will clearly outline what strategy the vault uses to maximize returns. A user (liquidity provider) could use them manually by simply reading the description, but they wouldn’t be able to be that cost effective.
Advanced users can access Labs. This Yearn Finance section lists vaults that employ unconventional and experimental yield farming strategies.
YFI tokenomics
YFI token is an ERC-20 utility and governance token. YFI token holders can use their stacks to vote on new vault trading strategies or even change withdrawal fees and other aspects of the protocol.
YFI tokens are almost as rare as typical NFT collections. There is a maximum supply of 36,666 YFI tokens all in circulation. Due to its rarity and high demand, the YFI token price hit a staggering high of $93,435 in May 2021, while its all-time low was $739 in July 2020, just as the platform was gaining momentum.
In addition to earning YFI tokens by depositing into Yearn Vaults, they are available on decentralized and centralized exchanges.
Risks Associated with Yield Farming
Whether indirectly through Yearn Finance or directly, yield farming can be risky. According to Chainalysis’ August report, up to $2 billion in crypto assets have been drained by smart contract exploits.
Aside from the technical vulnerability stemming from poor programming practices and lack of auditing, the assets themselves could be risky. For example, algorithmic stablecoins are pegged to other cryptocurrencies, making them vulnerable to extreme market conditions.
TerraUSD (UST), DEI (DEI), Fantom USD (fUSD), and Neutrino (USDN) are just a few of the algorithmic stablecoins that failed to maintain their dollar peg. If this is done in liquidity pools, secured loans could be liquidated.
Additionally, due to the interconnected trading strategies, one token debasement could lead to the next, triggering a contagion cascade. One only has to look at the Yearn Finance TVL chart above to see that this has already happened after Terra (LUNA) collapsed in May.
Disclaimer for the series:
This series article is for general guidance and information only for beginners participating in cryptocurrencies and DeFi. Nothing in this article should be construed as legal, business, investment or tax advice. Consult your advisors for all legal, business, investment and tax implications and advice. The Defiant is not liable for lost funds. Please use your best judgment and exercise due diligence before interacting with Smart Contracts.
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