Yield farming in DeFi has been a hot topic in the cryptocurrency industry for the past few months. However, not many understand how it works. So we decided to invite Michael Gu and Kerman Kohli to our Virtual Meeting #5 on Wednesday, August 26th at 10:00pm EST to explain the intricacies of yield farming.
CoinGecko’s monthly Virtual Meetup is our live online community event where we examine various key topics in the crypto space and invite industry leaders to share their two satoshis.
In our discussion, we touched on the current yield farming hype – the incentives, the risks, and the prospects.
Here’s a quick breakdown of what Michael and Kerman shared.
1. What is yield farming?
Michael gave a simple explanation of the mechanics of yield farming. It is the process of depositing one form of cryptocurrency and receiving another type in return.
“You go into a bank and give them money to get a return on it.”
Yield farming returns are astronomical, however, with APY returns in excess of 10,000%. Michael initially thought it must be a scam. He further explained that instead of doing an ICO, these projects spend their coins on yield farming, which generates a lot of hype and encourages people to buy.
2. Why do the DeFi protocols incentivize us to provide liquidity?
Kerman told us to imagine using Uber in its infancy 5 years ago. But instead of paying Uber, you get paid in Uber stock to use their service. Since you rode Uber, the company is now worth a little more. This then means your Uber stock is now worth more too, and this becomes an appreciation loop.
3. APY (Annual Percentage Yield) offered by some of these DeFi apps are astronomically high, sometimes reaching as high as 1000% and some as high as 3000%+. Do you think that is sustainable?
Our two guests are of the opinion that such high yields are not sustainable in the long term.
Kerman believes there will be more projects in the next three months than any yield farmer can comprehend. There will be so many yield growing opportunities and lead to increased competition which will result in lower and more sustainable yields.
Meanwhile, Michael offered a more cynical point of view.
He pointed out that yearn.finance (YFI) is a yield aggregator. It has Y Vault which you can use to farm other projects resulting in a recursive loop. After YFI there are other projects like Shrimp (SHRIMP), Zombie (ZOMBIE), DFI.money (YFII), YFValue (YFV) and more. These projects farm each other, which is simply a recursive loop. In addition, projects integrate other functions into yield farming, such as B. Rebasing and mining. Michael described this as the “honeymoon phase”. While it’s interesting, he doesn’t think it will go on like this for long.
4. What is the future of yield farming and what is a sustainable yield?
“How yield farming will look in the future is more of a coordination mechanism,” Kerman said. “If you think of YFI and the rest, they seem like logs but they are actually games. In yield farming, it’s a way of bringing together all these people who would eliminate each other if they could, but instead force them to work together to create wealth for all.”
“I think a sustainable return would probably be higher than 30%, but don’t hold me to that,” Michael noted.
These returns will also depend on the risks. This varies depending on the pool you are farming in. When you deposit stablecoins into a contract, you do not take the risk of a temporary loss. However, there is a risk that the contract will break and your money will be blocked.
In the meantime, if you put your money in a liquidity pool, you risk suffering temporary losses. This happens when the token drops sharply in value, resulting in a temporary loss that becomes very permanent when you decide to withdraw.
For example, Michael bought some YFFI, paired it with DAI and ran liquidity farms with it. However, the price soon fell from $800 to $1. But since he was in the liquidity pool he was essentially buying the dip as a liquidity provider as he buys every time someone sells.
“For such pools, 300% to 400% could be sustainable for new projects because the risks are so high,” he said. “Since you provide liquidity for swaps, developers will want to incentivize you to do so. Market makers cost a lot, but these developers can incentivize liquidity providers to play the role of market makers in the form of their own coins.”
5. Given the high gas fees, what is the minimum amount required to start yield farming?
Michael started yield farming with just $100. While this may seem like a small amount, he was only testing it before committing further funds. He tested staking his funds and then released them just to make sure it was working.
Kerman has a contrary opinion.
If the project is good, you should just buy the token instead of farming it, especially if you don’t have $10,000 left.
“Because these opportunities are so risky, the odds of losing your money are basically the same as with yield farming,” Kerman explained. “If your downside is the same, you might as well buy it and hope it goes up. That’s what I did with YFI, I didn’t think it would go on for so long. But in hindsight it was a good decision.”
6. With products like Ampleforth and YAM, we now seem to be entering a new era for blockchain tokenomics, where the rebase feature will be used extensively. Can you explain how rebasing works?
“The way these things work, it’s almost like a game,” Michael said. “The coin is self-aware of its price and can rebase its price to change it.”
This rebase feature affects whoever is holding the coin. An example of a rebasing token is Ampleforth (AMPL), which must be $1. In the situation that AMPL is at $3, it will increase its supply to lower the price and the price should move towards $1. If it is below $1, the supply will shrink to bring the price back to $1 and this is called rebasing. For YAM, the price went up and the rebase functionality brought the price down again. However, due to a smart contract failure, YAM exploded.
7. What risks are yield farmers exposed to in this area?
Michael and Kerman agree that yield farmers face multiple risks. For Kerman, the biggest risk is the integrity of the team behind the project.
“If the team is anonymous, there’s no loss of reputation if it’s an exit scam,” Kerman explained.
Team ethics is another factor to consider.
“Have they created a backdoor that allows them to intentionally destroy things or mint an unlimited amount of tokens?” he asked.
“Maybe the code could be cracked, and one day someone could just hit the right function and break it.”
As for Michael, he agrees that the risk of token mining is the biggest when it comes to yield farming. He also mentioned that jumping into a new project is also risky.
“What if the creator has the ability to mint infinite coins?” he thought. “This will allow them to mint the coins and just sell anything in the market.”
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Shaun Paul Lee
Shaun is a research associate at CoinGecko with a penchant for memes and farming on the blockchain. Follow the author on Twitter @ShaunPaulLee
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