Yield farming has been a popular topic in the DeFi space for a while. We know you may have many questions about yield farming – what is it? Why is it causing such a stir?
Let’s start with a simple statistic. In 2020 so far, the DeFi space is growing by 150% as measured by Total Value Locked (TVL) in dollars. In comparison, the cryptocurrency market cap has only grown 37% so far.
Many experts credit yield farming for the amazing growth of the DeFi space this year. The progress is due to the concept of liquidity farming. Both investors and speculators are involved in this, providing liquidity to platforms that offer lending and lending services. In return, the lending and lending platforms pay them high interest rates. As an incentive, they also receive a portion of the platforms’ tokens.
The current stars in the DeFi space are the liquidity providers. They are referred to as yield farmers. Leading names include Compound (COMP), Curve Finance (CRV) and Balancer (BAL).
Comp, Curve and Balancers
Compound: First to start the liquidity farming trend
It all started with the live distribution of Compound’s COMP token on June 14th. COMP is Compound’s governance token. The live distribution of the COMP token was very successful. As a result, the platform achieved a total value lock (TVL) of $600 million. It was the first time a DeFi protocol overtook MakerDAO in the DeFi Pulse leaderboard.
The distribution of COMP was followed by the distribution of Balancer’s BAL token. Balancer launched its log rewards incentive program in May. They started live distribution of their BAL token a few days after COMP. It was also very successful. They were able to reach a TVL value of US$70 million.
Although the ongoing yield farming craze started with COMP, it was a part of DeFi before that.
It was Synthetix who came up with the concept of protocol token rewards. Synthetix presented the concept in July 2019. They rewarded the users who provided liquidity to the sETH/ETH pool on Uniswap V1 with token rewards.
Yield Farming – The Answer to DeFi’s Liquidity Problems
What is the main concern in the DeFi space? The answer is liquidity. Now you must be wondering why do DeFi players need money? First of all, banks also have a lot of money and yet they borrow more money to do their day-to-day business, invest, etc.
With DeFi, strangers on the Internet provide the necessary liquidity. Therefore, DeFi projects attract HODLers with idle assets through innovative strategies.
Another thing to consider is that some services require high liquidity in order to avoid serious price fluctuations and have a better overall trading experience. A prime example are decentralized exchanges (DEX).
Borrowing from users turns out to be quite a popular option. It could even compete with borrowing opportunities from lenders and venture capitalists in the future.
So what is yield farming?
To compare it to traditional finance, yield farming could be described as depositing money in a bank. Over the years, banks traditionally paid different interest rates to those who kept their money in deposits. In other words, you get a certain annual interest rate for having your money in a bank.
The situation is similar with yield farming in the DeFi space. Users lock their money using a specific protocol (like Compound, Balancer, etc.) which then lends it to people who need to borrow at a specific interest rate. In return, the platform would reward those who lock their funds and sometimes share some of the fees for providing the loan with them as well.
The income that lenders make from interest rates and fees is less significant. When it comes to the actual payout, the units of the new crypto tokens from the lending platform matter. If the crypto lender’s token value increases, the user will make a bigger profit.
yield farming
What is the relationship between yield farming and liquidity pools?
Uniswap and Balancer offer liquidity providers fees. They offer it as a reward for adding liquidity to the pools. Both Uniswap and Balancer are DeFi’s largest liquidity pools at the time of writing.
In Uniswap’s liquidity pools, there is a 50:50 ratio between the two assets. On the other hand, the liquidity pools at Balancer allow for up to eight assets. It also offers custom allotments.
The liquidity providers get a share of the fee earned by the platform every time someone trades through the liquidity pool. Uniswap liquidity providers have delivered excellent returns due to the recent surge in DEX trading volume.
Explore Curve Finance: Complex yield farming made easy
Curve is one of the leading DEX liquidity pools. It was designed to provide an efficient way to trade stablecoins. As of now, Curve supports USDT, USDC, TUSD, SUDS, BUSD, DAI, PAX in addition to BTC pairs. Curve uses automated market makers to facilitate low slippage trades.
The automated market makers also help Curve keep transaction fees low. It has only been on the market for a few months. Nevertheless, it is already ahead of many other leading exchanges in terms of trading volume. iCurve’s performance has outperformed some of the top names in the yield farming industry.
It is currently ahead of Balancer, Aave and Compound Finance. Curve is the top choice of most arbitrage traders as it offers many savings while trading.
There is a difference between Curve’s and Uniswap’s algorithm. Uniswap’s algorithm focuses on increasing liquidity availability. The focus of the curve, on the other hand, is to allow minimal slippage. Therefore, Curve remains a top choice for high-volume crypto traders.
Understand the risks of yield farming
Ephemeral Loss
When it comes to yield farming, there’s a good chance you’ll lose your money. For certain protocols like Uniswap, automated market makers can be quite profitable. However, volatility can cause you to lose money. Any unfavorable price change will cause your share to lose value compared to owning the original assets.
The idea is simple and only possible if you are using non-stablecoin tokens, as that way you are exposed to price volatility. In other words, if you stake 50% ETH and 50% of a random stablecoin to farm a third token, you may lose more money if ETH price falls sharply than if you had simply bought the token in the market you do farming.
Example: You stake 1 ETH (price: $400) and 400 USDT to farm YFI while the price is $13,000 (the example is not based on existing liquidity pools). Your daily ROI is 1%, which means you should earn around $8 from YFI every day for your initial $800 investment. However, due to high market volatility, the price of ETH drops to $360 and you lost 10% of your ETH while making, say, $8 in YFI. If you bought $800 worth of YFI instead and the price didn’t change, you would have gotten your value.
The concept known as “Impermanent Loss” is explained in detail in this article by Quantstamp.
Smart Contract Risks
Hackers can exploit smart contracts, and examples of such cases abound this year. Curve, $1M compromised in bZx, lendf.me are just a few examples.
The DeFi boom has seen the TVL of emerging DeFi protocols increase by millions of dollars. As a result, attackers are increasingly targeting DeFi protocols.
Total value of DeFi, including yield farming, as of September 8, 2020. Source: Defi Pulse
Risk within the protocol design
Most DeFi protocols are still in their early stages and hence there is an opportunity to take advantage of the incentives. Take a look at the recent events at YAM Finance where a bug in the rebasing mechanism caused the project to lose over 90% of its dollar value in a matter of hours. However, the development team had clearly disclosed the dangers of using the untested protocol.
High risk of liquidation
Your collateral is subject to the volatility associated with cryptocurrencies. The market fluctuations can also put your debt positions at risk. Therefore, undercollateralization can occur. You may also face further losses due to inefficient liquidation mechanisms.
DeFi tokens are subject to bubble risk
The underlying tokens of yield farming protocols are reflexive. Their value can increase with increasing use. This is reminiscent of the early days of the 2017 ICO boom. We all know how it ended. The DeFi boom could be different; However, most projects enjoy the hype rather than the utility of reaching higher than expected market caps.
carpet handles
It is important to remember that on platforms like Uniswap, which are at the forefront of DeFi, anyone can withdraw their liquidity from the market at will unless it is locked by a third-party mechanism.
Furthermore, in many cases, if not most cases, the developers are responsible for large amounts of the underlying asset and can easily dump these tokens on the market, leaving investors in bad taste. The most recent example comes from a touted project called Sushiswap, where the lead developer dumped multi-million ETH worth of its tokens, causing the price of SUSHI to plummet by more than 50% in an instant.
Diploma
Yield farming has become the latest trend among crypto enthusiasts. It also attracts many new users to the world of DeFi.
However, one must not forget that there are serious risks involved. Temporary losses, smart contract risks, and liquidation risks are a major concern to consider.
While it can be particularly profitable, it’s important to consider these challenges and only invest capital that you can afford to lose.
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