Yield farming is a high risk, high return investment strategy. Also referred to as “liquidity mining”, yield builders look for high-yield opportunities in exchange for lending digital assets like stablecoins or bitcoin to emerging DeFi projects or exchanges.
In return, farmers contribute to the overall well-being of a developing DeFi project or exchange by providing beneficial liquidity.[1]
Yield farmers use smart contract platforms, decentralized applications or DeFi exchanges to lend digital assets. In exchange for lending or “staking” valuable digital assets, farmers receive interest or fee payments — often in the form of “governance tokens” native to the lending platform. A governance token is a project-specific digital asset issued to farmers by a protocol or project developer. Governance tokens are designed to incentivize token holders to competently govern protocol-related decisions. Token reward structures help ensure that farmers and other token holders participate in the success of the project.
Interest rates generally depend on the utility or demand for the loaned asset. The demand to rent a digital asset is often related to its use cases and popularity, in addition to the Layer 1 or Layer 2 solution that drives it.
If a farmer receives a digital asset reward while still in its infancy and the price increases significantly, yield farmers can make significant profits.[2]
Experienced, successful farmers employ complex agricultural strategies to compete for the best opportunities, or “crops,” and to maximize yields.
The origins of yield farming
In June 2021, yield farming evolved into an investment strategy when the credit market “Compound” began distributing its COMP governance token on the Ethereum blockchain. [3]
Compound increased demand for its native COMP asset by creating a distribution structure that generously rewarded lenders COMP in return for providing meaningful liquidity. COMP holders have been empowered to use governance token revenue to vote and propose improvements for the network. The Compound farming community made additional investments to ensure the company’s success.
Demand for COMP surged significantly, fueling Compound’s notable gains while paving the way for yield farming as an attractive investment strategy within DeFi.[3]
The advantages and disadvantages of yield farming
Yield farming attracts adventurous investors.
The potential for high Annual Percentage Returns (APY) attracts investors hoping for returns in excess of traditional investments. [2]
Complex farming strategies with high yields harbor significant risks. If demand for allocated reward tokens collapsed, profits would be lost and liquidations would likely occur.
Market manipulation is also a legitimate concern. Farmers who join a community early have the potential to accumulate significant token holdings and thus manipulate the market price of a governance token. Known as “whales,” these farmers can throttle worthwhile returns for smaller investors or laggards in the community. Farmers or whales can also create artificial demand by lending and then borrowing the same digital currency, driving up the market price of that token. Many anticipate that the US Securities and Exchange Commission will find ways to regulate yield farming as a security offering in the future.
Many anticipate that the US Securities and Exchange Commission will find ways to regulate yield farming as a security offering in the future.[4]
DeFi yield farming continues to attract adventurous investors seeking returns that outperform traditional financial sector securities. This investment strategy is thriving despite the lack of safety nets (like the FDIC) available to TradFi investors. Yield farmers are looking to DeFi for unprecedented investment opportunities to park assets and maximize yields. Emerging DeFi projects aim to generate income for farmers to strengthen platforms and provide liquidity, which is crucial for emerging projects. We expect this entrepreneurial sector to rapidly innovate and define creative reward pathways within DeFi.
references
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