Yield farming is one of the hottest trends in decentralized finance. Since last year, it has taken the entire ecosystem by storm. It offers investors rewards for locking their crypto holdings on a DeFi market. This guide examines yield farming and its components, their attractiveness to investors, and possible future risks.
Here’s what you’ll learn in this Forkast.News explainer on yield farming:
- What is yield farming?
- Understand liquidity pools
- Example: Yearn Finance
- Understand the risks of yield farming
- What the future holds for yield farming
What is yield farming?
At its core, yield farming is a process that allows cryptocurrency holders to earn rewards for their holdings. In yield farming, an investor deposits units of a cryptocurrency into a lending protocol to earn interest from trading fees. Some users are also rewarded with additional returns from the protocol’s governance token.
Yield farming works in a similar way to bank loans. When the bank lends you money, you pay back the loan with interest. Yield farming does the same thing, but this time the banks are crypto holders like you. Yield farming uses “idle cryptos” that would otherwise be wasted on an exchange or hot wallet to provide liquidity in DeFi protocols like Uniswap in exchange for yields.
Understanding of liquidity pools, liquidity providers and the automated market maker model
Yield farming works with a liquidity provider and a liquidity pool (a cash-filled smart contract) that powers a DeFi market. A liquidity provider is an investor who deposits funds into a smart contract. The liquidity pool is a smart contract filled with cash. Yield farming capabilities based on the Automated Market Maker (AMM) model.
This model is popular on decentralized exchanges. AMM eliminates the traditional order book that contains all “buy” and “sell” orders on a cryptocurrency exchange. Rather than specifying the price at which an asset should trade, an AMM creates pools of liquidity using smart contracts. These pools execute trades based on predetermined algorithms.
The AMM model relies heavily on Liquidity Providers (LPs) depositing funds into liquidity pools. These pools are the bedrock of most DeFi marketplaces where users borrow, lend and exchange tokens. DeFi users pay trading fees to the marketplace; The marketplace splits the fees with the LPs based on their share of the pool’s liquidity.
Let’s take Compound for example. The protocol provides liquidity to borrowers looking to borrow money in cryptocurrencies. The compound finance system uses smart contracts on the Ethereum blockchain for this. LPs deposit funds into the liquidity pools. These contracts serve as a matching engine for market participants.
Once an interest rate has been agreed on the loan, the borrower receives the money.
In return for their funds, LPs will receive Compound Finance’s native COMP tokens. They also get a share of the interest that borrowers pay.
The most common DeFi-related stablecoins include USDT, DAI, USDC, and BUSD. Some protocols can also mint tokens that represent your coins deposited into the system. For example, if you deposit ETH at Compound Finance, you will receive cETH. If you deposit DAI, you will receive cDAI.
Calculation of yields from yield farming
Estimated returns are calculated using an annualized model. This shows the potential earnings for locking your cryptos for a year.
The most common metrics include annual percentage return (APY) and annual percentage return (APR). The main difference between them is that the APR does not take into account compound interest, which is about paying back your winnings to increase your returns.
Nevertheless, most calculation models are only estimates. It is difficult to accurately calculate yields from yield farming as it is a dynamic market. A yield farming strategy might provide high yields for a while, but farmers could always adopt it in large quantities, which would result in a drop in profitability. The market is quite volatile and risky for both borrowers and lenders.
Example: Yearn Finance – a yield optimization protocol for agriculture
Yearn Finance, also known as yEarn, was perhaps the standout yield farming protocol of the past year. Launched earlier this year by developer Andre Cronje, the protocol has enjoyed widespread popularity as it offers users the highest returns on ETH deposits, top altcoins and stablecoins.
When a user deposits tokens into yEarn, the protocol converts them into yTokens (like yDAI, yUSDC, and yUSDT). The protocol smart contract examines DeFi protocols with the highest APR for farming; Once it finds it, it sends the tokens there.
The protocol also features the YFI token, which Cronje launched last July to boost Yearn’s user base. YFI is an ERC-20 token running on the Ethereum blockchain. According to data from CoinGecko, it is capped at 30,000 units and since its launch nearly a year ago in July 2020, its value has skyrocketed by 122,417.5%. At press time, the retail price was $38,629.
Should You Try Yield Farming? First, understand the risks
Despite its obvious potential, yield farming carries risks. They include:
Smart contracts are paperless digital codes that contain the agreement between parties on predefined rules that are self-executing. Smart contracts eliminate intermediaries, are cheaper and more secure to conduct transactions. However, they are vulnerable to attack vectors and code bugs. Users of the popular DeFi protocols Uniswap and Akropolis have all suffered losses from smart contract fraud.
Yield farming requires liquidity providers to pool funds to earn income and trading fees from decentralized exchanges (DEXs). This offers LPs market-neutral returns, but could be risky in the event of strong market movements.
This risk is possible because AMMs do not update token prices according to market movements. For example, if the price of an asset falls 60% on a centralized exchange, the change will not impact a DEX immediately.
As a result, a savvy arbitrage trader could use this small price gap to sell their token at a premium on a yield farming platform. LPs will eventually have to make up this difference and suffer losses if the price goes down. Since their capital is tied up in the pool, they cannot benefit if the price goes up. One way to address this issue is to choose protocols that trade assets with small price variances, such as the WBTC and renBTC pairs on Curve.
As in traditional finance, DeFi platforms use their customers’ deposits to inject liquidity into their markets. However, a problem could arise if the value of the collateral falls below the loan price. For example, if you take out an ETH loan backed by BTC, an increase in the price of ETH would result in the liquidation of the loan since the value of the collateral (BTC) would be less than the value of the ETH loan.
- Capital intensive and complicated process
Income farming is a capital-intensive operation. Most of the cost concerns relate to the issue of gas fees on the Ethereum network. Last August, Josh Rager, the founder of cryptocurrency trading service Blockroots.com, complained on Twitter that he had to pay up to $1,200 in fees to buy tokens for a DeFi project. This is more of a problem for smaller participants than for wealthier users who have access to more capital. Smaller participants may find that they cannot withdraw their earnings due to high gas fees.
Getting into yield farming is a risky venture if you have no experience in the cryptocurrency world. You could lose your entire investment in one fell swoop. Invest at your own risk. The world of yield farming is fast-moving and volatile. If you decide to try your hand at yield farming, you should not invest more than you are willing to lose.
What the future holds for yield farming
Yield farming uses investor funds to create liquidity in the market in exchange for yield. It has significant growth potential, but it’s not without flaws.
The most prominent is the use of the Ethereum blockchain. According to DeFi Llama, the DeFi space is now worth more than $121.5 billion at the time of publication. Most DeFi platforms run on the Ethereum blockchain, which has historically suffered from scalability issues. Due to network congestion, gas charges also increased.
Vitalik Buterin, the founder of Ethereum, even vowed not to dive into yield farming until it “stabilizes.” Several other blockchains like Polkadot and Solana have attempted to woo DeFi platforms with new features. Tezos has completed an upgrade dubbed “Delphi,” which it said would reduce developer gas fees by 75%. This proposal is expected to attract DeFi developers.
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