The central theses
- Yield farming is about generating capital through productive use
- The money market offers the easiest way to earn reliable returns from your cryptocurrencies
- Liquidity pools offer better returns than money markets, but there is additional market risk
- Incentive schemes can sweeten the deal and give high-yield farmers an extra reward
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Interested in yield farming but not sure where to start? Here is an overview of the main DeFi protocols and how to get started with them.
What is yield farming?
The hottest buzzword in crypto right now is “yield farming,” which allows people to earn fixed or floating interest by investing crypto in a DeFi market. Investing in ETH is not yield farming; Lending ETH on Aave for a yield that exceeds the ETH price surge is yield farming.
As it is the latest crypto trend, investors in this space need to understand what it is and how it works.
But before we get into the details, it’s important to note that given the intense competition between investors and high gas prices, yield farming is only profitable if you’re willing to put a significant amount of money into the work. Yield farming $100-$1,000 worth of crypto results in a net loss. Experimenting with small amounts to understand how it all works is fine, but the strategy is not profitable.
How and where to grow DeFi yields
Money Markets: Compound and Aave
Compound and Aave are DeFi’s main lending and lending protocols. The two together account for $1.1 billion in loans and $390 million in loans.
Source: compound
Lending capital in the money market is the easiest way to earn a return with DeFi. Deposit a stablecoin with either of them and start earning returns immediately.
Aave generally has better interest rates than Compound because it offers borrowers the option of choosing a stable rate instead of a floating rate. The stable rate tends to be higher for borrowers than the floating rate, increasing the marginal rate of return for lenders.
Aave log statistics, via AaveWatch
However, Compound has created a new incentive for users by issuing its native token COMP. Everyone who borrows or borrows Compound earns a certain amount of COMP. 2,880 COMP will be issued to Compound users per day. At $250 per COMP at press time, that translates to $720,000 in additional rewards per day.
Security against financial risks
Over-collateralization occurs in the DeFi money markets, which means that a borrower has to pledge assets with a higher value than their loan. When the Collateral Ratio (value of the collateral / value of the loan) falls below a certain threshold, the collateral is realized and returned to the lenders.
This setup is optimal for financial speculators looking to gain leverage. But it also ensures that lenders don’t lose money if the borrower defaults. Smart contract hacks still pose a significant risk, but Aave and Compound have avoided that risk so far.
Yield Farming Liquidity Pools
Uniswap and Balancer are the two largest liquidity pools in DeFi and offer liquidity providers (LPs) fees as a reward for adding their assets to a pool. In Uniswap, liquidity pools are configured between two assets in a 50:50 ratio. Balancer allows up to eight assets to be included in a liquidity pool with custom allocations between assets.
Most liquid pools in DeFi, via Pools.fyi
Each time someone completes a trade on a liquidity pool, LPs who have contributed to that pool receive a fee for their assistance in clearing that pool. Uniswap pools have brought healthy returns to LPs over the past year as DEX volumes increased. However, in order to maximize gains, investors must also consider temporary losses, ie losses incurred by providing liquidity to an asset that is rapidly appreciating in value.
Read more about fleeting losses in our guide to yield farming on Uniswap.
Balancer pools can mitigate transient losses because pools do not have to be configured in a 50:50 relationship. They can be set up in an 80-20 or 90-10 allocation to minimize but not completely eliminate transient losses. Additionally, users can earn Balancer’s governance token BAL by providing liquidity to a Balancer pool.
There is another type of liquidity pool that prevents temporary losses. Curve Finance facilitates trading between assets tied to the same value. For example, there is a curve pool with USDC, USDT, DAI, and sUSD: all USD-pegged stablecoins. There is also a liquidity pool with sBTC, RenBTC and wBTC: all pegged to the price of BTC.
Income for providing liquidity on Curve
Since all assets have the same value, there is no temporary loss. However, trading volume will always be lower than general purpose liquidity pools like Uniswap and Balancer.
Ironically, Curve Finance LP yields skyrocketed over the past week as the yield farming narrative led to excessive demand for stablecoin-to-stablecoin trades. Conclusion: Curve Finance eliminates temporary losses, but Uniswap and Balancer result in higher fee charges.
Special mention: incentive programs
The aforementioned example of Compound introducing COMP as an incentive to use the protocol comes straight from the Synthetix playbook.
As an original incentive system, Synthetix first introduced an sETH ETH pool, which offers LPs an additional incentive through SNX rewards. Although this pool is obsolete, it has been extended to other liquidity pools. Synthetix currently has two main liquidity incentives: an sBTC pool and an sUSD pool on Curve, which offer LPs an additional reward in SNX.
SNX rewards for providing liquidity to other protocols via Mintr
Following in Synthetix’ footsteps, Ampleforth launched Geyser, which rewards LPs in Uniswap’s AMPL WETH pool with an additional reward in AMPL.
Using these incentives can be incredibly lucrative. But investors should make sure they don’t earn a dud token. Nobody wants to participate in an incentive scheme that rewards them with BitConnect tokens.
Choosing a suitable farm
For slightly risk-averse people who simply want to earn a return on their stablecoins, money markets or providing liquidity through Curve Finance are the best options for lower-risk interest rates. For those who have large cryptocurrency holdings and want to use them productively, liquidity pools like Uniswap or Balancer are good choices. Additional incentives are just the icing on the cake.
However, the perfect income farm for each individual will vary depending on their capital level, investment horizon, and desired level of risk.
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