Yield Farming: Money Doesn’t Grow On Trees, It Grows On Blockchains
Often billed as the Wild West of Decentralized Finance (DeFi), yield farming is crypto’s answer to traditional lending. Proponents promise returns as high as double digits, but the stakes are high; in June 2021 billionaire investor Mark Cuban reportedly took a hit when the DeFi token Titan crashed to $0 from $60 in just one day1. The SEC has also expressed criticism, putting the industry on notice that it has reservations about whether the practice should be regulated as a security.2
In this edition of Alt Class we’ll dig into how yield farming works, and why it’s so controversial even amongst die-hard crypto fans.
A Brief Intro To Decentralized Finance
Let’s start with a quick look at Decentralized Finance, or DeFi as it’s known for short. This buzzword was first used on a Telegram chat in 2018 to describe a new breed of financial services built on a blockchain or a digital ledger. They’re “decentralized” since there’s no single central source controlling a transaction. Most of the biggest DeFi services run on the Ethereum network, including decentralized exchange Uniswap and lending platform Aave.
For example, when you pay for your latte at the local coffee shop using a credit card, there’s a financial institution that sits in the middle of the transaction and has the authority to stop it from going through and record the transaction details. But if you choose to pay with Bitcoin, there’s no middleman.
Today DeFi has become big business with an impressive $112 billion locked up in DeFi services as of November 10th 2021.3 Crypto insiders expect this figure to continue to grow, with seasoned crypto investor Matthew Roszak recently announcing DeFi could be worth $800 billion a year from now.4
How Does Yield Farming Work?
If you’re new to yield farming, the easiest way to understand it is to think of it as lending cryptocurrency. Investors stake or lend crypto assets with the aim of generating potentially very high returns, but at the risk of losing it all (more on this later). Returns are typically expressed as an annual percentage yield (APY).
Crypto investors who wish to lend out their crypto are known as liquidity providers. Liquidity providers are required to lock up their crypto assets in a liquidity pool, which is essentially a piece of code on the blockchain. This gives newly-launched blockchain apps the liquidity they need for long-term growth. In return, lenders earn either interest from lenders, a percentage of transaction fees, or so-called governance tokens in the case of liquidity mining.
Yield farmers need to stay ahead of the latest developments in the DeFi space to identify the best opportunities. Many use very complex strategies and frequently move their crypto assets between different lending marketplaces to maximize returns. That’s why it’s been compared to high-frequency trading.5 Yield farmers are also very protective when it comes to the best strategies since the more popular a strategy becomes, the less lucrative it is likely to be.
What About Liquidity Mining?
In the early years, most yield farmers were staking popular stablecoins like USDT, DAI, and USDC which peg their value to some external reference like the US Dollar. Most popular DeFi protocols now operate on Ethereum, and offer investors governance tokens for providing liquidity to decentralized exchanges or DEXs via a process known as liquidity mining. These are tokens that confer voting powers on future rules and goals as well as changes to the blockchain architecture.
Liquidity mining first became big news when Compound started issuing its governance token COMP to platform users. The basic idea is that yield farmers can receive an additional form of compensation with these governance tokens. Governance tokens can typically be traded on centralized exchanges such as Binance as well as decentralized exchanges like Uniswap.
7 Of The Best Yield Farming Protocols
As we mentioned already, yield farmers hop between DeFi platforms to maximise their returns. Let’s run through some of the most popular yield farming protocols:
Aave is a popular open source protocol where lenders can earn compound interest in the form of AAVE tokens. Until very recently Aave had the highest TVL (Total Value Locked) of all DeFi protocols, but in October $4.2 billion or 18% of the TVL was withdrawn by Justin Sun, the founder of the Tron network.
Yearn Finance converts invested tokens into yTokens which run on Ethereum. This tool is growing in popularity becuase it works as a yield optimizer, automatically rotating funds between the best-performing DeFi protocols to achieve the highest returns for investors.
Compound is another open source protocol where investors can earn an algorithimically-adjusted compound interest rate as well as the previously-mentioned COMP governance token. It bills itself as “the most secure protocol” and has a thorough auditing and verification programme.
Balancer allows anyone to create liquidity pools or add funds to them. Unlike some other protocols, trading fees can be customized and their liquidity pools can be composed of up to 8 different cryptocurrencies.
Uniswap is a very popular DEX that allows users to swap pretty much any ERC20 tokens such as Tether, Shiba Inu, Chainlink, and so on. Liquidity providers are required to stake both sides of the liquidity pool and earn in return the UNI governance token plus a proportion of the transaction fees.
Synthetix’s main selling point is that it allows investors to create “synthetic” assets, giving exposure to real assets like stocks, commodities, or fiat currencies via the blockchain. These assets are known as Synths and their value is pegged to the underlying asset. One key advantage of Synthetix is its diverse ecosystem for yield farming.
Curve Finance is one of the largest DEXs with a current TLV of just under $21 billion. It’s designd to allow users to exchange stablecoins with low fees and low slippage (which occurs when prices move between the time an order enters the market and the execution of a trade).
Just How Risky Is Yield Farming?
Since yield farming burst onto the crypto scene during the DeFi summer of 2020, crypto veterans have been boasting about three and four-figure APYs. Yet on the flip side, would-be investors should bear in mind that these types of investments are unregulated and subject to violent price swings.
High Volatility: Yield is earned in the form of protocol tokens, which exposes investors to potentially volatile price swings.
“Rug pulling”: Meme tokens have become popular, offering unbelievably high APY returns which are often simply too good to be true. Many are complex scams that end in “rug pulling”, or the developers withdrawing everything and disappearing with the funds.
High Ethereum gas fees: Yield farming is usually subject to high Ethereum gas fees, which means it’s usually only financially viable if significant capital is used.
Regulation: As discussed earlier, the SEC has expressed interest in regulating yield farming as a securities offering. This could have serious consequences for the industry if the SEC takes it further.
Vulnerable to hacks: Vulnerabilities and coding bugs in smart contracts can leave yield farming susceptible to hacks. In October 2020 the yield aggregator platform Harvest.Finance lost over $20 million following a massive crypto hack.6
Losses are permanent: DeFi losses are often permanent due to the intrinsic immutable nature of blockchains.
Final Thoughts
Yield farming and the wider DeFi ecosystem is a complex and fast-moving space that really requires extensive research and understanding, and even then veterans like Mark Cuban still suffer huge losses. Is yield farming right for you? That’s a question only you can answer, based on your appetite for risk and your ability to financially weather the loss of your entire investment.
Disclosure: All opinions expressed herein constitute the author’s judgment as of the date of this article and are subject to change without notice. Statements made are not facts, including statements regarding trends, market conditions, and the experience or expertise of the author are based on current expectations, estimates, opinions, and/or beliefs. Such statements are not facts and involve known and unknown risks, uncertainties, and other factors. Past events and trends do not predict or guarantee or indicate future events or results.
https://markets.businessinsider.com/news/stocks/mark-cuban-says-he-lost-money-trading-defi-token-titan-that-crashed-to-zero-2021-6
https://news.bloomberglaw.com/securities-law/whats-yield-farming-and-why-is-the-sec-frowning-quicktake
https://defipulse.com/
https://markets.businessinsider.com/news/currencies/defi-crypto-800-billion-industry-billionaire-decentralized-finance-vesper-2021-08