By Nathan Ferguson
For a few months rolling up to a year now, Yield Farming has been the most trending topic in the decentralized finance (DeFi) space, but despite the popularity of the topic, there exists a tendency that a few people might just be hearing of it but does not have an adequate understanding of the subject matter, hence the reason for this guide.
This guide will answer almost every question you have on the concept of Yield Farming in the DeFi space, ranging from the definition to the reason why there is so much buzz around it.
To get started, let’s take a look at a simple statistic. It was said that in 2020, the rate the DeFi (decentralized finance) space is growing is 150% judging from the total value locked (TVL) in the space in USD. Contrastingly, the market capitalization of the crypto market has only grown by 37% within the same period.
With this astonishing feat recorded for the DeFi – decentralized finance – space, most experts have credited yield farming as the reason for such growth in the space. Also, the progress was credited to a concept called Liquidity Farming. Basically, this concept involves both speculators and investors alike as they provide liquidity to various platforms in the space which offer services around lending and borrowing. The borrowing and lending platforms, in return, pay huge interest to the liquidity providers and they also receive some other incentives like the platform’s native token.
Currently, the stars in the decentralized finance (DeFi) space are the liquidity providers, and they are also referred to as the yield farmers. The leading names in the list of platforms offering these services include Balancer (BAL), Compound (COMP), and Curve Finance (CRV).
Compound (COMP): The Pioneer of the Liquidity Farming Initiative
The whole craze of yield farming or liquidity farming all began with the live distribution of the COMP token belonging to Compound on the 14th of June, 2021. The COMP token is the native and governance token for the Compound platform and the live distribution of the token was successful. This idea helped the platform reach a total of $600 million in TVL – Total Locked Value, and also makes it the first DeFi protocol to race past MakerDAO on the DeFi Pulse leaderboard.
After Compound saw a successful distribution of the COMP token, Balancer took after them by distributing its BAL token. Before the distribution, Balancer had launched a reward incentive program for the protocol in May 2021. They went ahead to have a live distribution of the BAL token just after a few days Compound completed its live distribution which was recorded as a success. With the move from Balancer, the platform was able to reach $70 million in its Total Value Locked (TVL).
Even though the ongoing craze with liquidity farming all started with Compound, the concept has been in the DeFi space way before that.
The first protocol to initiate the concept of token rewards is Synthetix. The protocol introduced this concept first in July 2019 when they were incentivizing their users with token rewards for providing liquidity to the sETH/ETH pool on the first version of Uniswap dubbed Uniswap V1.
Yield Farming: The Answer to the Liquidity Woes in the DeFi space
So, a question here, which of the issues in the DeFi space is more pressing? It is definitely Liquidity. And the next concern is why do players in the DeFi space need money? The basic explanation for starters is the bank illustration. Even though banks have access to much funds, they still borrow more money to invest, run their activities and operations on daily basis, etc.
In the DeFi space, there are strangers on the internet that gives the required liquidity, and that is why the DeFi space attracts HODLers that have idle assets through different innovative strategies.
Another point to take into consideration is that there are some services in the space that required huge liquidity so as to avoid unnecessary price slippage and also to give a better trading experience. The prime examples of these are the Decentralized Exchanges (DEX).
As you will conclude already, borrowing from users to facilitate their services has proven to be the next option and it is growing popular day by day. In the nearest future, the concept may even rival the idea of getting funds from venture capitalists and debt investors.
So, what is Yield Farming?
Comparing this concept with traditional finance, the idea behind yield farming can be described as putting your money in bank through deposits and savings options. The fascinating thing there is that banks have different rates of interests that pay their users for saving money with them. In other words, you will get a certain interest often calculated per annum for keeping your idle money in the bank.
So, think of DeFi space’s yield farming like this. Users intentionally lock their money with a certain protocol (for example, Balancer, Compound, etc.), which in turn lend the money to people on the platform who want to borrow it for different use at a particular interest rate. As compensation, the protocol gives people who locked their money with them incentives based on their reward program (often the governance token of the protocol), and sometimes, they share a part of the interest they earn with them as an extra reward for locking the funds.
Even if the liquidity providers earn a share of the interest fees paid by the borrowers, it is often times insignificant. However, the real deal is with the units of new crypto assets they earn from the protocol. It can be so rewarding depending on the growth and the market of the token. In simple terms, when the value of the token earned by the user rises, that automatically translates to higher profits for the user.
The Relationship Between Liquidity Pools and Yield Farming
Balancer and Uniswap offer fees to people providing liquidity. The fees are offered as a reward for providing liquidity to the pools. As of the time this guide is compiled, both Balancer and Uniswap are the largest liquidity pools in the DeFi space together with Curve Finance.
In the liquidity pools at Uniswap, the two assets on the protocol have a 50/50 ratio. On the other hand, Balancer’s liquidity pools give room for more assets up to eight, and it also offers custom allocations to the assets.
Every single time someone executes trade through the protocol’s liquidity pool, a fee is charged, and the protocol shares the fee earned with the liquidity providers. Recently, the people providing liquidity for Uniswap have seen a huge return on their investment because of the rapid growth of the trading volumes of the DEX.
Exploring the Curve Finance Protocol: Demystifying Complex Yield Farming
Currently, Curve Finance is one of the largest decentralized exchanges (DEX) liquidity pools. The protocol was built to provide users with an efficient way to trade stablecoins. As of the time of compiling this guide, the protocol supports USDT, TUSD, USDC, DAI, PAX, BUSD, and SUSD, together with the BTC pairs. Curve Finance leverages automated market makers as a way to enable low slippage trades.
The AMM – Automated Market Makers help the protocol to keep the transaction fees charged low. Even though the protocol has just entered the space for only a few months now, it is currently ahead of its counterparts in terms of the trading volume. Also, the performance of the protocol has been stronger than the big names in the yield farming industry.
Currently, Curve Finance is ahead of Compound, Aave, and Balancer. Also, because the protocol offers a lot of saving during the trades, it has become the top choice among all other arbitrage traders in the industry.
It has been established that there is a huge difference in the algorithm of Curve Finance and Uniswap. The study shows that the algorithm of Uniswap focuses on increasing the availability of liquidity on the platform while that of Curve Finance is focusing on enabling the minimum possible slippage for traders. This is the main reason why Curve Finance remains the best option for crypto traders with huge trading volumes.
The Risks Involved in Yield Farming
No matter how lucrative an investment idea looks, there are some levels of risk involved in it. This is the reason why it is always advised for everyone to carry out in-depth and proper research before making any financial decision to avoid loss of investment. In this section, this guide will cover the risk involved in the hottest trend in the DeFi space.
- Impermanent Loss
When it comes to yield farming, the chances of losing your money are very high. In certain protocols like Uniswap, the automated market makers (AMM) can be profitable, but volatility can result in your loss of money. Any unfavorable change in price can cause a reduction in the overall value of the funds you locked compared to holding the original assets.
Here is the simplest way to explain the risk; the value of the tokens you staked that are not stablecoins may reduce when they are exposed to volatility. So, let’s say you stake Ethereum (ETH) and another stablecoin at random to farm another token, the sharp reduction in the price of Ethereum will reduce the value of the Ethereum you staked and there is no damaged control since the funds are locked. It can be so adverse that you might end up losing your money compared to when you buy the token you are trying to farm from the market.
Here is an illustration: if you stake 1 ETH (which is priced at that moment at $400) and 400 USDT to farm YFI, whose price is sitting at $13,000. By the way, this is just an imaginative illustration, it is not based on the existing liquidity pools. If the daily ROI is 1%, that means you will be earning $8 worth of YFI every single day on the $800 with of ETH and USDT you staked.
Now imagine that the price of ETH dropped based on severe market volatility from $400 to $360. That means your ETH has lost 10% of its value while being staked to earn YFI worth $8. If you had bought YFI worth $800 in the market at a more stable price, you would have preserved the value of your money.
In simpler words, it is possible that the token you will earn while farming will not cover the loss of value on your investment. This concept is called Impermanent Loss.
- Risks of Smart Contract Vulnerability
As a yield farmer, you are exposed to whatever risks are associated with smart contracts since that is the technology the concept is running. These risks include smart contract exploits by hackers. One of the things you must know is that a booming industry always attracts people with illicit intentions, and the DeFi space is no different. This year alone, there are few examples of such incidents. A few examples include Curve, lendf.me, and bZx, where about $1 million was compromised.
The booming nature of the DeFi space has led to a massive surge in the Total Value Locked (TVL) of protocols in the DeFi space by millions of dollars. This is the simple explanation for why there are plenty attackers in the space.
- Risk Within the Protocol Design
Most of the protocols in the DeFi space are currently in their growing stage, and there exists a possibility of gaming their incentives. Take a closer look at the recent incidents with YAM finance, where a single error in their rebasing mechanism that cause over 90% drop in the dollar value of the project in just about few hours. Though, the dangers of using an unaudited DeFi protocol have been disclosed clearly by the development team earlier.
- Risk of High Liquidation
Another thing to note when considering the yield farming concept (especially as a borrower) is that your collateral is subjected to market volatility associated with cryptocurrencies. The price swings in the market can put your borrowing positions at huge risk. One of them is that your positions can be undercollateralized. Another one is that you stand a chance to face further losses just because of the liquidation mechanisms that are inefficient.
- DeFi Tokens are Subject to the Bubble Risk
The tokens created by protocols basically for yield farming are reflexive. The increase in their value is just a response to the uptick in their usage. This brings the early days of the ICO boom in 2017 to memory. And everyone knows the end. Even though this boom and craze with decentralized finance (DeFi) might be different, what to pay attention to is that most projects receive all the hype and not the utility behind their development which may push their value more than the expected market limits.
- Rug Pulls
This risk is a serious one that must not be overlooked. It is absolutely important to keep in mind that the DeFi protocols can see anyone remove their liquidity off their market at will and unless the protocol uses a third-party mechanism to lock it.
Also, in a reasonable number of cases, if not all of them, the developers are always controlling a higher percentage of the underlying assets on the protocol, and they can dump these tokens easily in the open market and this will leave investors with nothing but dust (basically, tokens with no value). The most recent of such examples come from a protocol that was dubbed the most promising project called Sushiswap. The lead developed of this project dumped all the tokens he is holding which is worth millions of ETHs in an open market. as a result, the price of the SUSHI token crashed by over 50% instantly. This is obviously going to be a huge loss for unsuspecting investors and retail traders.
Conclusion
The concept of yield farming has been the hottest trend in the DeFi space and is also among most crypto enthusiasts. More interestingly, it is attracting new investors and retail users to the decentralized finance (DeFi) space. Currently, the total value locked (TVL) of the DeFi space is around $231 billion, and Curve Finance alone has $21.3 billion which amounts to 9.20% of the TVL.
However, one must not be carried away by the craze and the promising rewards in the industry but must be aware of the huge risks involved in associating with the industry. Among the serious risks to account for are impermanent loss, liquidation risks, and smart contract risks. This is to say, even though the space is crazily profitable, you must also know that there are some challenges involved and also invest the funds you can afford to lose.
Here is a disclaimer; this guide is compiled for educational purposes and not to give any form of investment or financial advice. Hence, readers are informed that any financial decision made on account of the content of this guide is solely their responsibility.