If the terms “yield farming,” “DeFi” and “liquidity mining” are all Greek to you, fear not. We’re here to catch you up.

What Is Yield Farming? The Rocket Fuel of DeFi, Explained

The domain of decentralized finance (DeFi) is thriving and the statistics are consistently increasing. According to DeFi Pulse, the current worth of crypto assets that have been locked in DeFi stands at $95.28 billion, which is a notable rise from the $32 billion from the previous year. The Ethereum-based Maker protocol is at the forefront of the DeFi market with a market share of 17.8%.

The exceptional growth of this sector can primarily be accredited to the ROI-maximizing strategy that is unique to DeFi, famously known as yield farming.

Where it started?

In June 2020, Compound, a credit market based on Ethereum, initiated the distribution of COMP Tokens to its users. These governance tokens grant their owners exclusive voting powers over proposed modifications to the platform. The token's automatic distribution method and the resultant high demand for it have propelled Compound to the top of DeFi at that time.

The current hype surrounding "yield farming," which refers to clever tactics where lending cryptocurrency to a startup's application temporarily yields more cryptocurrency, has given rise to another term, "liquidity mining." This buzz has gradually increased as more individuals become interested in the concept.

Even the casual observer of cryptocurrency who only engages when there is a surge in activity may begin to sense that something significant is happening. Our assurance is that yield farming is the source of those sensations. We will begin by introducing the fundamentals of yield farming and then progress to more complex aspects.

What are tokens?

Tokens are akin to the currency that gamers earn while engaging with monsters in their preferred video games. These tokens can be used to purchase weapons or gear within the game universe. However, with blockchain technology, tokens are not limited to a single massively multiplayer online game. They can be obtained in one game and utilized in numerous others. Typically, tokens represent ownership in something, such as a small portion of a Uniswap liquidity pool, or access to a service, such as buying ads in the Brave browser using the basic attention token (BAT).

If tokens hold monetary value, then it is feasible to bank with them or perform activities that resemble banking activities. This concept is the foundation of decentralized finance.

Ethereum, the second-largest blockchain globally, has found that tokens are the most popular use case. The "ERC-20 tokens" term is used to describe a software standard that enables creators to establish rules for their tokens. Tokens can be employed in a few ways, such as a type of currency within a set of applications. For example, the Kin token was created to allow web users to transact at minimal amounts that almost appear to be nonexistent.

On the other hand, governance tokens serve a distinct purpose. They differ from video game arcade tokens, as so many tokens have been described in the past. Governance tokens operate more like certificates that allow the holder to vote on protocol modifications within a constantly changing legislature.

MakerDAO, the platform that proved DeFi could soar, provides an example of governance tokens. Holders of its governance token, MKR, vote almost every week on minor changes to parameters that regulate borrowing costs and savers' earnings, among other factors.

Regardless, all cryptocurrency tokens are tradable and possess a value. Consequently, if tokens have value, it is feasible to bank with them or engage in activities that closely resemble traditional banking practices. This concept is the basis of decentralized finance.

What is DeFi?

Decentralized Finance (DeFi) is a new financial technology that allows people to borrow, lend, and trade cryptocurrencies without the need for intermediaries like banks or financial institutions. Unlike traditional finance, where personal data is required to make transactions, DeFi applications do not require any personal information from users. Instead, users can borrow money by putting up collateral in the form of cryptocurrency.

To try out DeFi, one can use an Ethereum wallet with a small amount of cryptocurrency to purchase tokens like FUN or WBTC on Uniswap, create DAI on MakerDAO, or borrow USDC on Compound. However, it is important to note that DeFi is still experimental and risky, so it is advised to only invest what one can afford to lose.

The most common reason for borrowing in DeFi is for trading purposes, such as shorting a token or holding onto a token while still playing the market. DeFi's technology has significant implications for the financial industry, as it allows for more freedom and privacy in financial transactions without the need for trust in intermediaries.

Doesn’t running a bank take a lot of money upfront?

In Decentralized Finance (DeFi), strangers on the internet provide the majority of the funding. Therefore, the startups behind these decentralized banking applications have devised creative tactics to entice HODLers with idle assets. The primary concern of all these different products is liquidity, which refers to the amount of money locked in their smart contracts. According to Avichal Garg, the managing partner of Electric Capital, borrowing from users instead of venture capitalists or debt investors can greatly enhance the product experience in some cases.

Consider Uniswap, an "automated market maker" (AMM), as an example. Uniswap is an internet robot that is always willing to buy and sell any cryptocurrency for which it has a market. Almost any token on Ethereum has at least one market pair on Uniswap. Behind the scenes, Uniswap makes it appear that it is directly exchanging any two tokens, but it's all based on pools of two tokens. Larger pools make these market pairs more effective.

Why do I keep hearing about ‘pools’?

To explicate the reasoning behind the benefits of additional funds, let us deconstruct the inner workings of Uniswap.

Suppose there exists a market for two stablecoins, USDC and DAI. Despite the dissimilarities in their methods of retaining value, both tokens are intended to maintain a value of one US dollar each consistently. This claim generally holds true for both tokens. Uniswap displays the price for each token in any pooled market pair based on the balance of each token in the pool. Simplifying this for the purpose of illustration, if a USDC/DAI pool were to be established, both tokens should be deposited in equal amounts. In a pool consisting of only 2 USDC and 2 DAI, a price of 1 USDC for 1 DAI would be offered. Imagine if someone placed 1 DAI and retrieved 1 USDC; the pool would then have 1 USDC and 3 DAI, leading to an out-of-balance situation. An astute investor could easily generate a profit of $0.50 by depositing 1 USDC and receiving 1.5 DAI, resulting in a 50% arbitrage profit. This is the problem of limited liquidity. Incidentally, Uniswap's prices tend to be accurate because traders monitor them for minor inconsistencies from the wider market, and they can swiftly trade them for arbitrage profits.

However, if 500,000 USDC and 500,000 DAI were in the pool, a transaction of 1 DAI for 1 USDC would have a negligible impact on the relative price. That is why liquidity is beneficial. One can deposit their assets in a Compound and earn a modest yield. However, this method is not very imaginative. Yield farmers are users who explore ways to maximize their yield.

These effects apply across DeFi, and markets desire additional liquidity. Uniswap solves this issue by imposing a tiny fee on every transaction. This is accomplished by slightly reducing the value of each trade and leaving the residual amount in the pool (thus, one DAI would exchange for 0.997 USDC, after the fee, and the overall pool would increase by 0.003 USDC). Liquidity providers benefit from this approach because they own a share of the pool when they place liquidity in it. If there has been substantial trading in the pool, it will have earned numerous fees, and the value of each share will rise.

This brings us back to tokens. Liquidity added to Uniswap is represented by a token, not an account. As a result, there is no ledger stating, "Bob owns 0.000000678% of the DAI/USDC pool." Bob merely has a token in his wallet, which he may sell or use in another product. We will return to this later, but it helps to explain why people enjoy referring to DeFi products as "money Legos."

So how much money do people make by putting money into these products?

Deviating from the conventional method of depositing money in traditional banks, DeFi (decentralized finance) has proven to be more profitable, especially with the advent of governance tokens being handed out by startups. Consider the case of Compound, where a depositor can earn approximately 3% interest on their USDC or tether (USDT) deposits as of January 2022. In contrast, most U.S. bank accounts offer negligible interest rates, usually less than 0.1%.

Despite these appealing rates, there are some caveats to consider. Firstly, DeFi is a riskier space to park your money. Consequently, the interest rates offered are much higher than what is available in traditional banking, and there is no Federal Deposit Insurance Corporation (FDIC) to protect your funds. Therefore, in the event of a run-on Compound, users can experience difficulties withdrawing their funds when they wish to do so.

Furthermore, interest rates in DeFi can be quite volatile, and depositors cannot determine with certainty the yield they will earn over the year. Although USDC's rate is currently high, it used to hover around 1%. Similarly, depositors may be tempted to opt for assets with more lucrative yields like USDT, which typically has a much higher interest rate than USDC. However, the transparency of USDT about the real-world dollars it holds in a bank is not up to par with that of USDC. The disparity in interest rates often indicates that the market perceives one instrument as riskier than the other.

Large-scale depositors in these products turn to companies such as Opyn and Nexus Mutual to insure their positions because the nascent DeFi space lacks government protection. As such, there are ample risks to consider.

While depositors can put their assets in Compound or Uniswap and earn a modest yield, some seek to maximize this yield creatively - these are known as yield farmers.

OK, I already knew all of that. What is yield farming?

Broadly speaking, the concept of yield farming encompasses any effort to put crypto assets to work to generate maximum returns. At its most basic level, a yield farmer may engage in a constant rotation of assets within the Compound, always seeking out the pool that offers the highest APY on a week-to-week basis. Although this approach may require a yield farmer to occasionally take on additional risk, the ability to manage this risk is a key attribute of the profession.

According to blockchain consultant Maya Zehavi, farming in this manner can open up new opportunities for arbitrage, which may have a positive spillover effect on other protocols whose tokens are held within the pool. Given that these positions are tokenized, there is ample opportunity to expand these efforts even further.

Indeed, the concept of yield farming itself is relatively novel in that it offers a means of generating a yield on a deposit or loan, rather than simply earning a return as a lender. As an example, a yield farmer may deposit 100,000 USDT into a Compound and receive a token called cUSDT in return. Although the actual ratio of cUSDT to USDT is not 1:1, this detail is unimportant for present purposes.

Having obtained cUSDT, the yield farmer can then deposit these funds into a liquidity pool that accepts cUSDT on Balancer, an AMM that allows users to set up their own crypto index funds. This arrangement typically generates a small additional amount in transaction fees, thereby increasing the overall yield. In essence, yield farmers seek to maximize their returns by identifying edge cases within the system and leveraging as many products as possible to extract the most yield from them.

Why is yield farming so hot right now?

Because of liquidity mining, yield farming has been supercharged, and this is achieved when a yield farmer obtains a new token in addition to the usual yield, for providing liquidity. This concept of providing liquidity and stimulating the usage of a platform increases the value of the token, which in turn attracts more users, creating a positive usage loop. According to Richard Ma, a smart-contract auditor at Quantstamp, liquidity mining is an excellent way to attract users. Yield farming examples are straightforward, with the farmer earning yield from the regular operations of various platforms. For instance, supplying liquidity to Compound or Uniswap will earn you a small cut of the business that runs over the protocols.

In 2020, Compound made an announcement that it would decentralize its product and give a substantial amount of ownership to those who made it popular by using it. In turn, ownership would take the form of the COMP token. While this sounded altruistic, the team and the investors owned over half of the equity. By giving away a considerable proportion to users, it was highly likely that the Compound would become a much more popular place for lending, making everyone's stake worth much more. To ensure the success of the idea, the protocol gave out COMP tokens to users every day for four years, a fixed amount every day until it was all gone. These COMP tokens control the protocol, just like shareholders in publicly traded companies ultimately do.

Every day, the Compound protocol scrutinizes everyone who has lent money to the application and borrowed from it, giving them COMP tokens proportionally based on their share of the day's total business. The results were quite unexpected, even to the Compound's biggest proponents. Yield farmers are resourceful, finding ways to stack yields and earn multiple governance tokens simultaneously.

COMP tokens have a value that is expected to go down, which is why some investors are eager to earn as much of it as possible now. This was a new type of yield on a deposit into a Compound, and it provided a way to earn a yield on a loan, which is unusual. However, savvy investors can make a significant gain by maximizing their daily returns in COMP. The distribution of COMP will only last four years, and then there will be no more, and this is driving the high price now. In conclusion, appealing to the speculative instincts of diehard crypto traders has proven to be a great way to increase liquidity on Compound. This benefits everyone, including those who would use it whether they were going to earn COMP or not.

Did liquidity mining start with COMP?

The use of liquidity mining in cryptocurrency is a debated topic, but it is believed to have originated from Fcoin, a Chinese exchange that created a token in 2018 to reward users for making trades. However, people began using bots to make pointless trades to earn the token. Similarly, EOS, a blockchain where transactions are free, was exploited by a hacker who created a token called EIDOS to reward users for pointless transactions.

Liquidity mining as we now know it first appeared on Ethereum in July 2019 when Synthetix announced an award in its SNX token for users who added liquidity to the sETH/ETH pool on Uniswap. By October, it became one of Uniswap's biggest pools. When Compound Labs created the COMP governance token, it carefully designed the behaviour it wanted and how to incentivize it. However, it led to unintended consequences such as crowding into a previously unpopular market to mine as many comps as possible.

Recently, 115 COMP wallet addresses voted to change the distribution mechanism in hopes of spreading liquidity out across the markets again. These initiatives show how quickly crypto users respond to incentives.

Is there DeFi for bitcoin?

Undoubtedly, Ethereum provides the perfect platform for savvy investors. Whilst bitcoin has proven to be a solid investment in the long term, its inability to self-replicate poses a unique predicament for holders. Skilled traders can navigate the volatile landscape of the crypto market and turn a profit, but such activities are both arduous and perilous and require a certain disposition.

Thankfully, the rise of decentralized finance (DeFi) has opened up a new avenue for accumulating bitcoin. Whilst not a direct approach, DeFi offers myriad opportunities for indirect growth. One can, for example, employ BitGo's WBTC system to generate simulated bitcoin on the Ethereum platform. Here, the user's bitcoin is held in WBTC, an asset that is pegged to the same value as BTC and can be readily traded. Once the user has generated WBTC, they can stake it on a Compound and earn a modest annual percentage yield (APY). As it happens, those who borrow WBTC on Compound are more often than not shorting bitcoin, i.e. selling it in anticipation of a price decline, purchasing it back when the price drops, and closing their loan position with the profit.

Thus, the wise HODLer can gain BTC from their counterparties' short-term victory. Truly, this is the game.

How risky is it?

As per Liz Steininger of Least Authority, a crypto security auditor, DeFi poses novel security risks due to the combination of various digital funds, automation of critical processes, and increasingly intricate incentive structures that function across protocols, each with their own rapidly changing technological and governance practices. Nonetheless, despite these risks, the high yields remain irresistibly alluring for users.

DeFi products have suffered major setbacks, with MakerDAO's debacle in 2020, now dubbed "Black Thursday," being a prime example. Additionally, bZx, a flash loan provider, faced an exploit. When these failures occur, funds are drained.

As this domain evolves, token holders may approve more opportunities for investors to benefit from DeFi niches. Currently, certain funds cannot resist the tempting offers and are directing substantial amounts of capital into these protocols to mine the new governance tokens. Nevertheless, these entities, which pool the resources of affluent crypto investors, are also hedging their bets. Nexus Mutual, a DeFi insurance provider, confirmed that it has reached the maximum coverage available for these liquidity applications. Open, the trustless derivatives maker, has developed a mechanism to short COMP in case this game does not pan out.

Unconventional events have transpired. At a certain point, the Compound held more DAI than the total minted supply worldwide. This is explicable upon closer inspection but remains dubious to everyone.

That being said, distributing governance tokens could significantly mitigate the risk factor for startups, at least concerning monetary authorities. As Zehavi wrote, "Protocols distributing their tokens to the public, meaning that there's a new secondary listing for SAFT tokens, [gives] plausible deniability from any security accusation." (The Simple Agreement for Future Tokens was a legal framework favoured by many token issuers during the ICO craze.) Whether a cryptocurrency is adequately decentralized has been a crucial aspect of ICO settlements with the U.S. Securities and Exchange Commission (SEC).

What’s next for yield farming? (A prediction)

COMP, the decentralized finance (DeFi) protocol, has caused quite a stir in the industry, not just in technical aspects but in other areas as well, inspiring a wave of novel ideas. Nexus Mutual founder Hugh Karp mentioned that other projects are also exploring similar concepts, and reliable sources have revealed that brand-new projects will be launched based on these models. We may soon witness more prosaic yield farming applications, such as forms of profit-sharing that reward particular kinds of behaviour.

One can only imagine what would happen if COMP holders decide that the protocol requires more funds to be invested and held for an extended duration. In such a scenario, the community can develop a proposal to deduct a small percentage of the token's yield and distribute it solely to those tokens that have been held for more than six months. Although the amount may be insignificant, an investor with the appropriate time horizon and risk profile may consider it before making a withdrawal.

This idea of incentivizing investment duration has a basis in traditional finance as well. For instance, a 10-year Treasury bond usually yields more than a one-month T-bill, despite both being backed by the full faith and credit of the US government. Similarly, a 12-month certificate of deposit pays higher interest than a checking account at the same bank.

As the DeFi sector continues to grow, its architects will devise increasingly sophisticated ways to optimize liquidity incentives. We could witness token holders approving more ways for investors to profit from DeFi niches. Whatever happens, DeFi yield farmers will remain nimble and quick to adapt, and while some fields may become less fruitful, new opportunities will undoubtedly emerge.