In this post, you'll learn What is Yield Farming in Decentralized Finance (DeFi) and How Does It Work?
In less than ten years ago, we’ve seen the novel crypto space reshape everything we know. Now, we are all on the verge of perceiving the rise of Decentralized Finance (or simply DeFiDecentralized Finance (DeFi) takes the decentralized concept of blockchain and applies it to the world of finance. Build...) becoming mainstream with its applications in the crypto world. With the surge of $4 billion total value locked (TVL) in DeFi, this ecosystem’s development is nothing but viable. Of course, DeFi or crypto is volatile, but it also unlocks more opportunities to the public.
The upshot? More DeFi projects are introduced to sustain and transform conventional financial products run on transparent protocols without intermediaries. That’s precisely how decentralized exchanges, insurance, lending, and borrowing give rise to the newer phenomenon — yield farming.
If you find yourself struggling to understand the fundamentals of yield farming or to assimilate the relationship between DeFi and yield farming, here’s what you need. Read on to deciphers what yield farming is all about, including its — mechanism, applications, profitability, and the underlying risks.
Yield farming is a practice allowing yield farmers to earn rewards by staking ERC-20 tokens and stablecoins in exchange to support the DeFi ecosystem. Yield farming, also commonly known as liquidity mining, involves depositing and lending crypto underlying a mining mechanism to liquidate the liquidity pool for lucrative rewards.
While yield farming is comparably similar to the staking’s concept, there is substantially more underlying complexity associated with this mechanism built on the Ethereum blockchain. Contrary to staking, yield farmers usually locomote their digital assets from one lending market to another in search of the highest yields.
Typically, a yield farmer is required to lock their funds into a lending protocol such as Compound or MakerDAO to liquidate the funding pools, in which borrowers and lenders earn an incentive in the process. For example, when a yield farmer stakes 1,000 USDT in a Compound, the farmer will get a token in return for cUSDT token. These tokens can then be pumped into an auto-market maker’s (AMM) liquidity pool that accepts cUSDT to leech off the transaction fees. In short, a yield farmer is earning incentives on Compound and the liquidity pool.
The emergence of the DeFi Compound (COMP) and Aave is what gives rise to yield farming’s boom in the early summer of 2020. Soon after the COMP governance token issuance took off, the succeeding AMM partakers like the Balancer, Kyber, Tendies, and SushiSwap in yield farming further strengthened its growth and position. It was thereby making yield farming one of the most popular trends in the DeFi industry. While it’s possible to farm using cryptocurrencies like ETH, stablecoins like DAI, USDT is still a more acceptable token across the AMM platforms.
Of course, there are plenty of reasons that contribute to the popularity of yield farming. But, the main attribution to yield farming popularity is that it offers a unique opportunity to earn a yield on loan. Regardless of your status, a yield farmer can find loopholes to stack yields to simultaneously earn multiple governance tokens.
Yield farming is never a standalone mechanism. It usually involves extensive participation of the automated market makers (AMM) — the liquidity providers (LP) that add funds to the liquidity pool from time-to-time to uphold the ecosystem. Following the staking concept, the LP earns rewards by facilitating the transactions in a blockchain network.
Hence, the liquidity providers and liquidity pool play an indispensable role in upkeeping the liquidation rate. After all, liquidity tends to attract more liquidity.
The AMM’s concept is direct yet intricate at the same time. Liquidity providers who provide funds into the liquidity pool enable yield farmers to lend, borrow, and exchange tokens. Every transaction will incur a fee, and these fees are paid out to the liquidity providers in exchange for the service. Besides the yields, new tokens will be paid out according to the unique implementation of the protocol to encourage LP to keep funding the liquidity pool.
It should be clear that DeFi is built based on ETH, and it is common that stablecoins are frequently deposited. In DeFi, stablecoins are pegged to USD. Hence, you’ll often see coins like DAI, USDT, USDC, and more in the DeFi ecosystem. However, according to the protocols, if you’re depositing USDT into Compound, instead of getting USDT, you’ll receive cUSDT. While there are no restrictions on how you circulate the coins for maximum yields, you’re bound to follow the protocols. That means your cUSDT is continually changing depending on the tokens that are pegged to the protocols.
However, yield farming is still at its initial stage. So, it is rather complex to comprehend the operations for maximum yields. On top of that, yield farmers rarely disclose their strategies to the public, making it even harder for beginners to understand.
Crypto mining is based on a consensus algorithm called Proof of Work, while yield farming relies on the decentralized ecosystem of “money legos” built on Ethereum. Compared to crypto mining, yield farming is an innovative way to earn rewards with cryptocurrency holdings using permissionless liquidity protocols.
While both yield farming and crypto mining involve mining pools, liquidity providers are the prominent elements that differentiate yield farming from crypto mining.
Beyond the shared, decentralized peer-to-peer network, what further differentiates yield farming is its resemblance to the borrowing and lending plan involving governance tokens to yield rewards. On the contrary, crypto mining aids the introduction of new coins into the existing supply by block mining a block is to hash each transaction taken from the memory pool individually.
Ultimately, yield farmers and crypto miners shared the same goal to earn incentives by deploying unique strategies to maximize yields.
In simple understanding, liquidity mining is by giving liquidity to accrue tokens and obtaining governance rights the token represents as an incentive. The curious amalgam of liquidity and mining’s concept gives rise to liquidity mining favoring the DeFi prospects. While the dissection of liquidity involves the supply of coins or tokens, mining, on the other hand, takes account of the Proof-of-Work (POW) computation power to receive new tokens minted by the algorithm. For example, an avid investor can supply liquidation by staking in a liquidity pool like Uniswap to earn a dividend of 0.3% swap alongside newly minted tokens upon each block’s completion.
On the contrary, yield farming is a liquidity movement across DeFi platforms utilizing different mechanisms, including fund leveraging and liquidity mining, to maximize returns. At the same time, yield farmers maximize their gains by moving funds from time-to-time with different strategies. These strategies could range from yield farming roots to increase liquidity for Synthetic ETH tokens or using the 100% APR approach to supercharge earnings by leveraging loans to borrow tokens that yield Compound.
Ultimately, both liquidity mining and yield farming indeed differ even though they are used interchangeably due to its nature to maximize returns by earning governance tokens.
Yield farming allows the token holders to generate passive income by locking their funds into a lending pool for some interests as a return. While staking involves a validator who locks up their coins, they can be randomly selected by the Proof-of-stake (POS) protocol at specific intervals to create a block.
When yield farming and staking compared side-by-side, staking usually involves a more considerable amount of crypto to boost the chances of being selected as the next block validator. Depending on the coin maturation, it can take up to a couple of days before the staking rewards come by for collection.
In contrast, yield farmers move the digital assets more actively from time-to-time to earn new governance tokens or smaller transaction fees. Unlike staking, yield farmers can deposit multiple coins into liquidity pools across several protocols. For example, yield farmers can deposit ETH to Compound to mint cETH, then consecutively deposit it into one to another protocol that mints third and fourth tokens.
Compared to staking, yield farming is more complex, and the chains can be hard to follow. And though yield farming has a higher return rate, it is also risker.
Anyone who invests would expect a return, and yield farming is no exception. As we discussed earlier, yield farmers earn rewards by lending in the liquidity pool, but it also sparks a discussion about whether yield farming is profitable.
Yield farming’s returns are normally calculated annually. That means you should expect an average return over the span of a year for more accurate prediction analysis. However, the profitability of yield farming is rather complicated as it highly depends on the capital you deploy, the strategies you use, and of course, to include the liquidation risks of your collaterals.
On the bright side, since yield farming is still at its early stage, those who decided to stake their cryptocurrencies into the protocols can expect significant returns. While the profitability is uncertain, some successful yield farming techniques are circulating in the crypto world with earnings as high as hundred-per-cent. With the continuous growth of active users in DeFi, the return-of-investments in the tokens with governance rights could be a massive hit in the upcoming years.
It is hard to estimate the returns of yield farming even in a short term period. As many factors could contribute to these uncertainties, some of the reasons include the volatile fluctuations in yield farming and the relentless competition. Let’s put the demand and supply concept to justify the idea. So, if one of the yield farming strategies is overpopulated, naturally, the returns will dwindle.
On the bright side, calculating the ROI of yield farming is still possible despite the limitations. Here’s an overview of the standard metrics:
APR does not consider compounding, which means the calculation only involves the multiplication of the periodic interest rate with the number of periods within a year. The yearly return rate is imposed on borrowers but is paid to the capital investors.
APY distinguishes itself from APR, wherein the return rate based on APY is imposed on the capital borrowers and then paid to the capital providers rather than the investors. Whereas the compounding interest is taken into account to bring more returns to the investors.
Basically, the main difference between these two metrics is that APR does not take compounding into account, while APY describes the return rate with interest on interest.
Every investment possesses some threats, and yield farming is no different. Yield farming is indeed profitable at its early stage, but the profit does not come easy without extensive strategic planning. In most cases, the most profitable yield farming strategy involves a highly complex process. It also requires a boatload of capital to deploy different investment tactics out the mechanism for the best.
In fact, if you’re unaware of the risks it comes alongside, you’re likely to expose yourself to the following threats:
In order to take a loan, you’ll need to collateral some assets. Depending on the protocols, some borrowers are required to over-collateral. Mainly to ease in some room for position adjustments in the market whenever there’s a sudden market crash. While some lenders require little to no collaterals. That’s precisely why it’s essential to take the collateral ratio into account to avoid liquidation from happening.
For example, you can only borrow an asset if you deposit according to the collateral ratio of 400%. By right, when your collateral value is 1000 USD, you can only borrow 250 USD. So, it means the higher the collateral ratio, the lesser you can borrow. It’s best to steer away from liquidation by adding more collateral from the actual asset you intend to borrow.
Yield farming relies on smart contracts to bind all two anonymous parties’ farming transactions without central enforcement. That means when there’s infiltration or error in the central data, many may fall victim to the system failure. That includes the leaks of financial information and the loss of funds.
The farmed token might grow great in value, but it could plunge too. While the DeFi hype might put up for the growth as a result of the public interest, the future is uncertain. Ultimately, the value drops whenever the trend dies down or there is an oversupply token in the market.
DeFi is built based on the idea of composability. Each of the building blocks deals with the inter-relationship based-off the application for a specific goal. While this idea helps to eradicate a third-party involvement, thereby making the protocols seamless and permission-less. The down part is when a block experiences a malfunction, the entire ecosystem needs to put up for the losses too.
It’s a lie if you’re told that yield farming is entirely safe. Like everything else, investment takes time, effort, and extensive research to understand the concept. So, it’s always dangerous for those who fail to appreciate the ideology behind it.
However, all these can be prevented by reading and understanding the terms for a smart contract. Try to be less reliant on outsourcing third-party to interpret the contract and instead know the contract’s ins-and-outs to flag out a scam. However, do note that smart contracts are vulnerable to system bugs. That means, if the system fails, you might risk losing the staked funds or values of a token in the protocol.
While some crypto enthusiasts believe DeFi or yield farming possesses boundless growth, the volatility is still undeniable. And it’s being speculated to be just another crypto bubble. After all, you should weigh your financial position and your capability to go out of the comfort zone to decide from the most logical standpoint.
It’s clear by now that farmers earn incentives by providing liquidity to a platform. So the interests and fees are varied depending on the capital growth and the strategies you deploy. The inevitable questions you may be asking what could be the protocol choices you can diversify your yield. Here’s the answer:
As a decentralized exchange (DEXDecentralise Exchange (DEX) is a crypto exchange platform that is built upon blockchain technology and negates the need ...), Uniswap involves AMM to swap two trustless cryptocurrencies into a fund pool. In exchange, the liquidity provider earns a 0.3% fee when liquidity is provided for each swap.
The Compound’s (COMP) token is granted to users who utilize COMP to borrow and lend crypto assets. This approach is one of the most popular strategies as it boasts simplicity, and anyone with an ETH wallet can supply assets to the COMP liquidity pool. However, the challenge here is to determine the tokens’ expected value while allocating sufficient liquidity to maximize the returns.
The great thing about yield farming if you can stake yields to generate more profits. Let’s say an LP received a token minted by the algorithm; then, re-staking it based on the other protocols, it’ll yield a third token.
Here’s are some of the platforms that support these protocols:
According to the algorithmic interest rates, lenders who deposited funds will get aTokens and immediately earn compounding interest.
Balancer adopted similar protocols like Uniswap to allow LP to allocate funds to the pool. However, LP can disregard the fixed funds’ allocation on Uniswap by allocating custom funds.
As stablecoins optimized swaps, Curve functions like Uniswap, except it allows users to make higher-value swaps with lower slippage rates. For example, a Curve token can be staked on Synthetix to yield sETH with the underlying minted token then redistributed to another staker.
Since yield farming is built upon Ethereum, the computation effort needed to execute a transaction or smart contract execution is inevitable. And to do so, we would need— Ethereum Gas. Ultimately, the more complicated a protocol is, the more gas is required to execute a transaction.
In short, gas is used to calculate the fees to pay within the network to perform a transaction. Let’s say you intend to interact with Synthetix; you’ll need more gas to transfer any of the SNX because the protocol is more intricate than the others.
The debt pool represents the total value of the tokens you funded in the platform. Taking Synthetix as an example again, when you stake by minting sUSD, you’ve already claimed a portion of the debt.
So, if the majority of SNX holders hold sETH while ETH soars, then the debt pool will increase proportionally. That means you need more funds to unlock the SNX again. Let’s say you minted 1000 sUSD, and the total circulation of Synths is at $1 million; your debt ratio is standing at 0.1%. You’ll be needing 1000 sUSD to unlock the SNX, while the unlock rate doubles as the prices of Synths doubles as well.
Calculating your short-term profit with APY can be misleading and confusing at the same time. Since the yields are usually based on an expected return for a year, the APY percentages in the short-term are not sustainable. Looking at the farming reward that only lasts a few days with a volatile rewarding system, APR’s actual calculation is doubtful.
DeFi and yield farming has shaken the internet since it’s first rolled out. With over a million active users in this ecosystem, it’s impossible to see what the future holds. Shall there be newer, more value-adding, and cut-edging applications to revolutionize the liquidation of yield farming or DeFi in general? Only the future can tell.
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DeFi has been the leading narrative in the crypto space in 2020 with its pulsating innovation and stellar growth. Not only has the entire concept of financial services been turned on its head but we’ve also witnessed some of the speediest development in tech of all time. In the savage unforgiving decentralized landscape, competition is fierce and protocols are required to iterate almost daily to survive.
All this growth and amplification of choices for investors has brought with it many gains beyond the 1,000%+ weekly ones. We’ve had the privilege of seeing how developers are pushing the edge of this fascinating technology and bringing real-world solutions to life.
Of course, as with all areas in any nascent space, some teething trouble has also arisen. Investors attracted by overnight wealth myths clashed with unscrupulous actors just waiting to scam them. Then we’ve had technical issues with smart contracts, oracles, and a lack of auditing.
Yet despite the early days of DeFi and the ups and downs, the fundamentals are growing stronger, the ecosystem broadening, and the value locked in its protocols continuing to climb, currently standing at over $11 billion. But while DeFi has been the most deserving focus of our attention this year, it’s not the only area where innovations are happening.
Non-Fungible Tokens (NFTs) otherwise known as crypto-collectibles have also seen tremendous growth this year. Made famous by the unforgettable CryptoKitties back in 2017 when the popular collectible cat platform clogged the Ethereum network–and went on to sell its most sought-after collectible for $170,000–NFTs had slipped off many people’s radars. Yet, their use cases are expanding at a rapid pace, with more than $8 million traded volume in the last month.
That might be small fry compared to the money changing hands in other areas of blockchain, but we’re talking about digital collectibles like in-game items, limited-edition player cards, and online pets. And we’re even beginning to see NFTs merge with DeFi to offer liquidity mining and incentivize users with provably rare or digitally unique items, such as the winners of the OKEx User Voting event, MEME, and GHST.
Beyond entertainment, such as creative memes and sport player cards, the technology behind NFTs has explosive potential. The creation of rare and unique items that can’t be destroyed, replicated, or forged, and that come with an immutable history can be used in the tokenization of fine art, precious jewelry, and even real estate as a way of authenticating ownership and facilitating the transfer of ownership.
Great developments have been made that will make navigating the web and storing data a safer and more secure experience for all while enabling us to access faster speeds and tap into idle computational power across decentralized networks.
In fact, the area of decentralized data storage has already seen some really impressive players and promising projects like STORJ, GOLEM, and MAIDSAFE. And, with the Filecoin mainnet launching this week, it will be interesting to see how far–and how fast–we move into the decentralized web.
Why is it so important? Because it will allow us to work in ways that we were previously unable with greater speed and decreased cost. It also creates a fair decentralized ecosystem in which people connected to it are paid for providing their free computer space. Golem as a “supercomputer” can allow network participants to make faster and greater advancements in the fields of AI, machine learning, and so much more.
Decentralized cloud storage made possible by projects like Storj Network and Filecoin will allow us to circumvent central actors such as Amazon Web Services (AWS) for a faster, safer, and more affordable storage alternative that cannot be closed down or censored.
At OKEx, we’re proud to be pioneers in such early-stage technology and its continued expansion. Not only do we provide support for key projects in the areas of DeFi, NFT, and decentralized data storage, but we also iterate and create, BUIDL, and experiment with the technology through high-quality cutting edge products like our decentralized public blockchain OKEx Chain and our accelerator program that allows for liquidity mining, OKEx Jumpstart.
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The hiring of DeFi developers has to be done in the most systematic manner. Also, you have to be sure about every single step being made in the process of generating tokens. Whether you have a specific skill or not, you need to endeavor to provide the best fixes to your clients. By doing that, you prepare your team members to react very fast and also to pass things on to the advanced level. In this way, things get streamlined and you make your project impeccable.
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