read the following article first as introduction to DeFi: Decentralized Finance will reshape (or eat?) Centralized Finance

Upfront – I personally perceive Yield Farming as a highly controversial topic and it seems I am not the only one. Vitalik Buterin, co-founder of Ethereum and Bitcoin Magazine, criticized the hype and compared yield farming with the irresponsible monetary policy of central banks and warned against "naïve stubbornness". Taking to his Twitter, Buterin said:

Seriously, the sheer volume of coins that needs to be printed nonstop to pay liquidity providers in these 50-100%/year yield farming regimes makes major national central banks look like they're all run by Ron Paul.

So what is yield farming? Yield farming is the act of leveraging different DeFi protocols and products to earn a yield or a return on their assets, in some cases obtaining profits well over 100% APY through a combination of lending interest and token incentives. Yield Farmers therefore try to chase the highest yield by switching between multiple different strategies.

  • Low Risk Strategies: Low risk yield farming strategies are usually those that are part of fully audited, battle-tested and reputable protocols. They are less lucrative in terms of net returns but offer safer and more stable yields over the long-term. (example protocols are Curve, Compound and Balancer)
  • High Risk Strategies: High risk yield farming strategies are those that are brand new, untested, unaudited, and typically only last for a few days or weeks. (example protocols are YAM Finance, Yearn.finance)

The most profitable strategies usually involve at least a few DeFi protocols like compound curve, synthetics, you and you swap, or a balancer. If the strategy does not work anymore, or if there is a better strategy available yield farmers circulate their funds e.g. between the different protocols, or by swapping coins to other ones that are currently generating more yield. This procedure is often called crop rotation.

To compare this with traditional finance (centralized finance) imagine people trying to find the best savings account; with the highest APY (Annual Percentage Yield). Dependent on the individual country it is common to see traditional saving accounts around 0.1% APY (3% and above is pretty much unheard of these days; cf. Investopedia – Best High-Yield Savings Accounts).

Yield Farming APY's could outperform traditional offerings. In comparison the current "Yield Farm Rankings" on CoinMarketCap clarify that APY's of multiple hundred % are at the given moment achieveable.

Source: CoinMarketCap

How is this possible? And where is the catch? There are three main elements to achieve this return: 1. Liquidity Mining, 2. Leverage and 3. Risk.

Liquidity Mining

Liquidity mining is a process of distributing tokens to the users of a protocol. One of the first DeFi projects that introduced this approach was Synthetix. The company started rewarding users who helped by adding liquidity to the sETH/ETH pool on Uniswap with SNX tokens.

Liquidity mining creates additional incentives for yield farmers e.g. rewarding users with newly minted native tokens. All on top of the yield that is already generated by using the specifically used protocol. Actually this is in comparison not new – in late 2018 several centralized exchange operators in China offered liquidity mining incentives on their platforms. The most prominent of these was an exchange called FCoin. FCoin offered large incentives to traders who traded on its platform, hoping that the liquidity this created would attract more organic users. FCoin bet that users would stay on the exchange after liquidity incentives ended – they closed their services in 2020.

Nowadays a good example would be mining COMP tokens orginally introduced by Compound. Initially they have given higher rewards to users which were borrowing assets with the highest APY. This incentivized yield farmers to start borrowing these assets as the value of freshly minted COMP token was compensating them for the highest borrow rates they had to pay.

Centralized exchanges like Binance are catching up as well. Binance Liquid Swap does enable its users to earn interest in addition to a cut of the trading fees for the pool. A so called AMM liquidity pool (Automated Market Makers) will allow to provide liquidity by depositing tokens. Binance primarily addresses directly towards Uniswap and its clones and will be integrated into the Binance.com exchange, allowing users to pool tokens in their wallets to earn rewards. The company is prioritizing liquidity for its own tokens so the first pools offered on launch will be USDT/BUSD, BUSD/DAI and USDT/DAI.

Source: Binance Liquid Swap

Leverage

Besides liquidity mining, leverage is an additional key component to achieve possible ultra-high returns. A leverage strategy basically means using borrowed money to increase the potential of an investment. Yield farmers can deposit their coins as collateral to a lending protocols and borrow additional coins. After this they can use borrowed coins as further collateral to repeat this procedure multiple times.

Leverage can increase profits only if the user guesses the price dynamics correctly. If a yield farmers prediction fails, their losses will increase just as much: they lose someone else's money on top of losing their own.

Risk

  • Liquidiation Risk: The collateral might be be liquidated and repaid to lenders which is due to over-collateralization – when the collateralization ratio (value of collateral / value of the loan) falls below a certain threshold,
  • Liquidity Crunch: A significant amount of particular asset locked in different protocols to earn yield can create a liquidity crunch in the market. This leads to highly volatile assets and can directly affect the asset price and yield mechanism of the different protocols.
  • Smart Contract Exploitation: DeFi protocols are implemented using smart contracts, and these smart contracts are openly accessible by everyone. Therefore, there is always a risk of bugs surfacing and smart contracts get exploited in order to steal funds.

Final thoughts

While other investment opportunities offer steady returns – yield farming does put your investment up against liquidation risks and smart contract risks. Also it is hard to say if this will set the path for consistent long-term growth. This means when incentives begin to hit the decline, farmers might also begin to leave.

Additionally yield farming is definitely not simple, nevertheless there are more and more tools which make it more simple.

  • Etherscan's new Yield Farms page offers an unfiltered and extensive list of projects that have ongoing yield farming campaigns.
  • yieldfarming.info provides a curated list of yield farming opportunities and detailed wallet-based stats (APY etc.).
  • Zerion is a dashboard interface for blockchain-based protocols in DeFi applications; another good platform is Instadapp.
  • Lastly, relatively new is APY.Finance. The platform automates yield farming to "fund the best risk-adjusted farming strategies".

Website and the information contained herein is not intended to be a source of advice or credit analysis with respect to the material presented, and the information and/or documents contained in this website do not constitute investment advice.