What is Yield Farming and How Does it Work?

2021/06/02 04:27:01

While the internet allows us to do incredible things, website owners can gather enough data to learn your whole life history from just a single purchase. With decentralized finance (DeFi), you can do things such as borrowing funds without ever revealing your name. This revolution in financial technology (and beyond) is now reconstructing the banking system in an open and permissionless way.

Startups backing DeFi applications today have come up with sensible ways to attract crypto holders with idle assets. These applications do not worry about identity as the trust factor between the users since collateral does the job instead. This gave birth to yield farming, currently the biggest driver of growth for the nascent DeFi sector.

What is Yield Farming?

Making money in the crypto industry in the past was mostly reliant on speculating on the price of assets like Bitcoin and trading when the time is right. This changed when people built numerous applications on the Ethereum blockchain that acted somewhat like banks, but without bankers. Users could take a loan out against without showing their ID, paperwork, or credit rating. All one had to do was to own some ether and put it up as collateral, and get dollars in return.

Thus, we saw the birth of yield farming, a new way to earn interest on deposits. Also known as liquidity mining, yield farming is simply a way to generate returns from lending cryptocurrency to the platform itself in order to provide liquidity. A user can lock up their owned crypto and gain interest in the form of additional crypto. Owners can sit back and relax while their crypto assets are put to work and benefit them with rewards.

How Does Yield Farming Work?

Users, also known as liquidity providers (LPs) add funds to liquidity pools as collateral. These liquidity pools are smart contracts that contain the funds, and act as the marketplace where users can borrow, exchange or lend tokens. Once LPs add their funds to the liquidity pool, they start earning rewards.

The process of reward distribution can be a very complicated process, and it depends on the individual liquidity fund. These can be in the form of interest from lenders, a certain percentage of the transaction fees, or even multiple tokens. As more LPs come into the picture and invest in liquidity pools, the value of the returns received increases.

Tokens received from rewards can also be deposited back in liquidity pools, and the yield farmers are likely to move their funds around across multiple DeFi platforms in search of higher yields. Further, the returns earned are directly proportional to the liquidity provided, thus huge rewards are backed by huge capital investments.

Why is Collateralization Important in DeFi?

Collateral acts as insurance for when assets are borrowed as a loan. However, certain yield farming protocols give importance to their collateralization ratio, which a user must keep constant track of. If the collateral provided by the borrower falls below the margin requirements in the marketplace, their collateral is forcefully liquidated on the open market.

Many systems also work with a system called overcollateralization. To reduce the risk of market crashes which would forcefully liquidate massive amounts of collateral, borrowers must deposit more value than what they are looking to borrow. Thus, many protocols have extremely high collateralization ratios, going up to 750% to keep their system safe from this risk.

The Most Popular Yield Farming Protocol

Compound is an Ethereum-based borrowing and lending dApp (decentralized app). Users can lend their crypto out and earn interest on it. Alternatively, if someone needs some money to pay rent or buy groceries but the only funds they have are crypto, they can then simply deposit their owned crypto as collateral and borrow against it.

This algorithmic money market allows anyone with an Ethereum wallet to invest in Compound’s liquidity pool. LPs then start earning rewards, whose rates are adjusted based on demand and supply. Compound is one of the core protocols of today’s yield farming ecosystem.

The start of the yield farming boom is attributed to the launch of the COMP token. This governance token of the Compound Finance marketplace was used to attract liquidity providers to this decentralized blockchain. As LPs added liquidity to the protocol, they earned COMP tokens with additional liquidity incentives. Even though this is not what invented yield farming, it sparked the idea of token distribution.

Risks of Yield Farming

Yield Farming is not as easy as it sounds. While being incredibly complex, it carries notable financial risk for lenders and borrowers. Traders can experience temporary loss of funds occasionally in such volatile markets. One must thoroughly understand the process otherwise they are very likely to lose money. Further, with high Ethereum gas fees, yield farming only becomes worthwhile when large amounts of capital are invested in the first place.

Vulnerabilities will also always exist in the usage of smart contracts, opening the door for hacks and fraud. An example is DeFi’s Yam Protocol, which raised over $500 on the platform before a critical bug was exposed, crashing its stock price down to $0.

Further, there has also been a recent rise in protocols issuing such absurd meme tokens on their platforms that offer massive annual percentage yield (APY) returns. Thus a trader must be very careful with these unaudited protocols that could also result in rug pulling, a practice where the developers withdraw and disappear with all the invested money.

Conclusion

As this space becomes less volatile, designers will come up with more efficient ways to optimize liquidity incentives. The way forward could be profit-sharing that encourages long-term investments, where a slice of each token’s yield is shaved off and paid to tokens older than a certain number of months.

Yield farming today is a high-risk and high-reward practice, that with the right amount of research, understanding, and capital investment can be a well rewarding path. No matter what the result, crypto’s yield farmers will never slow down and keep hunting for new yields that bring them more money.