With yield farming becoming a buzzword in the world of Decentralized Finance (DeFi), it’s probably best for us to look into it and learn about how it works.
Today, we’re bringing you a quick guide on how to successfully make the most out of DeFi yield farming.
But first, have you read our first article on DeFi?
DeFi yield farming only happens in the Ethereum blockchain, providing passive income for people who know how to play their crypto tokens within the DeFi market. This is very different from hodling, as it requires more work than just keeping things in place while other crypto players move their assets in and out of the market.
As a yield farmer, you’re expected to jump around protocols, switching currencies in the process in order to build bigger returns. You can make quite a bit of profit if you know how and where to move your assets, which is part of what we’ll be talking about today.
The actual boom of DeFi yield farming occurred after the release of COMP, the governance token by Compound. It allows users to own stocks in the company, reaping roughly over 100% in annual percentage yields (APY). This is why Compound is currently recorded on DeFi Pulse to have a Total Value Locked (TVL) of $4.5 billion.
COMP gives people voting points with which they can make changes to the Compound protocol, fully decentralizing the system for patrons who take interest in its future. COMP tokens can also act as liquidity providers (LPs) when moving your assets around the DeFi market. If you want to be a yield farmer, you should very much get acquainted with these liquidity providers.
- A refresher on governance tokens
- The ins and outs of DeFi yield farming
- How does yield farming work?
- What’s “staking yield” and how do you do it?
- When does COMP come into play?
- How do UNI, BAL, and CRV work?
- Where’s my Return of Investment (ROI) in all of this?
- What are the best places to “harvest” your maximum yield?
- The battle between Balancer, Uniswap, and Curve
- How does one make yield farming profitable?
- What are the risks involved in yield farming?
- Frequently Asked Questions (FAQs)
A refresher on governance tokens
Governance tokens have been Ethereum’s driving force since the initial coin offering (ICO) release that drove people nuts for it. The problem was, the boom also attracted scammers who put out fake and valueless coins for a given amount of money. This made Bitcoin purists register in their heads that every token from Ethereum was a “shitcoin”. Of course, stereotypes would come and go, especially with the rise of the ERC-20 tokens.
Governance tokens have moved past being simply a token or money and are now actually acting as a legislative certificate. If you’re a hodler that owns a few of these, you’d be capable of increasing the tokens’ value along with using it to modify the protocol via votation. More on this later.
The ins and outs of DeFi yield farming
Just in case you forgot, the DeFi market allows everyone to lend and borrow tokens without divulging personal information. It’s quite different from how real life works, as getting a loan from a bank would mean signing a ton of paperwork and disclosing your credentials.
With DeFi, you can make use of tokens by playing around the protocols and token values until you have succeeded in making a profit. These tokens are super easy to move around, as DeFi makes things highly accessible so you can easily trade, lend, and borrow at the blink of an eye. The only minimum requirement here is that you get yourself a Web 3.0 wallet. That’s not too bad a deal, right?
How does yield farming work?
To be a yield farmer, all you have to do is maximize the offerings of Compound by moving your assets around in order to get the best APY, taking into consideration its risks and profits. The best foot forward in doing this would be staking yield.
What’s “staking yield” and how do you do it?
Well, this is how the cycle ensues.
What usually happens is that a protocol gives tokens to farmers in exchange for giving their market pool some liquidity. From there, a yield farmer can check for other protocols and platforms to put their tokens into for a better yield.
Here’s a more tangible example:
Let’s say a farmer could provide some liquidity to Compound by putting in 1000 USDT and, in exchange, they would be given cUSDT for their service. The small “c” prefix indicates that the token came from Compound. From there, the yield farmer could look into an Automated Market Maker such as Balancer to find a pool to put their cUSDT into. Given that most transactions have small fees involved, the farmer would opt to earn a bit of yield through those fees, as they provide liquidity into the pool from Balancer.
In doing so, the farmer would earn money by having 1000USDT inside Compound and 1000 cUSDT inside Balancer. Nifty, ain’t it? From there, they could easily look forward to more cases for the best possible yield. We can see that from one source of liquidity, a wise enough yield farmer could easily earn and bring out yields by throwing their assets and tokens around multiple platforms.
When does COMP come into play?
COMP is how people start to recognize the potential of DeFi yield farming. A previous strategy that worked before Compound closed the loop was this:
- Lend some USDC
- Borrow some USDT of the same value in return
- Swap out the USDT for more USDC
- Lend some more USDC
- Repeat as necessary
To be honest, it became too easy of a loop, and Compound eventually put it to a stop. Nevertheless, this exploit pushed people to turn into the yield farmers we all know and love today. Through staking, the interest or yield from lending USDC would suffice for the common crypto trader. But for yield farmers, they spin it around to make even more fun out of it.
How do UNI, BAL, and CRV work?
COMP may seem like the hottest craze in DeFi yield farming, but you should also check out these three tokens competing for the top spot.
The UNI token was just recently released in the market in mid-September 2020, and things are looking up for it. You can get your hands on them as long as you’re using Uniswap to farm, as free tokens were given out by Uniswap to their most esteemed patrons. Roughly a billion of these tokens are going around, and they don’t seem like they’re going to run out soon. Here’s how you can get your hands on them:
- Get yourself some ETH.
- Check out the Uniswap liquidity mining page and pick a participating pool that you would like to add liquidity to.
- Put 1 ETH and the corresponding amount of the other token in your chosen pool. (We’re only putting in 1 for now since gas fees are quite high. A good rule of thumb would be to split the stack of ETH into the token pair).
- Upon approval of token transfer and gas fees, a timer will be started in the Uniswap liquidity mining page as you await for the tokens to be deposited into your wallet.
Balancer has been giving out their BAL tokens since the start of June 2020, and yield farmers couldn’t be any happier. The values these tokens are going for are still quite good, so holding them, for the time being, wouldn’t actually hurt. Roughly 145k BAL tokens are given out every week. You might as well get in on them while they’re still there! Here’s how to do it:
- Pull out some ETH.
- Add liquidity to any pool in the Balancer protocol. (Go for ones that give more USD value, so you get more tokens).
- Wait for the BAL tokens to be credited to your wallet.
**Side note: You will only get BAL tokens if you’ve put in enough USD to equal 2 tokens.
Curve is quite late to the party, but that doesn’t mean it has lost its value. It started giving out CRV tokens in mid-August 2020. You can catch up on claiming tokens from previous transactions by registering it on the link over here. It’s not that hard to get your hands on some CRV:
- Get yourself the amount of ETH you want to transact.
- Add liquidity to any pool in the Curve protocol (the higher USD value you put in, the larger the amount of tokens you’re going to be credited for).
- Wait for the CRV tokens to be credited to your wallet.
Where’s my Return of Investment (ROI) in all of this?
As a yield farmer, you have several ways to earn as you go along. These include:
- Transaction fees – These small inclusions and deductions change from protocol to protocol and pool to pool. Sometimes they’re fixed (Uniswap has it flat at 0.03%) while some can vary as the pool is created (Balancer allows it to go between 0.001 to 10%). A percentage of these fees goes to the LPs or the governance token holders depending on the protocol.
- Token rewards – These are basically governance tokens, given as incentives to crypto traders who offer liquidity to certain LPs.
- Capital growth – This usually comes in the form of stablecoins as a substitute for rewards, assets, or fees. It makes future income easier to calculate for, and other tokens can make this process more difficult as their prices tend to fluctuate around a lot.
What are the best places to “harvest” your maximum yield?
There are three specific places you can look into: liquidity pools, money markets, and incentives.
First off is the LIQUIDITY POOL.
In the world of DeFi, liquidity is held in high regard when it comes to managing all protocols. In a world of high liquidity, what everyone gets are better fees and better user experience. On the founder’s side, it makes for easier sourcing of money, as they’d rather borrow from their users than succumb to venture capital firms.
In comparison to money markets, liquidity pools offer better yields and rewards but also present higher risks to anyone who does business with them. Such is the case for Uniswap and Balancer, both of which are currently going head to head in the crypto market. Uniswap as an AMM can only offer a pair of ERC-20 tokens up for trade. On the other hand, Balancer had created BAL, a governance token that’s not that far in function from Compound’s COMP. At this rate, people are more likely to go into Balancer than Uniswap unless Uniswap releases their own governance token.
The battle between Balancer, Uniswap, and Curve
|#||Coin||Price||Marketcap||Volume (24h)||Supply||Change||Last 24h|
|$ 7.48||$ 1.64 B||$ 729.66 M||215.06 M||15.02%|
|$ 176.28||$ 740.28 M||$ 82.96 M||4.15 M||16.20%|
|$ 18.11||$ 197.35 M||$ 74.61 M||10.80 M||16.46%|
Synthetix Network Token
|$ 12.15||$ 1.72 B||$ 217.26 M||141.75 M||21.76%|
Curve DAO Token
|$ 1.60||$ 319.03 M||$ 502.52 M||195.19 M||1.48%|
|$ 1.58||$ 120.27 M||$ 203.70 K||75.99 M||16.84%|
To have tokens for your platform, you’re required to pay LPs to put them out, which is what Balancer and Uniswap do. The only difference is that Uniswap pools only offer two tokens split while Balancer allows for up to eight assets in which owners can customize how much they cost or weigh.
Through every trade of these tokens, fees are processed to keep the LPs funded. Uniswap has been doing great in this but the only problem is that it incurs impermanent loss. Balancer easily lowers impermanent loss occurrence, as they allow for customized allocation and their BAL governance token furthers the liquidity for the given pool. But a third player has come in: Curve Finance. Curve has worked hand in hand with Synthetix to create a liquidity pool that’s way more appealing.
Curve easily eradicates impermanent loss by allowing token trades with stablecoins of the same value. Doing this allows for lower volume trading in pools, eliminating impermanent loss and bringing higher fees to the other competitors: Uniswap and Balancer.
Up next are MONEY MARKETS.
This system is highly focused on lending and borrowing, which are the easiest approaches for farmers to make up a yield. As you throw in your stablecoins, you can easily reap your yield as you put the numbers in. Some top TVLs on DeFi Pulse right now are Aave and Compound, so let’s check out how they work.
Aave offers better rates, given that they offer stable and variable interest. Stable interest works best for borrowers, and variable interest is more for lenders. The only edge Compound has against Aave is the COMP governance token as an incentive. These money markets push farmers to over-collateralized loans, with crypto patrons putting more stuff in than they’re taking out.
As we all know, a loan would require twice as more collateral on most lending protocols. This over-collateralization allows for lenders to not lose funds. The collateralization ratio is always maintained in order to avoid the entire thing from liquidating. Hence, you can’t put things up there and leave them until the numbers change. People who make loans should closely monitor how the numbers change and always maintain the collateralization ratio.
Lastly, we have INCENTIVES.
Think of an incentive as a bonus added value given to anyone who patronizes or uses a given product. Incentives usually come as rewards in the form of a token, such as Synthetix with their SNX token. You can get yourself some by transacting with the sUSD and sBTC pools on Curve. Ampleforth, on the other hand, has some AMPL tokens for people who transact with the AMPL-WETH pool in Uniswap. A good yield farmer can easily map out the best token giveaway while still keeping at it with staking and maximizing yields.
How does one make yield farming profitable?
To drop some hard facts, many wise yield farmers have successfully earned a passive income from June to July despite the value of ETH flat-lining to its boring resolve. Farmers have strategized into focusing on low volatility, maximizing on rapid price fluctuations that are sooner or later bound to happen. It’s risky, but it works.
If you’re the type who’s not into taking risks, a safer route would be to earn yourself some stablecoins on Curve by turning yourself into an LP. If you’re a larger holder, try going for Uniswap or Balancer. Being a wise and profitable yield farmer will always depend on one’s ability to work with risks, capital holdings, and the overall capability to monitor the numbers and positions or to just leave everything to luck and the universe.
The two biggest challenges a yield farmer may face are liquidation and impermanent loss. The former can easily be resolved by making sure that collateralization ratios are tight enough to not give into liquidation. But fear not, there are actual strategies and systems in place to make up for losses in these cases.
If you’re a wise enough yield farmer, you should also be able to work with or against the time horizon. Holding periods should be taken into great consideration, as their APY would usually take care of the fees with regards to gas or trading. With the cost of ETH being higher than ever, jumping around like crazy between protocols could easily eat up your funds before you know it, so look into that first before trying something too risky.
What are the risks involved in yield farming?
Everything related to crypto, especially DeFi yield farming, will always involve certain risks for consumers and patrons. A yield farmer’s “crops” can easily be distraught by unforeseen calamities. Some of the major ones that stand as a threat to most farmers are impermanent loss, black swan events, price oracles, platform risks, exchange rates, and smart contracts. With tricks and hacks coming out for certain platforms, it would be wise always to keep yourself updated on what’s going on and how it affects the lump sum of assets you have in crypto.
DeFi offers different and more unpredictable risks in comparison to years past, which is why there are high-interest rates to back the entire system up. With a lack of FDIC protection, interests fluctuate fast enough to leave you biting the dust if you’re not too attentive nor careful.
No one can really tell what’s going to happen, but there exist some predictions. With the COMP governance token ending in about 4 years, this whole craze would probably blow over by then. Since DeFi is still a fresh concept, there’s much to come in regards to maximizing liquidity incentives. You might be surprised to see how it all works out. The owners of governance tokens could easily use the tokens to make their profits skyrocket, while yield farmers could keep staking until the numbers come out beautifully positive.
Frequently Asked Questions (FAQs)
Impermanent loss occurs in a liquidity pool when one token in the pair gains value. In turn, the other loses some value, and the people currently holding those tokens lose profit. The total amount that the value of the token went down is called “impermanent loss.” If you take that token out, that is when the loss becomes permanent.
That’s actually all up to you, depending on how you want to play the game in maximizing yield.
No one can really tell since the value of most tokens is very volatile. The trick here is to check values from time to time.
This is unlikely, but it’s very uncertain how long the craze will last. The hype will only continue if token providers keep on changing their protocols to be more miner-friendly. But so far, with COMP giving straight out assets for only 4 years tops, that’s basically as far as we can look into the future.
These are the small amount of crypto deducted from every transaction made on the ethereum network. Gas fees also occur when you interact with a smart contract.