Intro to DeFi Yield Farming: Crypto’s Hottest Trend

Buzzwords may come and go, but this one seems like it’s here to stay. Check out our DeFi Yield Guide to help you on your crypto educational path.

Let’s catch you up a bit on Decentralized Finance (DeFi). Basically, DeFi allows its supporters and users to have full control of their assets through the use of peer to peer (P2P) decentralized applications (Dapps). The movement strives to further decentralize the already decentralized crypto market, giving users the ability to move currency around without any governing body controlling them like an invisible hand. 

Decentralized Finance isn’t something completely new in the cryptocurrency scene. The craze started back in July 2017, and the numbers don’t seem like they will be going down anytime soon, even with initial coin offering (ICO) going head to head with it. With roughly $1.9 billion liquidity locked in DeFi, the whole DeFi philosophy has proven to be a worthy challenger despite ICO reaching the $1 billion mark roughly three years ago. A chunk of crypto users has definitely switched to maximizing DeFi applications to their benefit, all thanks to Compound’s COMP governance token, which introduced the use of yield-generating pasture.

These governance tokens allow crypto users to control decentralized protocols through voting, giving them a sense of control through some form of democracy. This fairly new process manufactured by DeFi founders attracts crypto users to their assets like moths to a flame. Funnily enough, a pseudonym was formed for the group of people who have been supporting crypto liquidity, and that was how yield farmers and DeFi yield farming were born.

Start of something new

With DeFi Yield already explained, let’s take a look at its genesis to further understand what’s going on.

June 15, 2020 heralded the start of Compound’s distribution of the COMP governance token to their users who support their Ethereum-based credit market. Logically enough, the demand for these governance tokens shot up instantly despite automatic distribution being utilized. This easily put Compound at the forefront of the world of DeFi.

Also read: A Quick How-To On DeFi Yield Farming

The buzzword “yield farming” is what you’d call it when someone implements a strategy that concerns putting crypto into startup applications for a given period of time in order to yield higher returns once withdrawn. It’s actually not that far from the concept of “liquidity mining,” with both terms creating a lot of noise in the community.

How tokens work

Not to get all geeky on you, but tokens are technically an in-game currency one can collect while traversing a certain path and defeating monsters inside a video game. This currency can be used to easily upgrade items in order to make your player stronger and more formidable as a game progresses.

If you transfer this terminology to the world of crypto, the tokens you collect from a certain “game” are not exclusive to that game; they can also be used in any other game of your liking. Of course, the “game” as a figure of speech pertains to blockchains. But still, tokens seemed to get more exclusive to 1:1 features in the long run. This is where ERC-20 tokens come in, which allow for more universal use depending on one’s specific preferences. The functionality of this sub-currency sparked an interest for Kin to create tokens that didn’t feel like you were spending them in order to move them around.

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Fast forward to governance tokens. These tokens actually break away from the norm, as they do not easily equate to video game tokens or previous blockchain tokens.

Governance tokens are “certificates” that allow their owners to tweak the legislature of a certain protocol through voting.

Much like all tokens in the world of crypto, these currencies have a price equivalent and are viable for trade as the owner sees fit. This kind of functionality offers the need to have a bank-type system, which is where decentralized finance kicks in.

A clearer definition of decentralized finance

Long story short, Decentralized Finance allows people to move money around like it’s a game, with the only capital being your own crypto wallet. Let’s say you have an Ethereum wallet worth $20. You can easily use that balance to move around applications and swap currencies flawlessly as if you were simply borrowing money from a friend. To form an analogy, in the real world, you would have to provide certain information about yourself before you’d be able to purchase a home stereo, for example. With DeFi, you can borrow money without anyone actually knowing who you are. DeFi applications don’t care about who you are because they probably have double the collateral than the amount you owe them. That’s the magic to it right there.
Once you’ve tried playing around with DeFi applications, you can see how everything can easily be reverted as if nothing ever happened. But of course, tread lightly. The systems in place here are definitely more complex and allow for a larger room for error if you get too overconfident. If you don’t go at it carefully, there are small transfer fees that you may overlook, and the unpredictable rise and fall of Ethereum may mess you up.
So what do these DeFi applications get when you keep borrowing money? To cut to the chase, they can actually profit from the price falls of tokens and can easily manipulate and hold onto several other tokens to their liking.

The capital in building a DeFi application

The usual thing startup applications do in DeFi is attract HODlers with idle assets to invest in them and make their crypto grow. Borrowing money from users allows for better liquidity than taking the money of VCs and debt investors. For example, Uniswap easily controls the cryptocurrency market, as it allows people to buy and sell almost any cryptocurrency in existence. Uniswap works in such a way that a market pair of any two tokens can be traded for one sought-out token, making it a very easy and convenient tool for users to acquire currency. The thing is, these pairs are built around pools. Uniswap being built on a lot of pools that keep on growing means that they have better control of the ebb and flow of the token prices since they have access to a lot of varied tokens. 

What are pools?

Nope, you got it wrong. There’s no water here. But here’s where it all actually gets interesting. 

Uniswap (UNI)
0.7%
$ 29.47
$ 0.206290
⇣ 29.43
11 Apr
⇡ 30.58

What Uniswap usually does is it takes two tokens of the same value and pairs them up to form a pooled market pair. This would, of course, require that there’s a balance of deposits and withdrawals within the two tokens so that their values would be proportional 1:1. Every time there’s an imbalance, a wise enough investor may opt to balance it out. Let’s say we have a 1a:3b market pair. If the investor decides to deposit 1a, he would get 1.5b in return, in turn balancing everything out. With the 50% arbitrage profit, investors can easily maximize the use of limited liquidity. However, it’s worth noting that the same functions wouldn’t work with a market pair with numbers so large and investors moving only small amounts. This is also possible because of liquidity. To optimize liquidity for the market, what most startup apps do is charge tiny fees between trades in order to offer liquidity and grow shares for liquidity providers within a given pool. 

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With liquidity growing per provider helping a market pair, the shares they own in a pool would be directly converted into a token in their wallet that they could sell, trade, or use in another product. Yes, it’s a crazy concept.

How much do people earn from being liquidity providers?

Quick answer: not much, but definitely more than you would if you put your money into a bank. But of course, these numbers are only high because DeFi is a way riskier avenue through which to store your money. Especially with the value of blockchains and tokens varying so drastically, you’ll never know when you can actually profit the most or if you should just stomach the loss. With insurances going up and down like crazy, there are people who aim to maximize the numbers and actually make a living for themselves.

This group is what we call yield farmers.

What exactly is yield farming? 

To put it simply, yield farming is when you make the most out of your crypto assets by putting them to work and maximizing returns by wisely playing with the interest rates.

Yield farmers like to move their assets around by following the most profitable pools on a weekly basis. Yes, of course, they often play with risky pools like it’s a cakewalk. But that’s the thing about yield farmers – risk is pretty much their middle name. The act of farming easily opens up new price arbitrage which spills over into other protocols in which their tokens are in the same pool the farmer is currently playing with. This is basically where tokens are put to good use, as it takes more courage to take on a lot of risks.

For example, a yield farmer may opt to put a certain amount of crypto into a DeFi app. They would get a token instead of their crypto, and under normal circumstances, they’d be able to withdraw the same amount they deposited. That token of the same value would then be taken by the yield farmer to a liquidity pool. When taken to another crypto company, the yield farmer could actually earn profit through the transaction fees.

This is basically what yield farming is all about: yield farmers constantly look for currencies and liquidity pools that may bring bigger numbers every time they transact. What makes it easier for them is DeFi’s universal approach, making it a hot thing to do at the moment.

How did yield farming take off?

Two words: liquidity and mining. They work hand in hand with yield farming to actually make a ton of profit. Well, not actually A TON, but definitely more than what you should be earning. 

Liquidity mining happens when a yield farmer acquires a new token along with the return of their initial investment for just the price of a farmer’s liquidity. As long as the platform keeps getting used, fees stack up, the value of the token goes up, and more people want to get in on the platform. This would, of course, push growth and offer a positive loop for people to work with.

Our previous examples of yield farming run on ideally normal conditions, but with Compound’s recent announcement of the COMP token, things have changed quite a bit. COMP aids in fully decentralizing the product by giving its patrons the token as a form of ownership. It’s their way of saying thank you to the people who have made them as big as they are today. It may seem like a very altruistic and philanthropic move, but the owners of Compound already own more than half the company’s equity. Putting out the tokens for people to earn shares would only drive a larger crowd into the platform, ultimately making the numbers and the stakes a lot bigger.

The token giveaway is automated on a daily basis until it runs out. These COMP tokens command the protocol in such a way that it provides democratic control to its owners. The tokens are given away through Compound’s monitoring of the money borrowed from and lent to the application. Compound then gives their patrons COMP tokens equal to the amount of activity they’re engaged in on the platform.

Truth be told, this changed the yield farming game entirely. It was simply too much money being given out through a DeFi application. Ever since the start of distribution on June 15, 2020, COMP tokens have gone for a minimum of $200. If you’re a wealthy investor with big capital to spare, you can easily maximize returns on a daily basis through COMP tokens, as if you were giving yourself free money.

Also read: Understanding the Pros and Cons of Ethereum Staking

People have since become creative at maximizing their profit through COMP tokens. But of course, it was never built to last. Despite all the creativity that has been put into staking yields and raking in tokens, the spike of interest would only last for four years. By then, COMP token distribution would cease, and people began looking for something else to put their money into. But still, four years is a long period of time, and anything can happen in that span.

For now, people are figuring out how to make the most money in this span of time. Funnily enough, other crypto companies have been following suit. Governance tokens have been coming out left and right, with Balancer putting out BAL, and bZx, Ren, Curve, and Synthetix also planning to create liquidity pools and rake in liquidity providers that will help propel their value upwards.

This year has truly become a defining year for DeFi projects, as more and more companies have been trying their best to put out governance tokens just so they won’t be left out of the race.

Will there also be DeFi for Bitcoin?

Well, if you’ve been living under a rock, it’s all actually on Ethereum. To be honest, the best returns will always come from Bitcoin, it’s just that it can’t be regenerative enough to perform mitosis on itself. It’s not for everyone to be smart enough to get returns on Bitcoin, as the risk will always be too high. DeFi, on the other hand, allows for this to happen, albeit indirectly. If you’re patient enough to move things around, you can simulate Bitcoin on Ethereum, create WBTC, take it to Compound, short the value of BTC, and easily get returns.

The level of risk

Actually, it’s just enough for you to try your luck at it. There is already too much risk at stake, and with so many complex systems in place, you’re probably better off with them.

Of course, failures are imminent and due to happen at times, but that’s part of living life outside the grid. The most beautiful thing about it is that people have found a way to decentralize currency, and that’s one step towards a better and brighter future.

Who are the key players in the DeFi governance market?

Moving forward, it seems like it would be logical for yield farmers to further the decentralization process by forming a DAO or anything that revolves around having a group of yield farmers do a co-op thing for the entire process. If anything, it has boosted the MC of Yearn Finance quite quick, and the same attitude and process can easily work the same miracle for other Automated Money Markets (AMM) or DeFi Money Markets.

If you’re looking to check out other AMMs or DeFi Money Markets aside from Compound or Uniswap in order to get a grasp of the competition and how it moves on a day-to-day basis, take a quick peek at these:

uniswap
uniswap

Uniswap (UNI)

Price
$ 29.47
compound-governance-token
compound-governance-token

Compound (COMP)

Price
$ 440.70
balancer
balancer

Balancer (BAL)

Price
$ 50.46
curve-dao-token
curve-dao-token

Curve DAO Token (CRV)

Price
$ 2.94

How-To Guide on DeFi Yield Farming

Now that you know what Decentralized Finance is, we begin to participate.