DeFi and Yield Farming Boom
- Yield Farming Allows You to Make More Cryptocurrency Through Using Your Existing Cryptocurrency
- Yield Farming Can Be Traced All the Way Back to 2017
- The Compound Protocol With Its Governance Token Comp Brought Yield Farming to Fame
- Yield Farming Typically Favors the Ones With a Lot of Capital
When we discuss the latest boom in the world of cryptocurrencies Yield Farming, we are essentially talking about the process where you can earn a return on your capital by putting it to use. More specifically, money markets can offer a simple way through which you can earn reliable yields on your crypto which is being put through good use, where the liquidity pools have better yields than money markets. They do however have a higher level of risk involved with them.
Before we take a deeper look inside the world of yield farming, we’ll need to get a few fundamentals out of the way.
Crypto tokens are cryptocurrencies that represent an asset or a use case on a blockchain and they can be used for investments or to store value, or even make purchases. They are the digital currencies that facilitate transactions through the blockchain and have many uses, such as fee reduction when trading, or governance power. All of this will depend on the blockchain you will pick.
These tokens can be created through an initial coin offering, and they can represent the cryptocurrency variation of an initial public offering. They are created by the companies behind the projects in order to help them get a bit of capital, where the investors who are interested in the company itself are presented with the ability to purchase the token.
Decentralized Finance or DeFi on the other hand is intended to use technology as a way to remove any intermediaries between two parties, specifically throughout financial transactions. The components of DeFi are stablecoins, as well as a software stack that enables the development of apps. DeFi projects are financial services without a central authority, and they invoke taking traditional elements found in a financial system while replacing the middleman through using smart contracts.
Yield Farming: An In-Depth Look
You might have recently been hearing a lot about yield farming, well, this is the process through which people can earn fixed as well as variable interest through investing cryptocurrencies in a DeFi market. Investing in ETH, for example, is not yield farming, and lending out ETH for a return beyond the price appreciation can be.
Yield farming has been commonly referred to as a process through which you can make your crypto do the work for you, however, it has only been efficient if you have a considerable amount of funds, to begin with.
At its core, Yield Farming is a process that allows cryptocurrency holders to lock up their holdings, and this gives them rewards as a result. You lock up your funds, and you are provided with rewards by deciding to do so.
What happens is that your funds are being lent out through different DeFi protocols, and you can earn variable or fixed interest as a result of doing so. The rewards are much greater than the ones achievable through FIAT currencies but have higher risks associated with them due to the fact that, well, the cryptocurrency market is quite volatile.
Most of the time you will see that Yield Farming is actually done through the Ethereum network.
To truly get a grasp of why DeFi and Yield Farming had such a boom in recent history, we need to compare it to the traditional loans conducted with FIAT money on real-world banks.
You see, when you take a loan in a traditional bank with FIAT money, you’ll need to pay back the amount you were lent out with interest.
When you analyze yield farming, you will find that the process is quite similar, where cryptocurrencies that would otherwise just sit at an exchange, being on some user’s balance sheet without any function, can now be lent out through various DeFi protocols and can even be locked in smart contracts in order to start doing some work and generating returns.
This is a process that is carried out through ERC20 tokens and the rewards are a form of the same token.
Let’s take a step-by-step look at how all of this works so you can see how simple it actually is.
- You add funds to a liquidity pool which are smart contracts that contain the funds and the pool powers a marketplace where the people using it can exchange, borrow or lend out tokens.
- You become a liquidity provider as a result of completing the previous step.
- Since you have just locked your funds in the pool, you will generate rewards through fees that occur on the DeFi Platform.
To summarize, to lend ETH on a decentralized, non-custodial money market protocol with the intention of generating returns through the fees that end up occurring is yield farming.
The best part about this is the fact that you can even deposit the token rewards you receive to another liquidity pool, and have access to multiple passive money streams as a result.
As a liquidity provider, you can deposit funds in a liquidity pool, which are stablecoins linked to the USD most of the time. The returns you will get are highly dependent on the amount you invest and the rules of the protocol, however, most of the time, the higher your initial investment the higher the returns you end up getting. You can also create multiple money streams by just re-investing the rewards token into another pool.
Each yield farming protocol offers its own set of benefits and drawbacks, and its main intention is to offer you incentivized lending as well as borrowing from liquidity pools.
The most popular yield farming protocols include Compound Finance, AAve, MarkerDAO, Synthetix, Curve Finance Uniswap, Balancer, and Yearn.Finance.
Yield farmers will end up using extremely complex strategies in order to get the most out of their investments. They move their cryptos around all the time between different lending marketplaces in order to maximize their returns.
They will also be extremely selective when it comes to the strategies they implement.
The Yield Farming Boom
If we really look into it, we can trace yield farming all the way back to 2017. It is at this point in time where DeFi began to exponentially grow.
The project MarkerDAO and DAI essentially managed to create the foundations for the first-ever DeFi system that allowed for this type of practice, and this was due to the fact that DAI enabled the ability to offer credits with low volatility risks. You see, at this point in time, in the market, many traders were borrowing to buy Bitcoin as well as other cryptocurrencies that started rising in value. This meant that anyone who invested in tokens such as Maker, MarkerDAO’s governance currency, and DAI, within platforms such as AAve, had their profits essentially assured.
However, it was towards the end of 2019 and the start of 2020 where yield farming reached its maximum level of expression due to the fact that the Compound protocol entered the scene with its governance token COMP.
Investors essentially put money into their liquidity pools and brained profits on their investments. These profits came from two points. The first was through the interest of the loans which were made by the platforms through the usage of the funds from the said pool. The second was through the governance tokens that could be earned through participating in the platform as a reward. You can even re-invest these tokens in another pool as an additional method of earning funds in certain protocols.
Compound is one of the main reasons why yield farming sky-rocketed in terms of popularity, and it initiated the yield farming boom.
Collateralization in DeFi
Whenever you borrow assets, you will need to put up collateral in order to cover your loan. This acts as insurance for your loan.
If the collateral’s value falls below the threshold by the protocol, your collateral has the potential of being liquidated on the open market. To combat this, you simply need to add more collateral.
Each platform will have its own set of rules that need to be followed, and this is its own required collateralization ratio.
You will notice that most of them work with a concept known as “over-collateralization”, and this essentially means that borrowers have to deposit more value than they want to borrow to reduce the risk of market crashes that might end up liquidating a large amount of collateral within the system itself
The Pros and the Cons of Yield Farming
Pros:
- Yield farming can be carried out with different targets, protocols, and strategies.
- Investors can harvest a lot of money this way and re-invest it to generate even higher profits. This is a strategy that favors the biggest contributors.
Cons:
- You do require advanced financial knowledge in order to actually see positive returns.
- You require a large amount of capital in order to get the most out of yield farming.
Summary
DeFi and Yield Farming have gained a lot of popularity throughout the past few years, and things do not look like they are slowing down.
(Source: DeFiPulse)
According to CoinMarketCap, the top DeFi tokens by Market Capitalization are:
- Uniswap (UNI)
- Chainlink (LINK)
- Wrapped Bitcoin (WBTC)
- PancakeSwap (CAKE)
- Terra (LUNA)
- Aave (AAVE)
- Maker (MKR)
- Avalanche (AVAX)
- Dai (DAI)
- Compound (COMP)
Remember that DeFi protocols are fully permissionless and can seamlessly integrate with one another. The entire ecosystem of DeFi is reliant on these blocks, and this is why they can work together well. If one of the building blocks of DeFi ends up breaking, however, the whole ecosystem has the potential to suffer due to this. This means that yield farmers aren’t really only reliant on the protocol they pick, but all of the others it relies upon.