Yield Farming
The world of decentralized finance (DeFi) is booming and the numbers are only trending up.
Where it started
Ethereum-based credit market Compound started distributing COMP to the protocol's users in June 2020. This
is a type of asset known as a "governance
token" which gives holders
unique voting powers over proposed changes to the platform. Demand for the
token (heightened by the way its automatic distribution was structured) kicked
off the present craze and moved Compound into the leading position in DeFi at the time.
The hot new term "yield farming" was born; shorthand for clever
strategies were putting crypto temporarily at the disposal of some startup's
application earns its owner more cryptocurrency.
Another term floating about is "liquidity mining."
What are tokens?
Tokens are like the money video-game players earn while fighting monsters,
money they can use to buy gear or weapons in the universe of their favorite
game.
But with blockchains, tokens aren't limited to only one massively
multiplayer online money game. They can be earned in one and used in lots of
others. They usually represent either ownership in something (like a piece of
a Uniswap liquidity pool, which we will get into later) or access to some
service. For example, in the Brave browser, ads can only be bought using basic attention token (BAT).
Tokens proved to be the big use case for Ethereum, the second biggest blockchain in the world. The term of art here is
"ERC-20 tokens," which refers to a software standard that allows token creators to
write rules for them. Tokens can be used in a few ways. Often, they are used as
a form of money within a set of applications. So the idea for Kin was to create a token that web users could spend with each other at
such tiny amounts that it would almost feel like they weren't spending
anything; that is, money for the internet.
Governance tokens are different. They are not like a token at a video-game
arcade, as so many tokens were described in the past. They work more like
certificates to serve in an ever-changing legislature in that they give holders
the right to vote on changes to a protocol.
So on the platform that proved DeFi could fly, MakerDAO, holders of its
governance token, MKR, vote almost every week on small changes to parameters
that govern how much it costs to borrow and how much savers earn, and so on.
One thing all crypto tokens have in common, though, is they are tradable,
and they have a price. So, if tokens are worth money, then you can bank with
them or at least do things that look very much like banking. Thus:
decentralized finance.
What is DeFi?
DeFi is all the things that let you play with money, and the only
identification you need is a crypto wallet.
If you have an Ethereum wallet that has even $20 worth of crypto in it, go
do something on one of these products. Pop over to Uniswap and buy yourself some FUN (a token for gambling apps) or WBTC
(wrapped bitcoin). Go to MakerDAO and create $5 worth of DAI (a stablecoin that tends to be worth $1)
out of the digital ether. Go to Compound and borrow $10 in USDC.
(Notice the very small amounts I'm suggesting. The old crypto saying
"don't put in more than you can afford to lose" goes double for DeFi.
This stuff is uber-complex and a lot can go wrong. These may be
"savings" products but they’re not for your retirement savings.)
Immature and experimental though it may be, the technology's implications
are staggering. On the normal web, you can't buy a blender without giving the
site owner enough data to learn your whole life history. In DeFi, you can borrow
money without anyone even asking for your name.
DeFi applications don't worry about trusting you because they have the
collateral you put up to back your debt (on Compound, for instance, a $10 debt
will require around $20 in collateral).
If you do take this advice and try something, note that you can swap all
these things back as soon as you've taken them out. Open the loan and close it
10 minutes later. It's fine. Fair warning: It might cost you a tiny bit in
fees.
Most people do it for trade. It's also good for someone who wants to hold
onto a token but still play the market.
What are pools?
Let's say there was a market for USDC and DAI. These are two tokens (both
stablecoins but with different mechanisms for retaining their value) that are
meant to be worth $1 each all the time, and that generally tends to be true for
both.
The price Uniswap shows for each token in any pooled market pair is based
on the balance of each in the pool. So, simplifying this a lot for
illustration's sake, if someone were to set up a USDC/DAI pool, they should
deposit equal amounts of both. In a pool with only 2 USDC and 2 DAI it would
offer a price of 1 USDC for 1 DAI. But then imagine that someone put in 1 DAI
and took out 1 USDC. Then the pool would have 1 USDC and 3 DAI. The pool would
be very out of whack. A savvy investor could make an easy $0.50 profit by
putting in 1 USDC and receiving 1.5 DAI. That's a 50% arbitrage profit, and
that's the problem with limited liquidity.
However, if there were 500,000 USDC and 500,000 DAI in the pool, a trade of
1 DAI for 1 USDC would have a negligible impact on the relative price. That's
why liquidity is helpful.
Similar effects hold across DeFi, so markets want more liquidity. Uniswap
solves this by charging a tiny fee on every trade. It does this by shaving off
a little bit from each trade and leaving that in the pool (so one DAI would trade
for 0.997 USDC, after the fee, growing the overall pool by 0.003 USDC). This
benefits liquidity providers because when someone puts liquidity in the pool,
they own a share of the pool. If there has been lots of
trading in that pool, it has earned a lot of fees, and the value of each share
will grow.
What is yield farming?
Yield farming is any effort to put crypto assets to work and generate the
most returns possible on those assets.
At the simplest level, a yield farmer might move assets around within
Compound, constantly chasing whichever pool is offering the best APY from week
to week. This might mean moving into riskier pools from time to time, but a
yield farmer can handle risk.
In a simple example, a yield farmer might put 100,000 USDT into Compound.
They will get a token back for that stake, called cUSDT. Let's say they get
100,000 cUSDT back (the formula on Compound is crazy so it's not 1:1 like that
but it doesn't matter for our purposes here).
They can then take that cUSDT and put it into a liquidity pool that takes
cUSDT on Balancer, an AMM that allows users to set up self-rebalancing crypto
index funds. In normal times, this could earn a small amount more in
transaction fees. This is the basic idea of yield farming. The user looks for
edge cases in the system to eke out as much yield as they can across as many
products as it will work on.
Is there DeFi for bitcoin?
Yes, it's on Ethereum.
Nothing has beaten bitcoin over time for returns, but there's one thing bitcoin can't do on its
own: create more bitcoin.
A smart trader can get in and out of bitcoin and dollars in a way that will
earn them more bitcoin, but this is tedious and risky. It takes a certain kind
of person.
DeFi, however, offers ways to grow one's bitcoin holdings – though somewhat
indirectly.
How risky is it?
"DeFi, with the combination of an assortment of digital funds,
automation of key processes, and more complex incentive structures that work
across protocols – each with their own rapidly changing tech and governance
practices – make for new types of security risks," said Liz Steininger of Least Authority, a crypto security auditor. "Yet, despite these risks, the high
yields are undeniably attractive to draw more users."
We've seen big failures in DeFi products. MakerDAO had one so bad in 2020
it's called "Black Thursday." There was also the exploit against flash loan provider bZx. These things do break and when they do money gets taken.
Right now, the deal is too good for certain funds to resist, so they are
moving a lot of money into these protocols to liquidity mine all the new
governance tokens they can. But the funds – entities that pool the resources of
typically well-to-do crypto investors – are also hedging. Nexus Mutual, a DeFi insurance provider of sorts, told CoinDesk it has maxed out its available coverage on these liquidity applications. Opyn, the
trustless derivatives maker, created a way to short COMP, just in case this game comes to naught.
And weird things have arisen. At one point, there were more DAI on Compound than have been minted in the world. This makes sense once unpacked
but it still feels dicey to everyone.
That said, distributing governance tokens might make things a lot less
risky for startups, at least for the money cops.
"Protocols distributing their tokens to the public, meaning that
there's a new secondary listing for SAFT tokens, [gives] plausible deniability
from any security accusation," Zehavi wrote. (The Simple Agreement for Future Tokens was a legal structure favored by many token issuers during the ICO
craze.)
Whether a cryptocurrency is adequately decentralized has been a key feature of ICO settlements with the U.S. Securities
and Exchange Commission (SEC).
(There are precedents for this in traditional finance: A 10-year Treasury
bond normally yields more than a one-month T-bill even though they're both backed
by the full faith and credit of Uncle Sam, a 12-month certificate of deposit
pays higher interest than a checking account at the same bank, and so on.)
As this sector gets more robust, its architects will come up with ever more
robust ways to optimize liquidity incentives in increasingly refined ways. We
could see token holders greenlighting more ways for investors to profit from
DeFi niches.
Whatever happens, crypto's yield farmers will keep moving fast. Some fresh
fields may open, and some may soon bear much less luscious fruit.
But that’s the nice thing about farming in DeFi: It is very easy to switch
fields.
