Yield Farming

 

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.