Even if you are new to the crypto community, you’ve probably heard the term DeFi thrown around once or twice. As a quick recap, we abbreviate ‘decentralized finance’ to the term DeFi. Put simply, DeFi is a set of standard financial tools. These tools all have their foundation on the Ethereum blockchain. Since it is based on the blockchain, there is a level of anonymity that remains in each transaction. To identify the users of this platform, the blockchain will include crypto wallet ID’s. The use cases for DeFi continue to grow and have since become many in number. However, DeFi has taken on a whole new meaning in DeFi Yield Farming.
This might sound like a complicated process. But, we want to assure you that isn’t the case. That’s why we put together an overview of the top DeFi protocols and some of the trends surrounding this latest craze. Like all investment opportunities, we want to take this time to advise you we are not professional financial advisors. Therefore, after reading this article if you believe that yield farming is for you, you should continue to do your own research. We recommend doing this prior to putting any of your hard-earned savings on the line.
DeFi Yield Farming Defined
In addition to the term “DeFi yield farming”, you might also see liquidity mining pop up. Please note you can use these terms interchangeably since they mean the same thing. The term yield has come up, in relation to farming. On a farm, the measure of yield refers to the total amount of crop that’s grown. Yield farming terminology has since been adopted by DeFi. As a result, it can be referred to as the amount of interest that’s grown on top of underlying crypto assets. This means investing in Ethereum (ETH) alone does not classify as yield farming. However, lending out your Ethereum to earn additional returns on top of the natural growth in the value of the Ethereum coin is yield farming.
What is a liquidity provider?
In traditional financial markets a liquidity provider (LP) is financial institution that acts as a middleman in the securities markets. They strive to sure that the assets their customers want access to have sufficient liquidity. In DeFi, a liquidity provider can be anyone in the crypto community. As with legacy LPs, defi liquidity providers perform tasks that ensure an asset people want to trade has sufficient liquidity and movement by pooling and holding (“staking”) crypto resources to benefit the protocol.
Yield farms are for the crypto community members to ‘harvest’ by staking coins that the decentralized community can benefit from in the form of loans, payouts, airdrops and other community led actions. Naturally, with yield farming there’s always the chance of generating a higher rate of return. In some cases, this has amounted to over 100% of what an investor would earn in a classic savings account. This is possible since DeFi yield farming compounds returns by utilizing leverage to gain additional exposure to various crypto assets collateralized with USD-backed stablecoins. One of the ways to farm DeFi yields is through defi money markets. One of the most popular being Compound (COMP).
DeFi Yield Farming Takes on a New Meaning with COMP
Compound is one example of a DeFi lending and borrowing protocol. We can also associate its name with creating the buzz around yield farming. This is because the yield farming craze started shortly after the distribution of its governance token in June. Coincidence? We think not. As a lending protocol, a user might then decide to lend capital on one of these money markets to earn a return on DeFi. By depositing a stablecoin, you can earn returns almost immediately. These returns, however, are only significant since you also receive earnings from secondary coins like COMP. While it is competitive with a few token holders competing for the limited supply of tokens, the added incentives increase the investor’s potential for return, making it a worthwhile endeavor.
Compound continued to gain popularity with this new governance token. At the simplest level, a yield farmer might move assets around within Compound, constantly chasing whichever pool is offering the best returns from week to week. This might mean moving into riskier pools from time to time. While this sounds like a complicated tactic, most yield farmers have already decided that they are willing to handle this risk. Additionally, this tactic requires that users maintain the appropriate collateral in their accounts. As a precaution, too little collateral results in account liquidation.
Compound is now one of the largest (if not the largest) DeFi project. Their governance token, COMP now has the largest market cap of any DeFi token. The coin continues to be distributed as a means for users to participate in Compound’s 9 different markets. This token also gives users the ability to vote on the future of decentralized protocols and share new ways for DeFi founders to entice new assets onto their platforms.
Strategies To Make The Most Out Of Yield Farming Strategies
To further increase user’s earnings, some yield farmers have decided to take out leveraged loans. These loans can then be used to borrow the tokens which yield the most COMP. This is because the 2880 COMP tokens that are issued each day are distributed to those with the most leverage. Therefore, more collateral to leverage means you will earn more free money. To easily get started and use this strategy, check out the InstaDapp smart wallet project.
Other investors have shown that the rates to borrow USDT are reasonably low. This makes for an opportunity to borrow and lend back this stablecoin. However, this is not always the case. Therefore, to make the most of this strategy, investors will recommend monitoring the rates and switching when better opportunities are offered.
Higher APY returns are most often the result of new protocols. This means it can be wise to take advantage of early adopter incentives. Protocols are less efficient at this stage since their strategy is to expand their network at this stage. That said, you should weigh this against picking a coin that shows long-term growth potential. Taking advantage of new protocols is a strategy that only works if you are earning a token that will be worth something one day.
Other Yield Farming Opportunities
Another platform you might consider trying out is Balancer. The native token of Balancer is BAL. It can be earned when users provide liquidity to Balancer Pools. The contents of each pool can be reviewed and compared before adding liquidity. One reason for this currency’s popularity is that of 100 million BAL to be minted, 65 million have been allocated for liquidity provider rewards. This works out to 145,000 BAL per week or 7.54 M per year.
We’ll be the first to admit Compound, the company that has become all the rage, wasn’t the first to introduce yield farming. Rather Synethetix came before with an sETH to ETH liquidity pool. The pioneer of liquidity incentives is actually Synthetix. The idea with this protocol was for liquidity providers to get a regular annual percentage yield (APY). This is in addition to SNX (Synthetix network token) incentives. To earn SNX, the most common strategy is for traders to add liquidity to the sETH/ETH trading pool and then stake Uniswap sETH LP tokens on Synthetix’s platform.
Additionally Aave, UMA, and Curve are also set up to launch their own forms of yield farming. This means it is not too late to start! To keep up to date on some of the best yield farming opportunities, Tony Sheng has shared some great content on his Twitter.
Cautions of DeFi Yield Farming
While other investment avenues offer steady returns. DeFi is much riskier. This is because yield farming does put your investment up against liquidation risks and smart contract risks. The interest rate returns on COMP also fluctuate quite frequently as well. While earnings are good now, It is believed that COMP won’t continue to earn the same returns forever. This has led many to take riskier positions to earn more profits now. Since the incentives issued now can be considered artificially driven demand, it is hard to say if this will set the path for consistent long-term growth. This means when incentives begin to hit the decline, farmers might also begin to leave.
This means similar to other investment opportunities, the risk you will be willing to take on will be dependent on your comfort levels, and your goals. Therefore, even among yield farming options, there are more and less risky options. For those who consider themselves risk-averse, money markets are a great option to earn lower-risk interest. Alternatively, if you can handle a little more risk, a liquidity pool might be a great opportunity to increase your earning potential. This is believed to be the best strategy if you are holding onto a high quantity of crypto holdings.
Finally, you will only profit using this strategy if you have a lot of funds to put on the line. Without it, yield farming might actually cost you. This is especially true if you have less than $1000 worth of crypto.
The Future of DeFi Yield Farming
We’ll let you in on a little secret. At this stage, it is hard to say for certain what the future of DeFi Yield Farming really looks like for users. Many continue to believe that this concept will continue to push towards increased user adoption and more users considering the concept of being “unbanked.” Time will certainly tell in this fast moving industry!