What is yield farming? How Yearn and others are generating outsized returns for its users through decentralized finance.

Introduction

The DeFi ecosystem is full of promising new products that seek to upend the traditional financial system and at the very least, permanently change the way we look at financial products moving forward. Perhaps one of the most compelling aspects of DeFi are the incredibly alluring yields generated by dozens of platforms.  While some may dismiss these products and their associated yields as “too good to be true” so far these platforms pay out over USD 1 billion per day to “yield farming” participants without any signs of slowing down.  We estimate that 95% of the USD 41.5 billion total value locked (TVL) in DeFi is attributed to yield farming.  In this article we explore what yield farming is, and how DeFi makes this possible.

What is Yield Farming?

Yield Farming is a term used in decentralized finance to describe the act of lending or staking cryptocurrencies on a platform in exchange for earned interest or yield on that token.  This is made possible because there’s a counterparty on the other side of the transaction that pays to borrow the tokens loaned, or to perform an exchange of cryptocurrencies.

Because of the decentralized nature of DeFi, there are no centralized wallets or entities that provide seed capital, therefore all cryptocurrencies supplied into DeFi platforms are supplied by lenders and liquidity providers.  Thus, such DeFi platforms are simply software-based brokers, that help facilitate certain financial transactions in exchange for a small fee.  In order to incentivize cryptocurrency holders to lend their funds onto these platforms, they pay fees based on a dynamically updated yield, which is a function of the counterparty demand.

As an example, lending and borrowing platforms like Compound adjust the APY on a cryptocurrency based on the demand from borrowers.  If, for example, very little DAI is deposited on the platform, and the amount of borrowed interest is high, say 90% of the total available, the platform will increase the APY to DAI lenders based on a bonding curve. This encourages lenders to deposit DAI to earn the increasingly higher interest.  In doing so they are participating in yield farming.

Background

There are three major ways yield farming is performed in the DeFi universe. There are also a few important concepts to understand before we describe how yield farming works.

Smart Contract – all forms of yield farming revolve around a smart contract, basically a blockchain program that can warehouse cryptocurrencies and perform certain actions on them based on how they are programmed.  This is an important concept, since DeFi platforms have no human intermediaries and are operated entirely by these software programs.  Smart contracts are where funds are deposited into. They become locked while warehoused in these smart contracts and can only be unlocked with a one-of-a-kind key.

Proof of ownership – when you deposit funds at a bank, you might get a deposit slip as proof of that deposit.  On DeFi platforms when you deposit cryptocurrencies, you receive a special IOU token that is emitted by the smart contract.  This token goes by various names depending on the protocol (cToken on Compound, yToken on Yearn, LP share on Uniswap) but becomes a digital representation of your holdings and acts as a key to unlock the depositor’s funds.  These tokens are completely transferrable and are not tied to any specific wallet or person.  Anyone who possesses the unique cryptographic “key” can send it back to the smart contract that generated it and claim the holdings originally deposited to generate it.  This how DeFi  platforms are composable.

Now we can get into how these platforms work.


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How Does it Work?

We discussed a previous example of how they work in a lending protocol like Compound. There are at least two other methods in which yield farming is achieved.  One is performed when a liquidity provider deposits a token pair such as DAI and ETH, into a smart contract called a liquidity pool.  These pools typically exist on specialized decentralized exchanges called Automated Market Makers.  Uniswap, Curve and Balancer are all versions of such an exchange. The pools essentially allow traders to swap tokens by depositing one token into the pool and getting the proportionate amount of the other in exchange. They pay a small fee to execute the transaction, which then gets distributed into the entire liquidity pool. This fee is where the yield is earned by liquidity providers.  Based on this, we can infer how a more active pool will generate more fees on behalf of its liquidity providers.

Case Study: Yearn Finance

Arguably one of the best representations of yield farming occurs through aggregators like Yearn Finance.  Yearn works by automatically allocating a contributor’s funds across multiple platform’s pools (such as Compound and Aave) in order to maximize the yield earned. As we learned, the realtime supply and demand of a particular pool dictates its yield.  In fact, due to inefficiencies in the cryptocurrency markets, the yield for an identical DAI pool on Compound might be higher than in Aave, allowing for arbitrage.  It is possible to see double digit APY swings in the course of a 24-hour period in some of these pools.  Yearn works like an on-chain hedge fund, by actively tracking a basket of different pools and then depositing, locking, unlocking, retrieving and then moving said funds to the pool with the highest yield.  It does so programmatically and autonomously as frequently or infrequently as needed to achieve this.

This approach enables yield farming to generate the maximum possible yield based on a given strategy.  Yearn employs a dozen or so strategies depending on the cryptocurrency contributed and risk tolerance of the participant.  It does so in a completely permissionless and anonymous way – no information is collected, and all redemptions are performed exclusively with the yToken generated by the Smart Contract.  Contributors always receive their redemptions in the original cryptocurrency they deposited in.

So far, Yearn’s strategy has paid off.  According to tracking website CoinMarketCap, Yearn’s platform currently generates a yield of over 20% for each of the three stablecoins on its platform – DAI, USDC and TUSD, with TUSD earning 25.10% annually.

Achieving Yield

For the traditional investor, such yields seem “excessively high”, especially as interest paid on cash and fixed income products are substantially lower in today’s market.  As the decentralized finance market is still relatively young, liquidity is still in a state of development and growth. As such, the borrowing demand for cryptocurrency assets is substantial relative to the supply.  Therefore, borrowers are willing to pay more to borrow cryptocurrencies, and

thus lenders in yield farming are being paid more than comparable assets in traditional finance.

As an example, in a traditional brokerage account, shorting a stock is a relatively straightforward transaction, which involves borrowing the positions from the brokerage on margin, and covering the short with repurchased securities at a later time.  In the cryptocurrency space, the same transaction is not so straightforward, especially since many of the popular cryptocurrencies are extremely scarce, with a large majority sitting in cold storage wallets for long-term holding.  In order to encourage these large holders to make their holdings available for lending, borrowers are willing to pay relatively high rates, which has, incidentally, resulted in DeFi’s rapid explosion.

In addition to this, DeFi apps scale very well relatively to the assets they manage.  Since they operate entirely programmatically, there is little cost differential to scale to millions, hundreds of millions or even billions of dollars in locked value.  This cost savings is passed to yield  farmers, especially as DeFi apps have no holdings or liquidity of their own, they must incentivize participants to contribute to their ecosystem in order to function.

Risks

Yield farming is not without risks.  The sometimes exorbitant returns price in this risk.  For example, some projects can inflate the yield by introducing a short-term multiplier, where the project pays out an additional multiple of tokens to incentivize staking. Since the project owner may hold a large portion of the created tokens, they can pay these out to early token stakers. Since one must initially purchase and possess these tokens in order to stake them, the increased yield has the benefit of attracting greater demand for their token, which in turn drives the price up, providing more value for each token paid out in the yield.  However, as with any monetary system, continued issuance of a currency will put inflationary pressure on the token, which may eventually counteract the short-term price movement.

Beyond these token economic risks, there are other risks such as smart contract risks and scam risks.  DeFi projects rely exclusively on smart contracts to power their platforms.  These smart contracts are designed, architected and built by blockchain developers with varying levels of expertise and experience. Some teams are large and well capitalized, providing cross-coverage, code review processes and the ability to hire an external auditor.  Other teams are small, with a single developer that may have limited experience.  It’s sometimes easy to evaluate a list of projects with an assumption that they all function without issue.

However, there have been cases where smart contracts have been exploited to the detriment of the project.  Case in point, large yield farming project, Harvest, which has USD 350M in TVL, lost over USD 24M through an exploit of its software code.

For as long as crypto has existed, scammers have not been far behind. DeFi projects are particularly susceptible to certain types of scam risks that can be avoided through the additional scrutiny that centralized entities are capable of performing.

As an example, scammers employ a popular spoofing attack in which they create a token with the same symbol as a prominent project but with a different contract address, and then list this token on a DeFi platform like Uniswap.   The goal here is to get unsuspecting participants to perform swaps in these pools. These participants trade real Ether (ETH) in exchange for a fake token with a symbol that is identical to a legitimate project.

Other scammers promote seemingly credible projects with attractive yields, that result in a substantial contribution of assets by yield farmers, only to “rug pull” these pools and deplete their funds, leaving the yield farmers with little to nothing.  As DeFi projects are often created by anonymous developers, tracking funds down can be next to impossible.

Summary

The implications of DeFi yield farming are significant.  On popular DEX PancakeSwap, yield farmers can earn in the hundreds of percent annually in liquidity pools with millions of assets deposited.  In fact, the current yield for the CAKE-BNB liquidity pool is 117.52% APR, which is a substantial pool consisting of USD 534M in liquidity.  With respect to Yearn, so far there are no similarly accessible financial product equivalents in traditional finance, and none that generate over 20% return on USD equivalent assets.  While interest rates around the globe are at all-time lows, and yield has been increasingly elusive, DeFi yield farming is an incredibly alluring proposition that is already successfully challenging yield-based products in traditional finance.  With over USD 38 billion in deposited value in the DeFi ecosystem, yield farming is something that is likely to continue gaining exposure in traditional investor’s portfolio.