Intro to DeFi Yield Farming: Crypto’s Hottest Trend
Let’s catch you up a bit on Decentralized Finance (DeFi). Basically, DeFi allows its supporters and users to have complete control of their assets through peer-to-peer (P2P) decentralized applications (Dapps). The movement strives to decentralize the crypto market even further, giving users the ability to move currency around without a governing body controlling them like an invisible hand.
Decentralized Finance isn’t something completely new in the cryptocurrency scene. The craze started back in July 2017, and the numbers don’t seem like they will be going down anytime soon, even with initial coin offering (ICO) going head to head with it.
With roughly $110 billion liquidity locked in DeFi, the whole DeFi philosophy has proven to be a worthy challenger of traditional financial systems. Many crypto users have repurposed their investments to maximize the benefits of DeFi applications, all thanks to Compound’s COMP governance token, which introduced the use of yield-generating pasture.
These governance tokens allow crypto users to control decentralized protocols through voting, giving them a sense of control through some form of democracy. This fairly new process built by DeFi founders attracts crypto users to their assets like moths to a flame.
Funnily enough, a pseudonym was formed for the group of people who have been supporting crypto liquidity, and that was how yield farmers and DeFi yield farming were born.
- Start of something new
- How tokens work
- A clearer definition of decentralized finance
- The capital in building a DeFi application
- What are pools?
- How much do people earn from being liquidity providers?
- What exactly is yield farming?
- How did yield farming take off?
- Will there also be DeFi for Bitcoin?
- The level of risk
- Who are the key players in the DeFi governance market?
Start of something new
Let’s take a look at DeFi yield’s genesis to further understand what’s going on.
June 15, 2020 heralded the start of Compound’s distribution of the COMP governance token to their users who support their Ethereum-based credit market. Logically enough, the demand for these governance tokens shot up instantly despite automatic distribution being utilized for the first time ever. This easily put Compound at the forefront of the world of DeFi.
The buzzword “yield farming” is when someone implements a strategy that concerns putting crypto into startup applications for a given period of time in order to yield higher returns once withdrawn.
It’s actually not that far from the concept of “liquidity mining,” with both terms creating a lot of noise in the community.
How tokens work
Not to get all geeky on you, but tokens are like an in-game currency one can collect while traversing a particular path to defeat monsters and bosses. This currency can be used to easily upgrade items in order to make your player stronger and more formidable as a game progresses.
If you transfer this terminology to the world of crypto, the tokens you collect from a certain “game” are not exclusive to that game; they can be applied elsewhere. Of course, the “game,” as a figure of speech, pertains to blockchain technology.
The thing is, tokens seemed to get more exclusive in the long run. This is where ERC-20 tokens come in, which allow for universal use depending on one’s specific preferences. This sub-currency’s functionality sparked an interest in creating tokens that don’t feel like you’re spending them to move them around.
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Fast forward to governance tokens—these tokens actually break away from the norm, as they do not easily equate to video game tokens or previous blockchain tokens.
Governance tokens are “certificates” that allow their owners to tweak the legislature of a certain protocol through voting.
Much like all tokens in the world of crypto, these currencies have a price equivalent and are viable for trade as the owner sees fit. This kind of functionality offers the need to have a bank-type system, which is where decentralized finance kicks in.
A clearer definition of decentralized finance
Long story short, Decentralized Finance allows people to move money around like it’s a game, with the only capital residing inside your crypto wallet.
Let’s say you have an Ethereum wallet worth $20. You can easily use that balance to move around applications and swap currencies flawlessly as if you were borrowing money from a friend.
In the real world, you would have to provide certain information about yourself before you’d be able to purchase a home stereo, for example. With DeFi, you can borrow money without anyone knowing who you are. DeFi applications don’t care about who you are because they probably have double the collateral than what you owe them. That’s the magic to it right there.
Once you’ve tried playing around with DeFi applications, you can see how everything can easily be reverted as if nothing ever happened. But of course, tread lightly. The systems in place here are more complex and allow for a larger room for error if you get too overconfident.
If you don’t go at it carefully, there are small transfer fees that you may overlook, and the unpredictable rise and fall of Ethereum may mess you up.
So what do these DeFi applications get when you keep borrowing money? To cut to the chase, they can profit from the falling price of tokens and easily manipulate and hold onto several other tokens to their liking.
The capital in building a DeFi application
Usually, startup applications promote their DeFi product to attract investments from HODlers with idle assets. Simply put, borrowing money from users allows for better liquidity than taking the money of VCs and debt investors.
For example, Uniswap controls a portion of the crypto market, as it is one of the largest decentralized exchanges that facilitates purchases, sales, and swaps of any cryptocurrency. Uniswap works in a way that a market pair of any two tokens can be traded for one sought-out token, making it a straightforward and convenient tool for users to acquire currency. T
These pairs are built around pools. Since the application takes its roots from a network of combined assets, users have better control of the ebb and flow of token prices since they have access to a sea of tokens.
What are pools?
Nope, you got it wrong. There’s no water here. But here’s where it all actually gets interesting.
Uniswap takes two tokens of the same value and pairs them up to form a pooled market pair. Now, there needs to be a balance of deposits and withdrawals within the two tokens so that their values are proportional, 1:1.
Every time there’s an imbalance, a wise enough investor may opt to balance it out. For example, let’s say we have a 1a:3b market pair. If the investor decides to deposit 1a, he would get 1.5b in return, balancing everything out.
With the 50% arbitrage profit, investors can quickly maximize the use of limited liquidity. However, it’s worth noting that the same functions wouldn’t work with a market pair with big numbers and investors moving only small amounts.
This is also possible because of liquidity. To optimize liquidity for the market, most startup apps charge small fees between trades to offer liquidity and subsequently grow the share for liquidity providers within a given pool.
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With the increase in liquidity, the shares of liquidity providers in the pool are directly converted into a token deposited in their wallet. And yes, they can sell, trade, or use it for another product.
How much do people earn from being liquidity providers?
Quick answer: not much, but definitely more than you would if you put your money into a bank.
But of course, these numbers are only high because DeFi is riskier than putting your money into a savings account. You’ll never know when you can actually profit or if you should just stomach the loss, especially when the value of cryptos and tokens vary so drastically.
With rewards constantly going up and down, some people aim to maximize their investments in DeFi to make a living off of it eventually. These individuals dream of a life without a 9 to 5.
This group is what we call yield farmers.
What exactly is yield farming?
To not beat around the bush: yield farming is when you make the most out of your crypto assets by finding and playing with the best interest rates on the market, then putting your tokens to work in these pools.
Now for the long answer: yield farmers like to move their assets by following the most profitable pools on a weekly basis. It’s well-known yield farmers often play with risky pools like it’s a cakewalk. But that’s the thing about them – risk is pretty much their middle name.
The act of farming easily opens up new price arbitrage, spilling over into other protocols in which their tokens are in the same pool the farmer is currently invested in.
For example, a yield farmer may opt to put a certain amount of crypto into a DeFi app. They would get another token instead of their crypto, and under normal circumstances, they’d be able to withdraw the same amount they deposited. The yield farmer would then take that token of the same value to a liquidity pool.
When taken to another crypto exchange, the yield farmer could earn profit through transaction fees. It’s all a numbers game.
This is what yield farming is all about: yield farmers constantly look for currencies and liquidity pools that may bring bigger numbers every time they transact. What makes yield farming less of a pain is DeFi’s universal approach.
How did yield farming take off?
Liquidity mining occurs when a yield farmer acquires a new token along with the return of their initial investment for the price of a farmer’s liquidity.
As long as the platform continues experiencing an influx of users, fees stack up. And when there’s more liquidity from fees, the token’s value goes up, and more people want to get in on the platform. This would, of course, push growth in the exchange, thus forming a win-win situation for both the company and the user.
Our previous examples of yield farming run on ideal conditions, but with Compound’s recent announcement of the COMP token, things have changed quite a bit. COMP aids in fully decentralizing its product by giving its patrons the token as a form of ownership. It’s their way of saying thank you to the people who have made them as big as they are today.
It may seem like a charitable and philanthropic move, but the owners of Compound already own more than half the company’s equity. Releasing tokens for people to earn a share would only drive a more extensive crowd into the platform, ultimately making the numbers and the stakes bigger and better.
The token giveaway is automated daily until it runs out. These COMP tokens command the protocol in a way that provides democratic control to its owners.
Tokens are airdropped according to the money moving into the platform and being lent out to users. Compound gives their patrons COMP tokens equal to the amount of activity on the exchange. Not too hard to understand, right?
Truth be told, this changed the yield farming game entirely. There was simply too much money being given out through the DeFi application. Since the start of distribution on June 15, 2020, COMP tokens have gone for a minimum of $65.90.
If you’re a wealthy investor with cash to spare, you can easily maximize your returns on the daily through COMP tokens, as if you were giving yourself free money.
Savvy farmers have become creative at maximizing their profit through COMP tokens. But of course, it was never built to last. Despite all the creativity put into staking yields and raking in tokens, the spike of interest will only last four years.
By then, COMP token distribution will cease, and people will begin looking for something else to reap the rewards. But still, four years is a long time, and anything can happen in that span.
For now, people are figuring out how to make the most money in this timeframe. Funnily enough, other crypto companies have been following suit. Governance tokens have been coming out left and right, with Balancer putting out BAL, and bZx, Ren, Curve, and Synthetix also planning to create their own liquidity pools.
2020 has truly become a defining year for DeFi projects, as more and more companies put their best foot forward and released governance tokens left and right. It’s only a matter of time before we’re swamped with COMP-like tokens.
Will there also be DeFi for Bitcoin?
As aforementioned, DeFi originated on Ethereum, and it is by far the largest ecosystem for decentralized applications. But, to be honest, the best returns will always come from Bitcoin; it’s just that it can’t be regenerative enough to perform mitosis on itself.
It’s not for everyone to invest in Bitcoin, as the risk will always be too high. But if you don’t care about the risk, listen to this: DeFi can simulate Bitcoin on Ethereum, albeit indirectly. If you’re patient enough to move things around and well-educated on the matter, you can create WBTC, take it to Compound, short the value of BTC, and earn a pretty penny.
The level of risk
After you’ve learned more about DeFi and are confident about yield farming, go ahead and try your luck at it. But, be warned: there is still a tremendous amount of risk, and you’re likely to suffer from the consequences at first.
Of course, failures are imminent and will happen at times, but that’s part of living life outside the grid. The most beautiful thing about DeFi is that people have found a way to decentralize currency, and that’s one step towards a better and brighter future.
Who are the key players in the DeFi governance market?
Moving forward, it seems like it would be logical for yield farmers to further the decentralization process by forming a DAO or democratized organization.
If you’re looking to check out other DeFi exchanges aside from Compound or Uniswap, take a quick peek at these:
How-To Guide on DeFi Yield Farming
Now that you know what Decentralized Finance is, we begin to participate.