What is Yield Farming?

October 27th, 2020

What is Yield Farming?

In simple terms ‘yield farming’ is what it sounds like, making a return on an existing crypto currency holding. You achieve that in the online world of DeFi ‘decentralized finance’ by lending out your crypto holdings (typically using EC-20 tokens on Ethereum) for a return, which is significantly higher than you’d expect from a traditional high street bank savings account. Not surprisingly this is particularly attractive at present when bank interest rates are so low historically, and these high yield farming rates are also offering tokens as an additional incentive. As David Cawrey explains in a recent Coindesk article, “Yield farming, simply put, is when cryptocurrency holders sock digital assets like bitcoin (BTC) and ether (ETH) or dollar-linked tokens like tether (USDT) and dai (DAI) into blockchain-based, semi-autonomous lending and trading platforms in exchange for additional tokens as rewards..yield farming offers a quicker and more lucrative way of making money than, say, parking extra dollars in a JPMorgan Chase savings account at a paltry 0.01% interest rate.” And because you are in charge of your funds, it is easy to move them around to look for the fund with the best yield.

To keep it simple, let’s focus on the lending of stablecoins such as Tether. The way it works is that the lender will go to a DeFi project such as Compound (a self -styled “algorithmic, autonomous interest rate protocol built for developers, to unlock a universe of open financial applications”) to lend to borrowers in return for interest, much like a traditional bank but with a few important differences. The first is that Compound’s popularity is down to the fact that lenders also receive a COMP token, an ERC-20 asset that powers the community governance of the Compound protocol, in exchange for their participation, which has shot up in value itself. On each and every day, the Compound protocol checks every user who’d lent and borrowed from it and rewards them with COMP tokens proportionate to their share of that day’s business activity. “If the Comp token appreciates — and it’s more than doubled in value since mid-June — your returns skyrocket as well..Supposedly, the holders of coins like Comp can participate in the governance and improvement of these networks. But the vast majority of people using them currently are speculators, trying to earn fairy-tale-like returns,” according to Bloomberg. The term ‘yield farmers’ is reserved however for those users who look for creative ways to maximize their returns.

It sounds like easy money, but there are risks involved for the individual investor. For one thing exchanges are built on code, not bricks and mortar, so there is always the risk that hackers can exploit code vulnerabilities and get away with your money. A second, more likely risk is that while currently the value of these new tokens are doing well, over the longer term they could easily lose value. No one knows for sure as it’s such a new market, so it’s wise to remain cautious. Indeed, there’s always the chance that in the longer run regulators like the SEC could decide to classify the reward tokens from platforms such as Compound as securities, which would have a significant impact on their value. Finally, as Bloomberg reported, “Many high-yield harvesting strategies also carry the risk of liquidation. To maximize returns, many users are adapting complex strategies. For example, some investors have been depositing DAI tokens into Compound, then borrowing DAI using initial tokens as collateral, then lending out the borrowed funds. The idea is to get a greater portion of the allocated rewards: Comp tokens. A move in the wrong direction in a token’s value could wipe out all gains and trigger liquidations.”

Despite these obvious concerns, in the new and volatile market of yield farming, there are grounds for optimism that in the longer run that such DeFi yield farming experiments, notably Compound, are here for the long haul. First of all compared to traditional banks which in the US before 1999 weren’t even allowed to cross state lines, there are still few global banks. But now with the blockchain infrastructure and the use of smart contracts using Ethereum, these decentralized platforms are global by nature, open 24/7, 365 days of the year. You can easily access your funds anywhere around the world, without the need for a bank branch to get permission to remove or transfer funds. That said right now with yield farming in its infancy it’s mainly the preserve of those who can manage the risk, or who have deep pockets. Whether it will become a financial tool for the mass of people who may have tried investing in bitcoin using their stimulus check remains to be seen. But watch this portion of the DeFi space, it’s certainly going to get interesting over the coming months and years!

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