DeFi has been the buzzword in the crypto industry for months now. In the aftermath of the black Thursday crash in March, which saw Bitcoin crashing below 4000 USD, many DeFi applications successfully launched their main nets, which drew a lot of attention to the emerging space. DeFi related tokens like Compound’s COMP, Aave’s LEND, Balancer’s BAL or Synthetix’ SNX have since yielded astronomic gains for investors. But what exactly is DeFi and how do DeFi protocols work? Learn about it in our new six-part blogpost series “Demystifying DeFi”. New articles coming daily! Today we will deep dive into the concept of yield farming, before finishing off our series with an overview of the DeFi ecosystem later today!
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A concept we have to recall from our last posts is the concept of automated market makers (AMMs). The core idea of the concept is having liquidity providers depositing their crypto-asset funds into liquidity pools that power decentralized marketplaces offering lending & borrowing facilities or trustless token swaps. Usage of such platforms by users may incur fees which are subsequently paid out to liquidity providers according to their share of the liquidity pool. Rewards are normally paid out in the form of either the tokens provided into the liquidity pool, or in many cases in the native token (often a governance token) of the underlying DeFi protocol.
So, what exactly can be deposited into these liquidity pools? Mostly USD-pegged stablecoins like DAI or USDT, but in many cases a wide variety of ERC-20 assets (either native assets or tokenized assets (WBTC) native assets is also eligible.
What adds additional layers of complexity, is the fact that in many cases, users receive a wrapped form of their deposit, e.g. on Compund iin thee form of cDAI, rpresenting the deposited DAI, which can then be used within another protocol that for example mints new tokens representing cDai the cDAI.
But how are DeFi returns calculated? Normally this is donne on an annualized basis. This basically means the estimated returns expect over course of a year. The two most common metrics used for that are the APR or APY. As the APR doesn’t take into account the effect of compounding (directly reinvesting profits to earn add return) while the APY does, the two terms are often (wrongfully) used interchangeably.
What’s important to keep in mind, is that as mentioned above, these measures of return are just estimations. Why is that the case? Yield farming is a highly competitive and quite fast-lived environment. Rates can fluctuate rapidly and heavily. If a specific farming strategy works, many farmers will jump to adopt the strategy, which in turn might cause said strategy to stop yielding high returns and hence lose its attractiveness. Amid the fast pace of DeFi daily or weekly estimated returns would therefore make more sense.
Another important term we need to recall is collateralization: To borrow assets on DeFi platforms you need to put up collateral to cover the loan amount, essentially acting as insurance for loan. The collateralization ratio (determining how much collateral has to be posted) depends on the protocol. It’s important for DeFi users supplying funds to keep a close eye on collateralization ratios, because if said ratio falls below the minimum collateralization ratio required by the protocol, users face (partial) liquidation of their as collateral assets. To avoid liquidation, protocols normally offer ways for users to add collateral if. The collateralization ratio is in jeopardy of breaching the required limit. DeFi platforms today commonly work with the concept of over-collateralization (deposit more loan amount) to reduce the risk of violent market crashes liquidating large amounts of collateral in the system within short periods of time.
Yield farming therefore is all but a simple endeavor as it is a highly sophisticated market. Moreover, due to the high risk involved and the currently very high gas fees on the Ethereum blockchain (which has by far the largest DeFi ecosystem), DeFi seems to be more suited to those with more capital to deploy and has therefore already been labelled a. “whale game” by many in the industry already, which is causing doubts about the sustainability of the current DeFi system.
The high risk involved in using DeFi platforms for activities like yield farming mainly (but not exclusively) stems from the risk of protocol bugs, smart contract failures and attack vulnerabilities which can lead to loss of user funds. As many protocols are largely unproven and DeFis resilience to attacks is to be proven yet as well, this risk is not to be underestimated, especially as there are increasing numbers of projects launching unaudited or only partially audited protocols.
A concept mentioned in our first post about yield farming and very well embodied by the DeFi applications we want to touch upon next, is the idea of composability. Ethereum-based DeFi applications very easily work together. This allows to build applications on top of existing protocols. One prime example for this is the concept of liquidity aggregators, often also referred to as yield farming platforms. The most prominent example for that is yEarn.finance, which has made headline news as its token has exploded in price, surpassing Bitcoin’s price per coin to reach highs of USD 40k per token, with YFI token currently trading at approx. USD 30k.
But why did yEarn.finance go through the roof? Well, the concept itself is as brilliant as it is simple. In simplified terms, you can think about liquidity aggregators as the robo advisors of yield farming.
Recall that successful yield farming strategies are often highly complicated and involves moving funds from platform to platform on a continuous basis in order to harvest the highest yields. With every platform having its own way of functioning and posing its own risks to users, the degree of sophistication needed to accurately assess the amount of risk involved in a certain strategy is well above the average Joe’s level of crypto-financial literacy. This causes high barriers of entry to the yield farming market, preventing the large majority of crypto holders from having the possibility to earn returns on crypto-assets.
These barriers of entry are exactly what projects like yEarn.finance are aiming to break down. So, lets dive into how they are achieving this: YearnFinance is essentially a liquidity aggregator for decentralized lending services (e.g. Aave, Compound) or decentralized Exchanges (e.g. Uniswap). So, instead of developing and executing a successful yield farming strategy, users deposit their funds into yVaults. Using algorithms, yEarn.finance then aims to optimize the returns on the locked assets by reallocating between the highest yielding liquidity pools. To do so, funds are converted into yTokens upon deposit and subsequently periodically rebalanced to maximize profit. yEarn.finance therefore is very useful for farmers who want a protocol that automatically chooses best strategies for them (just like a robo advisor would do in traditional finance), thereby making YF more widely accessible
So that’s basically how yield farming and yEarn.finance work. Stay tuned later today for a brief overview of today’s yield farming ecosystem!