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 cover the basics of yield farming before deep diving into the concept tomorrow and finishing off our series with an Overview of the DeFi ecosystem on Sunday!
Basically, yield farming simply refers to the generation of yield from lending crypto funds to others via smart contracts. Smart contracts are programs that run on blockchain protocols. So, in return for providing funds, yield farmers earn return in the form of some cryptographic token (or multiple tokens in some cases).
But while the basic concept quite simple, yield farming in practice is not that easy. Successful yield farmers deploy complicated strategies, continuously moving funds between different lending platforms to maximize returns. In some sense, yield farming has become a wild west, with platforms offering astronomical returns on deposits and yield farmers consequently competing for the best crops.
But let’s get into the details of yield farming and look at what kickstarted the boom. In doing so, we will also touch upon the common TVL metric. Tomorrow we will also cover widely used return measures and the risks involved in yield farming, as well as explaining the concept of popular yield farming projects like yearn.finance, which are trying to make yield farming accessible to anyone.
To quickly recall, DeFi dApps are permission-less, open for anyone or anything with an internet connection and a supported wallet. Decentralized finance is trustless, meaning no centralized intermediary is involved, which. Users have to put their trust in. Through this unique property, decentralized finance has enabled new use cases for crypto-assets.
Yield farming is the poster-child of these use cases, being an innovative, new way of earning passive income using permission-less liquidity provision protocols.
As most DeFi applications run on the Ethereum blockchain, they all seemlessly work together. This feature, also referred to as composability, is one of the key strengths of the Ethereum DeFi ecosystem.
So, back to yield farming. The concept originally evolved around the question “why leave funds laying around if u can put to work?”, which mainly refers to crypto-assets held by long-term HODLERs, that have no actual use for the asset in their wallet. Yield farming has also been referred to as liquidity mining. As mentioned above, this means locking up crypto-assets in smart contracts, which in turn provide liquidity to power decentralized exchanges like Uniswap, Balancer or decentralized lending platforms like Compound.
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In the way crypto-assets are locked up, yield farming or liquidity ming is similar to staking on proof of stake blockchains. But instead of locking up assets n order to take part in the consensus mechanism of a blockchain network, therefore adding to the security of the network, in yield farming users merely provide liquidity to smart contracts called. Liquidity pools. These liquidity pools are the live blood of many other decentralized finance protocols. Depending on the underlying protocol of the smart contract where a user stores his funds in, he is rewarded in a certain cryptographic currency. Some protocols even pay liquidity providers in multiple reward tokens. In most cases, yield farmers deposit the rewards directly into other liquidity pools, in order to maximize farming returns.
While today yield farming is almost exclusively done using ERC20 tokens on the Ethereum blockchain, this may very likely change in future. Increasing innovation in the DeFi interoperability space like REN and WBTC bringing Bitcoin to the Ethereum ecosystem or interoperability projects like Polkadot and Cosmos, aiming to create a network of interconnected blockchains are important steps towards building a decentralized financial system composed of chain agnostic protocols with cross-chain value exchange and scalability gains realized through the implementation of multiple transaction layers.
But what sparked the immense interest in the DeFi space this year? Firstly, it’s important to note that many DeFi projects have years of development by highly reputable teams behind them. In this regard, the current DeFi frenzy sharply differs from the 2017/18 ICO bubble, with which DeFi has so often been compared lately. With many DeFii protocols successfully launching their main nets this year, it was really the launch of the Compound protocol and the introduction of the COMP token model, which started the yield farming fueled DeFi hype.
The interesting thing about Compounds token model is that COMP is a such called governance token. Governance tokens give voting rights to token holders. Token holders therefore essentially own and control the underlying protocol. These tokens normally also offer a reward function yielding high returns in the form of some sort of staking model. It was Compound, whose launch gave this token-based governance model a boost in popularity.
The most prominent metric in decentralized finance is total value locked (TVL). This metric measures how much crypto is locked in the smart contracts of a decentralized finance platform like a DEX or lending protocol. It’s a useful index to measure the strength of a project to attract liquidity from investors and the most popular metric in the ecosystem to evaluate the market share of DeFi projects. The meaning of the metric with regards to yield farming activity is simple. The more value is locked in a protocol, the more yield farming going on.
Stay tuned tomorrow for the second part of our introduction to yield farming, where we will explain what liquidity aggregators like yEarn.finance are all about!