DeFi Yield Farming Explained / How Yield Farming Works
The goal of this article is to enlighten you on all matters DeFi. Here you will learn its concepts such as yield farming, liquidity mining, and the genesis of DeFi. You will also learn of the different perspectives of industry experts on this topic.
DeFi has been the craze in crypto for the better part of 2020. While Bitcoin and other projects have lagged, DeFi projects have been going parabolic. The excitement around DeFi has a lot to do with FOMO and the nature of the space. The FOMO around it is reminiscent of ICOs when most investors rushed into ICOs and triggered the 2017 rally. Similarly, when the year started with DeFi projects outperforming the market, investors jumped in, creating a self-reinforcing loop. The excitement around DeFi also has a lot to do with the potential for non-speculative profiteering. In DeFi, you can make money by lending with interest, a process that is known as yield farming. You can also make money by borrowing to take advantage of profitable opportunities. These are opportunities that have drawn many to DeFi after several years of holding crypto without many gains. The DeFi space is also being driven by the growth of blockchain solutions that make borrowing and lending without an intermediary possible. Decentralized oracles such as Chainlink have been entirely instrumental on this front.
What Is Yield Farming?
Yield farming entails lending crypto through a decentralized pool in the hopes of increasing one’s crypto holdings. DeFi and its related concepts, such as yield farming, can be directly attributed to the launch of the ERC20 standard in 2015, which paved the way for the development of complex smart contracts. The ERC20 standard is the brainchild of Ethereum developer Fabian Vogelsteller. Not only did his innovation open the way for the ICO boom of 2017, but it also laid down the groundwork for DeFi. However, the implementation of DeFi and the start of yield farming is more related to the launch of a project called Compound (COMP) that was launched in 2017 with the backing of significant crypto players like Coinbase. Compound opened the DeFi space through an algorithm that autonomously calculates interests, allowing developers to build a wide array of financial applications. Rather than let crypto lie idle in a wallet, it offered investors a way to make money by joining pools and earning interest by lending. A yield farmer on Compound can choose a pool with the most gains and grow their crypto holdings over time. The project also introduced a governance token called COMP, which is one of the most revolutionary in crypto. Through the comp token, investors can determine things like yield rates, among other governance issues. Since then, more projects have come up in the DeFi space, and it keeps growing. Some of the key names behind Compound that are influential to the growth of yield farming are as below:
- Robert Leshner (CEO)
- Geoffrey Hayes (CTO)
- Torrey Atcitty
- Calvin Liu (Strategy Lead)
- Coburn Bery (Senior Engineer)
- Jared Flatow (Senior Engineer)
- Jayson Hobby (Head of Design)
- Max Wolff (Software Engineer)
- Mykel Pereira (Software Engineer)
Many other people have been instrumental to Compound and the growth of DeFi and yield farming in general. As more developers enter the space, so has the development of the number of projects where investors can earn a profit by lending.
Why is DeFi Hyping Now?
There is a lot of hype around DeFi at the moment, and this is evident in the increased mentions of the same on Google trends. For instance, the terms DeFi and Yield Farming have been gaining in searches over the past 12 months and peaked out in September. Similarly, the amount of Ethereum locked up in DeFi has been on the rise over the past year. All this excitement around yield farming has a basis in crypto trends post-2017 and the nature of DeFi.
The crypto bubble burst in December 2017 left the market in very dull territory. This means that the average crypto holder has not made much from HODLing both Bitcoin and altcoins. DeFi and the concept of yield farming gave lots of crypto investors an alternative way to make money in crypto without having to rely on speculation. In the early days, only crypto diehards made money from yield farming, but as word spread, the number of people doing it increased. Over time, this created FOMO and triggered the massive Bull Run that the DeFi space has experienced since the start of the year.
The Nature of DeFi
By its nature, yield farming is quite attractive to crypto investors. That’s because it allows investors to earn money by lending at rates that are unmatched by any centralized financial entity. This makes it attractive to investors who are looking for a way to earn a passive income in crypto. This has seen big players enter the DeFi space and further drive the positive momentum and add to the overall upside momentum.
The Borrowing Opportunity
The ability to borrow without background checks has also been instrumental to the rise of DeFi. When it comes to lending on DeFi, one only needs to over collateralize to eliminate the risk of default on the lender. At the same time, it offers investors a chance to make money through trading. One of the biggest uses of crypto borrowed in DeFi is arbitrage. This entails taking advantage of differences between crypto prices on different exchanges to make money before repaying and keeping the difference as profit.
How the Yield Farming Works
Yield farming is relatively easy to understand, even to someone new to crypto. As mentioned earlier, yield farming is simply about lending crypto to earn more crypto. The first step to start yield farming is to find a DeFi project with acceptable interest rates, then get involved. Since all DeFi projects are Ethereum projects, you first need to buy Ethereum, then transfer it to your DeFi project of choice. Breaking it down, here is how to make money in DeFi.
- Buy Ethereum and store it in a wallet like Atomic Wallet.
- Send Ethereum to a DeFi project of your choice.
- Join a pool and start lending.
Once you get involved in DeFi, you will come across the term liquidity mining a lot alongside yield farming and many others. So what exactly is liquidity mining? Simply put, liquidity mining is the process of lending crypto to provide liquidity to a pool. The pool gains liquidity to keep growing, while the token holder earns interest in the token they are lending. When doing liquidity mining, the lender also benefits by taking part in the projects’ governance that they are involved in mining. To better understand DeFi meaning, one needs to look at a major DeFi project like Compound concerning DeFi mining. When one locks in their assets in Compound, they get an annualized income and also get a certain number of COMP tokens. By holding these tokens, one is then in a position to take part in the governance of the project.
On top of that, one can liquidate their tokens for Ethereum and grow their holding. Liquidity mining is set to keep growing because it plays some critically essential functions in DeFi. Some of the most important tasks of liquidity mining are as below:
One of the key differences between DeFi projects and traditional financial organizations is in their source of liquidity. While conventional finance organizations have access to capital from central banks, DeFi projects do not have this luxury. While the founders and their backers can fund the initial part of it, they may not sustain it as the project grows. This leaves liquidity mining as the only sustainable way to grow. When investors lock in crypto hoping for gains, the project can unlock a pool of liquidity that makes it possible to lend to a possibly unlimited number of people and compete with traditional finance.
It Helps in Price Discovery
Liquidity mining also helps in price discovery in the DeFi space. As investors lock in crypto and liquidity grows, the rate of crypto exchange through lending and borrowing also increases. The result is that the actual value of the project is revealed. This is beneficial to the projects and the investors holding the project tokens.
What Are The Risks of Liquidity Mining?
The Risk of Getting Liquidated
One of the most significant risks in DeFi is that you can get liquidated if the contract malfunctions. An excellent example of such a malfunction relates to Compound in June 2020. At the time, there was a malfunction in the pledge rate settings, and investors lost thousands of dollars.
Like every other financial system, there are systemic risks when it comes to DeFi. One of these risks is pushing the limit of the collateralized debt position. This can lead to a collapse in the entire system and cause losses to investors. While there are safeguards against such, it is always a risk that can materialize and was evident when Compound (COMP) made changes to its mining system in Mid-2020. This created a surge in demand for DAI and led to an unhealthy increase in the collateralized debt position.
Perspectives and Takeaways
As DeFi grows, industry experts have weighed in on its development. In July, the head of trading at NEM stated that,
“The recent boom in the DeFi market follows the well-documented innovation adoption curve. Growth for an innovation, in this instance DeFi, is largely led by technological advancements, followed by capital and regulatory growth. Therefore, the overall growth of the space or ‘development’, is a function of usership, technological and regulatory growth, and capital. At its core, DeFi is providing a means of decentralized lending, lenders earn a yield and the loan is secured by some amount of collateral in the form of a token. That being said, DeFi is still very much in its infancy, with the infrastructure and processes still in the experiment phase – this was proven by the recent YAM finance collapse which recently fell 90% in value due to a bug in its code.”
Another industry professional that has weighed in on DeFi recently is Vitalik Buterin. While most people are bullish on DeFi, Vitalik is calling for caution. In a tweet in early September, he stated that,
“Seriously, the sheer volume of coins that needs to be printed nonstop to pay liquidity providers in these 50-100%/year yield farming regimes makes major national central banks look like they’re all run by Ron Paul.”
These opinions by industry experts offer important pointers on the future of DeFi, and everything about it, such as yield farming and liquidity mining. One important takeaway is that DeFi is a groundbreaking innovation with the power to change society and reward investors’ big time. However, it poses risks, mainly due to the greed for extraordinary gains by investors. Therefore, for it to thrive, there needs to be a balance between the need to grow the space and the urge for exponential gains in the short-term.
Where to Manage DeFi Tokens
There are many wallets where one can store and manage their DeFi tokens. In this crowded space, Atomic Wallet stands out for its superiority in terms of security and variety in listed DeFi tokens. When using Atomic wallet, you have full control over your private keys. The wallet also gives you access to hundreds of tokens, which means you have the opportunity to profit from as many projects as possible. The team is also planning on adding its native AWC token to the yield farm. This will further open up opportunities for DeFi investors.
FAQs about DeFi
What is Yield Farming?
Yield farming entails lending crypto through a decentralized pool in the hopes of increasing their holdings.
What is Liquidity Mining?
Liquidity mining is the process of lending crypto to provide liquidity to a pool.
What Is The Best Wallet for DeFi?
Atomic wallet is the best for DeFi. It gives the user full control over their tokens and also has quite an array of DeFi tokens.
Yield farming entails lending crypto through a decentralized pool in the hopes of increasing crypto holdings due to the development of enabling technologies such as decentralized oracles. The underperformance of crypto HODLNG has also driven it since 2018. DeFi Space is also driven by a wallet such as Atomic wallet that is safe and supports several DeFi projects.