Yield farming has skilled a Cambrian explosion of kinds over the previous few months, thanks partly to the emergence of assorted decentralized finance protocols. In its most simple sense, yield farming will be considered a course of the place customers present liquidity to DeFi protocols and are rewarded with a yield/return, often within the type of the platform’s native token providing. 

The idea was first made common by Compound, which gave COMP tokens to customers who provided and borrowed tokens on the platform. The yield supplied is often excessive and serves as an incentive for customers to supply liquidity to bootstrap the monetary assets of a brand new DeFi protocol.

That being mentioned, this novel token distribution methodology has gained a lot traction just lately — partly as a result of the returns are so exorbitant — that quite a few copycat tasks, in addition to random protocols, have began to abuse this observe since sensible contracts for yield farming distribution are open-sourced, and there are a selection of environment friendly decentralized functions that may be copied by virtually anybody with the correct quantity of engineering experience.

Nonetheless, Bobby Ong, the chief working officer and a co-founder of CoinGecko — a cryptocurrency monitoring platform — believes that the excessive yields are non permanent and never virtually sustainable. He additionally believes that as extra folks change into conscious of the expertise and begin to present liquidity to numerous protocols, the rewards will change into more and more extra diluted with the typical yield ultimately being pushed down, including:

“Liquidity suppliers are rewarded within the type of the DeFi protocol’s native tokens. To obtain the precise yield in USDT, the liquidity supplier might want to promote the native token to USDT for instance, thereby driving down the native token worth and yield additional.”

The best way to reap the benefits of yield farming

When discussing the idea of yield farming, it’s important to grasp that there are three avenues by which one can harvest a yield — specifically cash markets, liquidity swimming pools and incentive schemes.

Cash Markets

Merely put, crypto house owners can earn a revenue on their present holdings by lending tokens by way of a decentralized cash market similar to Compound, Maker, Aave, and many others. Moreover, totally different platforms supply various return charges; for instance, Aave gives customers with each a variable rate of interest in addition to a hard and fast one. Nonetheless, in the identical vein, Compound gives its native COMP tokens as an incentive to each lenders and debtors. Whereas the steady rates of interest are extra profitable for debtors, lenders often choose variable charges.

Lastly, a singular facet of DeFi cash markets is that debtors are required to “over-collateralize” all of their loans. What this implies is that farmers must deposit extra money than they will really borrow in order that lenders don’t find yourself dropping their belongings in case an individual defaults on their funds. Merely put, the thought behind making use of an over-collateralized mortgage framework permits the lender to effectively keep the “collateralization ratio” always to keep away from liquidation.

Liquidity swimming pools

Liquidity is extraordinarily essential for many DeFi protocols as a result of it permits them to supply their purchasers with a hassle-free buyer expertise. From a monetary perspective, liquidity swimming pools supply customers higher returns when in comparison with cash markets however, on the similar time, come laden with sure dangers.

One of the outstanding examples of such a setup is Uniswap, an automatic market maker that provides customers with varied liquidity swimming pools that maintain two tokens every. Technically talking, every time a brand new pool is established, the person who first gives liquidity is the one who’s chargeable for setting the preliminary worth of the belongings within the pool. On this regard, it’s clear that if the preliminary token worth considerably deviates from international market costs, an arbitrage alternative opens up.

Additionally, liquidity suppliers are incentivized by native platform tokens to place in an equal worth of each tokens to the pool, such that their total ratio stays fixed at the same time as an growing variety of folks begin to add their tokens to the pool.

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Whereas Uniswap makes use of the fundamental aforementioned framework, platforms similar to Curve make use of a unique algorithm that provides customers extra engaging price charges in addition to decrease slippage throughout token exchanges. Moreover, Balancer allows customers to create liquidity swimming pools that may maintain a number of tokens — as much as eight — on the similar time.

Incentive Schemes

Yield farmers even have the choice to acquire returns within the type of incentives. For instance, DeFi platforms similar to Synthetix give liquidity suppliers SNX tokens in alternate for his or her work. Equally, Ampleforth permits customers to earn native AMPL tokens for his or her liquidity-related efforts.

Lastly, when it comes to how simple it’s to arrange a yield farm operation of 1’s personal, every part appears to boil all the way down to how a lot expertise the particular person has round crypto and DeFi tech. For instance, some yield farming methods are fairly advanced and require customers to own immense, in-depth information of assorted platforms, in addition to a stable understanding of the monetary and technological dangers concerned.

Thus, for much less superior customers, there are less complicated methods to partake in yield farming, primarily by platforms like Yearn.finance, the place all one has to do is deposit some tokens like Ether (ETH) or stablecoins and acquire the yield.

The grey areas

As issues stand, there at present exist quite a few yield farming tasks like Kimchi and Pickle that declare to be delivering income in extra of three,000%. Thus, it solely appears honest to delve into the questions of How is that this even doable, and is there a scammy ingredient hooked up to those schemes?

One of many primary the explanation why there are such excessive returns is as a result of the governance tokens related to platforms similar to Kimchi act extra like shares — i.e., they signify a declare on the long run earnings of the platform. Additionally, with most protocols distributing greater than half of their fairness price a whole bunch of thousands and thousands of {dollars} to liquidity suppliers, it’s actually no shock that terribly excessive returns will be achieved, at the least within the brief time period. Kris Marszalek, the CEO of Crypto.com — a crypto funds platform — advised Cointelegraph:

“Initiatives like Kimchi and Pickle are of a unique breed to extra ‘conventional’ platforms similar to Compound or Curve. The basic distinction right here is that they don’t have an present product that generates income to provide their token financial worth. As a result of these tokens derive their total intrinsic worth on guarantees of future earnings that will not materialize, they must distribute a a lot increased proportion of tokens inside a a lot shorter span of time in an effort to appeal to customers.”

Equally, Jason Lau, the chief working officer of crypto alternate OKCoin, additionally believes that these APY percentages are deceptive since these figures are often based mostly on an anticipated return, given the speed is sustained for a whole 12 months. He added that the present returns being supplied by platforms similar to Katana, Solarite and Kimchi are based mostly on a mixture of hype, restricted entry and hidden dangers, clarifying:

“The precise calculation of yield percentages will not be clear, and farming for any explicit reward typically solely lasts a couple of days to weeks, with tasks typically lowering the reward over time.”

Dangers concerned

There are a variety of main dangers related to yield farming. For starters, the annual proportion yield of most such platforms is commonly denominated within the reward token that’s being farmed — that are typically fairly unstable. Moreover, as soon as farming begins, there is a gigantic promote strain upon the reward token, and thus, the APY typically goes down shortly.

There’s additionally the problem of impermanent or divergent loss the place new tasks often reward those that present liquidity into AMM liquidity swimming pools, which require two totally different belongings. So, if the worth of the asset adjustments relative to the opposite, there’s a probability that customers incur some losses versus holding the underlying tokens outright. Offering his ideas on the topic, Joel Edgerton, the chief working officer of bitFlyer USA crypto alternate, advised Cointelegraph:

“Probably the most elementary danger is the software program code could possibly be flawed. It could not carry out as marketed or it could possibly be manipulated or hacked. These tasks are nonetheless very younger and haven’t stood the check of time or been stress examined. Additionally, despite the fact that these tasks declare the DeFi mantle, there are nonetheless single factors of failure, similar to the person who wrote the code may pre-mine the tokens, pump the worth, dump the belongings, and disappear with the cash.”

From a safety perspective, Lau believes that the sensible contracts making up most yield farming schemes are sometimes launched pretty shortly and thus stay unaudited. Because of this, there could possibly be an opportunity that these sensible contracts could possibly be susceptible to sure safety loopholes, both inadvertently, like seen with the primary iteration of the YAM token, or intentionally by the creator of the contracts.

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Not solely that, owing to the complexity of those protocols, even those who have had safety audits performed can nonetheless face points, like bZx. Lau added: “Many of those protocols are literally fairly centralized, with one or a handful of individuals making and executing selections.”

Ong additionally outlined that protocol builders can tempt customers with excessive yield to farm tokens — with a Uniswap 50/50 pool involving ETH — solely to then dump their tokens later. Equally, he additionally identified that builders could steal staked tokens as a result of relying on sure contracts, customers are generally required to ship tokens to a separate sensible contract, making the theft simple. Ong added:

“The yield supplied is given at a selected worth based mostly on the native token worth. When the worth of the native token drops, your yield could go down considerably as properly, and it’s possible you’ll not get the returns as supposed. Not solely that, the entrance finish could lie or cover sure data that’s totally different from the contract.”