Yield farming in the world of DeFi
An Insight into its mechanism and potential for retail investors
Decentralised Finance, commonly known as DeFi, refers to a financial system built on blockchain technology, particularly Ethereum, that aims to recreate and improve upon traditional financial systems and services. Unlike the centralised financial system, where intermediaries like banks, brokerages, and exchanges control financial transactions, DeFi operates on a peer-to-peer basis, eliminating the need for middlemen.
While the Crypto and NFT craze has noticeably cooled down, the innovation in DeFi has matured over the years with real world implementations creeping up slowly. What started with decentralised lending and borrowing platforms, followed by decentralised financial exchanges and Stablecoins, has gained user interest in newer DeFI services like Yield Farming
But what is Yield Farming?
Yield farming, often likened to staking, is a method where users provide or "lock up" their assets in a DeFi protocol to receive rewards. These rewards can be a result of interest from borrowers, fees generated by the platform, or even new tokens minted as incentives. The allure of yield farming is the potential for high returns, especially when compared to traditional financial instruments.
How does It work?
The process begins with liquidity providers (LPs) who supply assets to DeFi platforms. In return, they receive LP tokens, which represent their share in the liquidity pool. These tokens can then be staked or deposited in other protocols to earn additional rewards, creating a cascade of potential earnings.
For instance, consider a DeFi platform that allows users to lend or borrow assets. Lenders earn interest on their deposits, while borrowers pay interest. In a yield farming scenario, the platform might incentivise lending by distributing its native token to lenders. This means lenders earn both the interest from borrowers and the additional token rewards, amplifying their overall returns.
The technology behind yield farming
Smart Contracts
These are the backbone of any DeFi protocol. A foundational element of many blockchain platforms, Smart Contracts are self-executing contracts with the terms of the agreement directly written into lines of code. They offer a transformative approach to conducting transactions, ensuring that agreements are automatically and transparently executed once predefined conditions are met.
Originating from the vision of computer scientist Nick Szabo in the 1990s, smart contracts became a reality with the advent of Ethereum, a blockchain platform designed specifically to facilitate such contracts. Unlike traditional contracts, which require intermediaries like lawyers or notaries to enforce terms, smart contracts operate autonomously, reducing the need for middlemen and the potential for human error or bias.
Liquidity pools
In essence, a liquidity pool is a smart contract-based reservoir of funds, containing two or more tokens in a predetermined ratio. These pools facilitate trading by providing liquidity, ensuring that trades can occur without significant slippage, even if there isn't a direct buyer or seller for a particular trade.
Users, known as liquidity providers (LPs), deposit their assets into these pools and, in return, receive LP tokens. These tokens represent their proportional share of the total assets in the pool and can be redeemed for the underlying assets at any time. As trades occur within the pool, a small fee is typically charged, which is then distributed among the LPs, providing them with a return on their staked assets.
Oracles
At their core, oracles are third-party services that provide smart contracts with external information, bridging the gap between on-chain and off-chain worlds. Given that blockchains are deterministic and cannot natively access external data, oracles act as the eyes and ears for smart contracts, ensuring they can interact with real-world data.
Within the DeFi landscape, the utility of oracles is profound. For instance, lending platforms require accurate and timely price information to manage collateralization ratios and liquidations. Similarly, synthetic asset platforms, which allow users to mint tokens representing real-world assets, rely on oracles for accurate pricing. Yield farming strategies, which often involve intricate interactions between multiple protocols, also depend on oracles to optimise returns based on external data.
Governance tokens
In essence, governance tokens epitomise the ethos of DeFi by democratising protocol governance. They represent a holder's voting power within a DeFi protocol. By holding and sometimes staking these tokens, users can propose, debate, and vote on changes ranging from protocol parameters, fee structures, to future development directions. This decentralised approach ensures that the platform remains adaptive, transparent, and aligned with its users' interests.
They empower users to shape the platforms they use, ensuring that DeFi remains a truly community-driven and decentralised financial landscape. However, their effectiveness hinges on equitable distribution and active community participation
Token distribution is a critical concern; if a small group holds a majority of tokens, it can lead to centralisation of decision-making power. Additionally, voter apathy, where only a fraction of token holders participate in governance, can skew decisions in favour of a vocal minority.
So how can retail investors earn from yield farming?
Yield farming is interesting because it is a process where a retail investor can enter either as a borrower or a lender and earn from either role, and in some cases earn higher than the amount they borrowed!!
This is extremely unique because in traditional financial systems borrowers don’t have the ability to earn from the system
Lenders
Interest Rates
At the most basic level, lenders earn interest on the assets they supply to DeFi platforms. This interest is generated from borrowers who pay to borrow these assets. Platforms like Compound and Aave have dynamic interest rate models where rates adjust based on supply and demand for the asset. When demand to borrow an asset is high, lenders can earn a higher interest rate.
Liquidity Mining
Some DeFi platforms incentivize lenders to supply assets by distributing their native governance tokens as rewards. This practice, known as liquidity mining, means that lenders can earn two types of returns simultaneously: interest from their lent assets and the platform's tokens. These tokens can either be sold for a profit or held for potential future appreciation and governance rights.
Compounding
Many yield farming strategies involve reinvesting earned interest or rewards back into the platform, allowing lenders to benefit from compounding. Over time, this can significantly amplify returns.
Borrowers:
Token mining rewards
While borrowers pay interest on their loans, some platforms offer token rewards that can offset or even exceed the cost of borrowing. For instance, a borrower might pay a 5% annual interest rate on a borrowed asset but earn a 10% annual return in the form of the platform's tokens. This creates a net positive return for the borrower.
Leveraged yield farming
Borrowers can use their borrowed assets to enter leveraged yield farming positions. For example, a user might deposit Ethereum as collateral, borrow a stablecoin against it, and then use that stablecoin to enter a high-yielding liquidity pool. This strategy amplifies potential returns but also comes with increased risk.
Collateral optimisation
Borrowers can also optimise their collateral to earn returns. Platforms like Alchemix allow users to deposit assets, which are then yield farmed. The returns generated pay off the user's loan automatically over time, allowing borrowers to take out a self-repaying loan.
However, it's also essential to be aware of the risks involved in a yet to be mainstream financial system which has often fallen prey to computer networks hacks at a large scale.
Smart contract vulnerabilities
 If a smart contract has a bug or vulnerability, it can be exploited, leading to a loss of funds. It's crucial to engage with well-audited and reputable platforms.
Impermanent loss
In liquidity pools involving two different assets, the value of assets can change relative to each other. If one asset appreciates significantly more than the other, LPs can experience an "impermanent loss," where they might have been better off holding the assets rather than providing liquidity.
Market volatility
The value of reward tokens can be highly volatile. If a token's price drops significantly after being earned, it can erode the profitability of the farming venture.
High gas fees
Especially on networks like Ethereum, transaction fees (or gas fees) can be high, eating into potential profits, especially for smaller investors.
Yield farming offers an innovative way for retail investors, to potentially amplify their returns. The technology, rooted in blockchain and smart contracts, provides a transparent and automated way to engage with financial protocols. However, it's imperative for investors to understand the associated risks, conduct thorough research, and possibly consult with financial advisors before diving into the world of yield farming.
In my day job, I work for Google across a host of things. In my spare time, I write to learn and build products. You can follow me on Twitter/X at HacrkLife