Seriously, what is Yield Farming?
Yield farming is a method to harness idle cryptocurrencies such as coins, tokens, stablecoins, and put those assets to work in a decentralized finance fund. These often generate interest rates that range between conservative 0.25% for less popular tokens and above 142% for some MKR loans (makerDAO token.)
There is no guaranteed passive income from DeFi lending or staking. The actual returns depend on each protocol’s path. The risks of not receiving the perceived returns could be caused by slow transactions, market volatility or even losing your whole collateral.
In trying to understand what Yield Farming is, we can compare it to traditional finance. A central bank issues money to commercial banks; the commercial banks then lend that money to businesses and individuals. Banks profit from levying interest rates on these loans.
A Yield Farmer, in the DeFi economy, acts as the banker in traditional finance. The Yield Farmer lends their funds to boost the adoption and use of coins and tokens. This means that any cryptocurrency owner can hold their own funds while also taking part in the lending activity. This will generate returns for the lender and increase the flow of value within the decentralized ecosystem.
Just as regular farmers plant, fertilize, and plough a crop then reap the harvest yearly, Yield Farming refers to reaping a high annual percentage gain while providing liquidity or various projects. Yield Farming resembles “Staking Coins” in that the user remains in control of their assets but keep it locked it in a temporary exchange for the returns.
Yield Farming has gained popularity with cryptocurrency enthusiasts and investors alike. It is often advertised as providing conjectural “swift gains” in the wake of high risk.
Is Yield Farming risk worth the reward? We should take a look at the mechanics so we can understand what it is and how it functions.
Yield farming is a relatively new concept within the Decentralized Financial (DeFi) ecosystem, and the term became popular jargon in the cryptocurrency world in 2020.
DeFi is a copy of the traditional finance system; however, one BIG difference is that DeFi is completely decentralized. DeFi has no legal hassles or third-party intermediaries thus a no-barrier entry to risk exposure.
DeFi developed from one of the use cases for the Ethereum Protocol. The prospect for cheap and borderless transactions accelerated the creation of startups which attempted to copy banks and other financial institutions. DeFi has spread out in many directions to include novel cryptocurrency trading, Algorithms, derivatives trading, margin trading money transfers, and of course the popular lending markets.
Largely because of two enormous projects – Maker DAO and Compound, Decentralized Cryptocurrency lending (DeFi) entered the phase of functional maturity.
The Celsius Network and BlockFi have combined cryptocurrency lending and cryptocurrency interest accounts into a single user-friendly platform. These two companies are leaders in an industry where offering more than 6% on BTC and 8.6% on stablecoins like USDC and USDT is considered to be the industry standard.
There are other projects which are aspects of DeFi and Yield Farming such as trading projects and decentralized exchanges. These projects use the liquidity from Yield Farming for trading. Check out Bancor, Augur and UniSwap to read more about these.
How Yield Farming Works
Yield Farming depends on the inflow and outflow of DAI (an anchor asset) which is dollar-pegged that originated with the Maker DAO protocol. As of August 2020, DAI is backed by ETH or BAT deposits and is used for loans, arbitrage or algorithmic trades. The system is more predictable by using the DAI dollar peg. This sets an automatic value for each token of $1. Yield Farming depends on the collateral of ETH or another token, which are used for loans and to generate passive incomes.
Follow these Steps:
- Add the Meta Mask plugin on Brave or Chrome Browser and create an Ethereum account.
- Ensure you save your seed phrase – write it down and save in a few secure areas.
- DeFi user locks in the Coins of Choice, using the Meta Mask ETH account.
- Once funds are locked in, the wallet will communicate with a smart contract on the Ethereum Network.
- Depending on the logic of the Smart Contract, value is extracted. The more traditional way is to levy an interest rate.
- Users must pay fees to transact on the ETH network.
- Due to the popularity of use, fees may rise quickly.
- The network may even be too congested to participate successfully.
ETH prices dropped sharply in mid March of 2020 creating a perfect storm of market panic. This triggered multiple algorithms on the Maker DAO platform. Ethereum network slowed down transactions, not allowing the owners to increase their collateral. Multiple deposits (known as vaults) were liquidated, and DAI lost its dollar peg briefly.
The 150% over-collateralization CAN help to offset risks partially and projects like DeFi Saver can automatically increase collateral to stave off liquidations. When the minimum collateral requirement breaks down due to price volatility, liquidations start happening.
It is important to note: DeFi is inclined to work better when asset prices are rising. For example: if ETH prices were to drop by 33%, this would liquidate most deposits on Maker DAO. Smaller price fluctuations also mean that holding ETH may, in the long run, be more profitable than Yield Farming.
Please let’s not make a new ICO bubble out of DeFi.Said Alexander Ivanov, founder of the WAVES protocol.
Ivanov was comparing DeFi to the market frenzy for Initial Coin Offerings. However, he is still optimistic about the future of DeFi. He was concerned and was only warning against another bubble due to unreasonable enthusiasm.
There is a marked difference in ICO and Yield Farming. Coins CAN be taken out of DeFi protocol almost any time; however, participating in an ICO means exchanging ETH or BTC for a new token.
The new token could then only be changed back by trading it once it was listed on an exchange. With DeFi, tokens can be immediately liquid as they are paired on the UniSwap exchange. (a decentralized, automated trading protocol)
What about the safety of Coins when doing Yield Farming?
Any type of Cryptocurrency trading/investing exposes you to risk.
You either have the stomach for it or you do not. It is important to know this before you delve!
In DeFi, the lender is always in control of their funds, as operations happen in automated smart contracts and do not require the oversight of third parties. Unlike token sales, a person can withdraw their collateral at almost any time.
However, smart contracts can dictate how and when you can withdraw your collateral, so be aware of what you’re getting into. And in particular during the cases of liquidation.
What are the Risks of Yield Farming?
There is always a risk involved when you lock your funds away in vaults and employ smart contracts. Smart contracts exploits, which abuse the logic of the smart contract to generate high returns and liquidations, pose major threats to collateralized funds. Another BIG risk is the peg of the DAI stablecoin, which MUST retain its $1 peg. To break this peg would decrease the value of the loans and create panic selling, and they would quickly lose liquidity.
The boom of DeFi brought a multitude of untested protocols. These included untested smart contracts which malfunctioned. For instance, the YAM DeFi protocol brought in nearly $300 million, but due to faulty smart contract behavior thousands of billions of extra tokens were printed. Other projects also released untested smart contracts, which may ultimately result in loss of funds.
.A MAJOR concern is a more recent development: Compound (COMP) DeFi fund is showing more than 1.3 Billion DAI in its lending and borrowing markets. This is while there are only around 421 Million DAI coins created (this is as of August 14, 2020.) This results in a debt bubble Yield Farmers have created in the process of lending; giving an artificial circulating value to DAI, amplified by Yield Farmers.
This situation may put serious pressure on the DAI dollar peg. Serious fallout would be expected in the case of liquidations. As of August 2020, rapid growth in Compound DeFi has boomed due to greed and prices.
What are the Best Projects for Yield Farming
Maker DAO was one of the first successful attempts at Cryptocurrency lending. The initial volume of capital was drawn in by lending DAI backed by ETH.
Compound followed closely with a similar lending platform. Compound further evolved beyond the lending platform, and it created its own incentive COMP token. A massive growth followed in the DeFi funding program between July and August of 2020 when the number of funds in Yield Farming doubled from around $2 Billion to above $4 Billion.
Maker DAO and Compound competed for the #1 spot in DeFi based on their well-known brands and locked value. In algorithmic trading terms, such projects as Augur, Bancor and dy/dx remain popular in that crypto space.
Not really Yield Farming per se, but decentralized lending platforms BlockFI and Celsius provide impressive returns of APY upwards in the range of 8.6% on stablecoins without all the complications of Yield Farming outlined here. So, if that is your cup of tea, you may want to look into those.
Conclusion – How does the Future look for Trade Farming?
Some things tend to occur very quickly in the cryptocurrency world and the rise in popularity of Yield Farming seems to have forayed into the mainstream from out of nowhere.
If a person were obliged to predict the future of Yield Farming, they should critically look at all potentialities – both positive and negative – to reach a conclusion.
On the one hand, Yield Farming could activate idle tokens and potentially create a passive income for holders.
On the other hand, it’s wise to consider the negative possibilities which range from price crashes or exploits that manage to trick smart contracts and reap gains from collateral. Since DeFi isn’t regulated, it isn’t covered with the protections that come with centralized financial institutions.
Since DeFi are not considered securities, the US security and Exchange Commission has not taken any divisive actions against them.
Some of the Yield Farming projects are well established and draw in the most collateral, and new DeFi algorithms enter the scene regularly. Some DeFistartups use copied, unaudited smart contracts, and these pose a risk—Namely, the YAM Yield Farming project which has recently crashed and took some of the market collateral with it.
The WAVES platform expanded into the DeFi world in August of 2020. WAVES brought with them a long list of ICO tokens that were repurposed for various forms of DeFi such as BAT, LINK, 0x, and Kyber Network. For a complete list, look on CoinGecko.
So, it seems that Yield Farming is a mercenary-like approach to the cryptocurrency world where risk-takers seek out the highest yields and thus cause token price volatility in their wake. (sounds vaguely like the HYIPs from earlier years)
Many DeFi projects are still in their Nascent phase and can be a bit hard to understand. This doesn’t seem to stop newcomers from rushing in to grab a share of the pie. The BEST advice for readers is to do your own research into what each platform has to offer and don’t lock in any funds you cannot afford to lose.