Decentralized Finance is a megatrend in the Blockchain space and may grow even more in the future. In particular, a look at invested capital shows that more and more investors are choosing to invest in at least one DeFi application.
However, DeFi is just an umbrella term that hides numerous subfields – one of these subfields is Yield Farming. But even though the interest in Yield Farming is growing limitlessly right now, investors keep asking themselves what Yield Farming is.
In this article we show where the term yield farming comes from. In addition, we will use different DeFi tokens to illustrate how yield farming works in practice.
What is meant by yield farming?
Basically, yield farming is based on the principle of opportunity costs and can be illustrated quite nicely using the example of agriculture. A farmer cultivates a wide variety of crops on his farm throughout the year. The harvest, which is decisive for the success of the farmer, follows only after several months of hard work.
But as soon as the harvest begins, farmers talk about yields. Of course, the yield is directly related to the crop grown. The higher the yield for a fixed input, the higher the return achieved. In English, yield is also referred to as yield and is thus the second relevant component of yield farming.
Accordingly, it should now become clear what is behind yield farming. The farmers in the crypto space are the investors who invest their coins in different platforms to earn maximum returns.
“Yield farming is an investment strategy for the DeFi market that allows people to earn a fixed or variable rate of interest.”
In direct reference to the crypto market, this means that yield farmers are people who measure their personal return in terms of interest earned. This results from investing assets like Ethereum with a DeFi platform like Aave invest.
Why is there hype around yield farming?
The hype around yield farming is based on the high demand for DeFi solutions. After all, yield farming is one of the current DeFi trends and enjoys high relevance among crypto investors. Earlier this year, we identified DeFi as one of the relevant market trends in blockchain technology.
In this regard, investors have already identified DeFi as a trend last year. The trend around Yield Farming, on the other hand, has emerged in recent months. Since the COVID-19 crash, the DeFi market has developed at a rapid pace, captivating investors.
One of the reasons why this trend occurred may be the launch of the native compound token, COMP. The launch of this token gave Compound investors the opportunity to earn COMP for using the platform.
In direct response to this, investors have decided to transfer large amounts of cryptocurrencies to the platform. The goal here is to farm the COMP token. Thus, investors want to transfer cryptos to the platform to earn a return in the form of COMP – so it is yield farming.
Of course, this megatrend during the DeFi market also caused the price of COMP to rush from one high to the next. In the meantime, COMP also became the DeFi token with the highest market cap.
However, Compound is not the only example of a platform that enables yield farming. Other platforms such as Balancer with the BAL token, Yield.Finance with YFI, or Synthetix with SNX are also fitting examples. Moreover, Compound is not the first platform to enable yield farming. Solutions from Balancer or Synthetix have been available on the market for longer.
What opportunities does yield farming offer?
Now, of course, the question arises why so many users have an interest in yield farming. The answer to this is quickly found because Yield Farming enables an additional return.
We must make a direct reference to the classical capital market, because now we are in a global economic crisis.
The key interest rates in the western industrialized countries are at zero or even negative. Accordingly, investors are not receiving any interest on money deposits – and inflation is also eating away at personal purchasing power.
One solution to this is the DeFi tokens of the established DeFi platforms. Those who invest in compound in DAI, for example, can expect an average return of 7.35%.
In the case of Aave, the return is as high as 18.99% in the same period under review. With the popular Stablecoin Tether (USDT), for example, a return of 17.85% can be achieved with Compound. Investors can always view the current returns at Defipulse.
A look at the downside of the current DeFi market.
Because of these high yields, it is not surprising that investors are finding their way to DeFi platforms. However, investors must also consider the returns in relation to the risk taken. On the one hand, while the returns are enticing, the risk to the return achieved is also higher.
For instance, there is no government deposit insurance to protect investors from a platform default. For example, many investors might want to withdraw money from Compound. If there is not enough liquidity, investors might not be able to withdraw their investment.
In addition, the interest rate, as the return is also just a variable. So it can be that at the beginning a high yield lures, which is annualized hardly higher than on a call money account. A good example of this is, for example, the returns at USDC, which have fluctuated greatly in the past.
Furthermore, Ethereum is arguably the most important cryptocurrency in the DeFi space. Especially in recent months, the high gas costs of the Ethereum blockchain have caused quite a stir.
As a yield farmer, this means investing a higher amount to cover transaction costs and generate a return. Those who operate with amounts of less than $1,000 are highly unlikely to make a profit.
Another problem relates to smart contracts, which can contain security vulnerabilities. In the past, it has already happened several times that hackers have exploited the gaps. However, the financial risk can be classified as comparatively low.
After all, the platforms rely on over-collateralization. This means that the collateral, as the security to be deposited, is larger than the credit that investors can take from a platform. In this way, DeFi platforms can reduce the loan-to-value of an extended loan.
If there is now an extreme price fluctuation, the collateral is automatically liquidated by the smart contract. The lender receives the collateral as compensation – this contributes to higher security.
Which platforms are particularly suitable for yield farming?
There are now many platforms that are suitable for yield farming. In the following, we present these platforms and show how investors can profit from yield farming.
COMP Farming – how investors can use Compound for Yield Farming
Compound is a DeFi platform that primarily functions for lending cryptocurrencies – such platforms are also referred to as so-called money markets. At the current time, the platform has a Total Value Locked (TVL) of around $1.44 billion.
So basically, Compound is a platform that transfers the business model of P2P platforms like Mintos or Bondora to the crypto market. The model is simple, understandable, and not quite as risky as traditional platforms thanks to the security brought in.
Moreover, lending is probably the easiest way to generate a return in the DeFi sector.
At Compound, investors can easily invest stable coins such as DAI, USDC or USDT and thus earn a return. However, investing a classic cryptocurrency like Ether is also possible.
But in addition to the interest income, investors in Compound receive another incentive for using the platform, the COMP token. A total of 2880 COMP flows to the community every day. At a COMP rate of around $150, this equates to around $432,000 per day.
In particular, the additional return through COMP contributes to investors transferring their assets to Compound and thus participating in yield farming. Those who do not want to park their cryptocurrencies with Compound, but still want to profit from the token’s development, can also purchase it on a crypto exchange like Kraken.
Yield Farming at Aave Protocol
Aave is also a decentralized protocol for lending and borrowing. Accordingly, investors can also earn returns by lending capital with this DeFi protocol. With Aave, lenders receive so-called aTokens for the cryptocurrencies they invest.
All aTokens begin earning interest immediately after they are deposited. Flash loans are particularly exciting for yield farming.
These take a key role in yield farming optimization. Overall, open-source flash loans help make the entire DeFi space even more efficient.
However, unlike other lending protocols, Aave does not distribute new LEND tokens to users. Accordingly, to acquire LEND, investors must go through an exchange such as Binance.
Bottom line: yield farming is a megatrend
Yield farming is a megatrend during a megatrend. The different protocols show that there are countless ways to participate in yield farming yourself.
However, the achievable yields also differ greatly in some cases among the individual protocols. Overall, however, yield farming is a good and worthwhile method to use one’s own cryptocurrencies productively.
Nevertheless, the good return potential is not available without risk. Due to the smart contracts, there is always the risk of a hack and the liquidation risk in times of high volatility should not be underestimated either.
However, those who can live with the risk and want to achieve sustainable returns through passive investments in addition to price gains should take a closer look at yield farming.
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