Everything You Need to Know About Yield Farming — The DeFi Series
The uninitiated could be forgiven for thinking that “yield farming” refers to the latest crop of corn or peanuts. Rather, the term refers to a cutting-edge trend by which those who own cryptocurrency can reap guaranteed, steady returns.
Yield farming is a way for those who participate in specific cryptocurrency-powered products to use their crypto to earn crypto. By promising users tokens (and interest, in some cases) in exchange for their participation, founders and promoters of decentralized finance products aim to whip up interest in their platforms.
What Is Yield Farming?
Understanding yield farming may require you to grasp what “yield” means within the context of finance. Per Investopedia, yields are “earnings generated and realized on an investment over a particular period of time”. Yields may generally come in two specific forms:
- Interest earned on an investment
- Guaranteed dividends paid in return for your investment
Yields can apply to several classes of financial assets, including but not limited to stocks and bonds. Yields can be fixed or may fluctuate with different variables, such as the value of the security being invested in. These same tenets may apply to yields issued in cryptocurrency rather than dollars, but there are also some noteworthy differences between traditional yields and crypto yields.Yield farming is a term particular to cryptocurrency, and DeFi specifically. Simply put, to farm yields is to invest your cryptocurrency in a specific DeFi platform or product in exchange for rewards, which may come as interest and/or dividends.
Some of the most prominent projects to date for yield farming, such as Compound, involve both lenders and borrowers of cryptocurrency receiving Compound tokens (COMP) as their yield. This practice may also be referred to as liquidity mining, because those who invest their crypto in platforms while earning a yield are providing liquidity to administrators of that platform. In this sense, their role is similar to a lender who exchanges cash for:
- The guarantee of future repayment, plus:
- Interest payments
While the investor farming a yield certainly benefits from the arrangement, they may not be the only ones reaping a reward.
Who Benefits From Yield Farming?
It is clear why someone might invest their cryptocurrency in a platform or product that offers them a yield. If they were not planning to liquidate their crypto shares in the near-term, then why not earn some extra (guaranteed) coin on their stake by farming for yields? Here’s how it goes:
An investor lends their money to the platform, they receive tokens for their investment, they are ultimately repaid their principle investment, and may earn interest on top of it. It’s the classic lender’s benefit, along with some extra token. That extra token is a key distinction between traditional lending and yield farming with DeFi platforms. If the value of the token provided as a dividend skyrockets, then a DeFi lender-investor may experience returns far beyond what they could get in traditional, non-crypto markets.
Heck, if the token being used as a dividend accumulates value quickly enough, it may even be possible to make money farming yields as a borrower. Say someone borrows cryptocurrency and receives tokens as a reward for engaging in the lending platform. So long as the value of that token increases at a rate greater than the cost of borrowing, they may ultimately earn a profitable yield despite paying interest on their loan. There is always risk in borrowing, and one would have to be very confident in the rate of a token’s appreciation to bank on making money by borrowing crypto. Still, this scenario is not out of the realm of possibility, and the rapid increase in value of Compound’s COMP token just months ago serves as real-world evidence.
The last party that may benefit from yield farming is the governors of a specific platform or token. Whether governors refers to a centralized collective or participant-investors in a decentralized platform, the interaction that yield farming incentivizes is generally positive for stakeholders.. As investors flock to a platform offering worthwhile yields, the platform itself and any connected token becomes more valuable due to greater popularity. As the token accumulates value, the yields (tokens) provided by participation in the linked platform become more attractive, more farmers flock to reap those yields, and so the cycle of growth goes…
What Is the Current State of Yield Farming?
Like many specific genres of decentralized finance, yield farming has seen significant growth in participation over recent years, and in the past few months especially. With Compound paving the most viable blueprint for yield farming to date, subsequent projects have garnered similar popularity. Balancer Labs’ BAL token was issued shortly after COMP token’s debut, becoming the second governance token that would facilitate yield farming in the DeFi space, according to NASDAQ. It went on to debut with a single-day 235% spike in value, once again illustrating the fervor for yield farming, and by extension the tokens and platforms that allow for yield farming.
As more and more investors sink their crypto capital into platforms offering yields in return for liquidity, the sustainability of the practice appears real. Unless regulators crash the party, the attractiveness of yield farming may persist.
How Do Regulators View Yield Farming?
You’d have to be a regulator to answer this question. Generally speaking, there is some worry that regulators will eventually want to have a say in how the DeFi sector is run, including how punitive measures are doled out to fraudsters. Yield farming may not be immune to this development if and when it occurs. Whenever the term “risk” becomes associated, fairly or not, with a financial sector, you can bet that at some point regulators will act. Whatever you think of their motives, this generally tends to be the case.
Like any investment, yield farming carries risk, with questions about the token issuers’ legitimacy being one of those risks. However, it is not yet possible to know for certain how regulation will affect yield farming. For now, yield farmers seem to be of the opinion that they may as well be getting it (yields) while the getting is good.