Yield Farming and How it Works
Yield farming is a term used to describe leveraging DeFi products and protocols to generate high rates of return. Traditionally, yield farming is defined as earning enough from lending to beat the appreciation of the coin you lent out. But with some of the bonuses and incentives being offered by the DeFi platforms, return rates have reached over 100% annualized yields.
Decentralized Finance (DeFi) is the collection of various decentralized applications that give anyone access to blockchain-based financial services with only an internet connection. These services can involve simple financial services like buying, selling, lending and borrowing—or more complex ones like algorithmic trading, synthetic assets, financial derivatives and margin trading.
With interest rates all over the world at or near zero, there is very little interest to be earned from the traditional financial system. Interest rates have been much higher for lending out cryptocurrency, particularly stablecoins. With the rise of Compound and its new incentives for all its users, the return you can get has skyrocketed. So much so that a user can loan out $1,000 worth of DAI and then take out a loan for $2,500 worth of BAT and earn more in COMP rewards than it cost to borrow the BAT. The increased demand in BAT rose beyond 20,000%, massive development for a previously obscure token. 0x has undergone a similar scenario, where the yields for borrowing it on Compound have spiked dramatically.
If you like this article, check one of our previous in-house articles, “Is Bitcoin Really Fiat?“
Compound recently overtook Maker as the most popular DeFi protocol in terms of USD value locked in. Compound launched a native token called COMP and used it to reward liquidity providers and users of the platform. In anticipation of the token’s listing on Coinbase, the price zoomed from a low of $16 to a high of $400 when it was finally listed on Coinbase Pro. This allowed the value of the rewards for lending and even borrowing to become quite substantial. When combined with leverage, the returns can really accelerate. And with leverage comes risk and that concerns many in the cryptocurrency world.
Are There Concerns with Yield Farming?
Vitalik Buterin, a founder of Ethereum—the platform upon which many DeFi platforms are based—sounded an alarm over the weekend. Buterin wrote on Twitter that, “Honestly, I think we emphasize flashy DeFi things that give you fancy interest rates way too much.” He also identified that interest rates which significantly outstrip the traditional financial system are “inherently either temporary arbitrage opportunities or come with unstated risks attached.”
While the returns offered by decentralized finance as compared to traditional finance are about 1000% greater, is the risk also that much higher? Experts believe that these rates will decline on their own once these platforms mature, growing in size and volume. But gimmicks like the rewards being offered by the DeFi platforms and leverage on top of that make for some very risky business.
The entire DeFi infrastructure is extremely new and heavily reliant upon smart contracts. Smart contract security, therefore, is a major concern when such huge amounts of currency are on the line.
The massive speculation being undertaken harkens back to the frenzy that was the 2017 cryptocurrency bubble. If the ability to use cryptocurrency to leverage and earn income becomes the main attraction of cryptocurrency, it will become a risk-laden asset, more akin to purchasing a lottery ticket than a store of value.
Decentralized finance (DeFi) exploded during the month of June 2020, platforms like those of Compound, Maker and many others have experienced a jump both in their token price as well as the money locked in them. These reward tokens being offered by these platforms to reward and incentivize new users are undergoing massive appreciation. So much so that users are able to earn more from the act of borrowing on these platforms than the cost of borrowing itself. This is a strange situation that many crypto enthusiasts and investors are currently exploiting to generate over 100% in annualized returns.
While it doesn’t seem very risky to take advantage of this now to an individual trader, from a macro view it is very concerning that a market is being built on rewards and debt. It sounds almost like something central banks would devise. Taking a blasé view of debt is precisely what led to the financial crisis of 2007 and 2008. Massive speculation is what created the cryptocurrency bubble of 2017. While decentralized finance holds great promise for helping the unbanked and others who are left behind by the traditional financial system, the massive degree of speculation taking place seems to cast a shadow over this promise.