How DeFi Yields Are Generated5 min read
Decentralized finance (DeFi) has ballooned into a booming industry that demonstrates some of the efficient and creative possibilities of the crypto industry. Tens of billions of dollars in crypto assets today are locked in DeFi, a significant increase from 2021.
One reason it continues to grow is the appeal of “yield farming,” a strategy that leverages crypto assets and helps users maximize their returns. The strategy allows crypto investors to maximize their cryptocurrency rewards across multiple DeFi platforms through different strategies shared below.
Yield farming creates an intriguing opportunity, but also involves complex strategies and a keen eye. There is also a significant risk of losing your principal capital if you’re not careful.
How Did The “Yield Farming” Concept Come About?
The concept of yield farming gained prominence in the summer of 2020 after the Ethereum (ETH)-based credit market, Compound, began distributing governance tokens, known as COMP, to its users. The governance tokens gave voting rights to holders on proposed platform changes. The increased demand for the COMP token — triggered by its automated distribution — led to the beginning of the DeFi yield craze.
As the demand grew, the term “yield farming” gained popularity. The term summarizes the practice of creating strategies to put cryptocurrency in some DeFi applications to earn the owners more cryptocurrency.
How Does DeFi Yield Generation Work?
When investors generate yield in the DeFi ecosystem, they are putting tokens or coins into decentralized apps (dApps) like lending and borrowing protocols, decentralized social media outlets and decentralized exchanges (DEXs). Yield farmers use decentralized platforms to loan, borrow or stake different coins to earn interest while actively speculating on the price movement of the underlying crypto assets. To facilitate yield farming, smart contracts are used. These contracts are pieces of code used to enforce financial agreements between two or more people. There are various types of yield farming used:
Liquidity is a term you’ll hear quite a bit in DeFi, as yield farming is often intertwined with liquidity mining, which provides liquidity to the decentralized protocol.
Liquidity providers are users who deposit two coins to a decentralized exchange to offer trading liquidity. The DEXs charge a fee to do a token swap, which is then paid to the providers. The fee is sometimes paid via liquidity pool tokens.
For example, I can put $1,000 worth of ETH and UNI and put it into an ETH/UNI pool ($500 of each asset), and earn a percentage of yield on all of the trades.
Lending Or Borrowing
Yield farmers also do a fair bit of lending or borrowing to generate yield. One party may lend cryptocurrencies to a borrower through smart contracts and then earn a percentage yield from any interest paid.
When someone borrows cryptocurrency, they put up collateral and receive another token on the loan. Users can subsequently farm yield with the borrowing coins/tokens, allowing the yield farmer to retain the initial holding. The holding may increase in value over time while the borrowed coins simultaneously generate yield.
For example, Party A lends $1,000 to Party B for 30 days. Party B agrees to pay Party A 5% for the 30 days loan. To derisk Party A, Party B puts up $1,300 worth of crypto collateral. That means if Party B fails to repay the loan, Party A gets the collateral.
There are two types of staking done to facilitate yield farming. The main type of staking is done on proof-of-stake blockchains. On these blockchains, users are paid interest to pledge tokens to the network for security purposes. The alternative staking method involves staking liquidity pool tokens earned from supplying decentralized exchanges with liquidity. Users can yield twice with the latter method, paying for supplying the pools in liquidity tokens which they can then stake to earn more yield.
How Do You Calculate Yield Farming Returns?
Yield returns are typically annualized, with all prospective returns calculated over a year.
Annual percentage yield (APY) and annual percentage rate (APR) are two metrics often used. Unlike APY, APR accounts for compounding, the reinvesting of gains to accumulate larger returns.
It’s important to stress that APY and APR used in yield farming are estimations rather than finalized numbers, so there is a bit of guesswork done through calculating potential returns. Both measurements are projections rather than guarantees. Yield rates are hard to quantify because yield farming is a highly-competitive world with incentives constantly changing on the fly. When yield farming strategies work for a significant period, other yield farmers will copy them, causing those strategies to stop generating high returns. It’s a 24/7, fluid market with the party and counterparty always trying to deploy strategies that benefit them at the expense of the other.
What Should You Be Aware Of With Defi Yield Generation?
Yield farming comes with risk, whether you’re a lender or borrower. Markets are unpredictable, with price slippage and volatility being common. As tokens are locked in, values can sharply rise or fall, posing risks to yield farmers, especially when crypto markets experience bear runs as we’re seeing in mid-2022.
Regulatory risk is involved in yield farming as crypto is still mired in some doubt, with the Securities and Exchange Commission (SEC) declaring some digital assets as securities. Also, some states have issued cease and desist orders against more notable centralized crypto lending sites.
Additionally, there are potential smart contract hacks, though there have been security improvements made thanks to optimized third-party audits and code vetting. Meanwhile, there are scams like rug pulls, where crypto developers collect investment funds for projects but abandon them and make off with the money, never repaying the money to investors.
Always make sure you know what you’re investing in and how it works. Make sure you understand how yields are generated. Never put in more money than you can afford to lose, and above all, if it seems too good to be true, then it probably is.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.