There has never been a better time to be in crypto: we appear to be at the start of another bull market - Ethereum went up nearly 100% in the past month. As things become spicy in the cryptocurrency space, we explore what is yield farming and whether it is the hottest new thing in DeFi.

Beyond the typical hawk-like eyes trained on the prices of Bitcoin, Ethereum and other top coins, lies a hot trend that may be behind the huge increases in cryptocurrency value recently: DeFi and its continued growth and evolution.

DeFi Pulse reports that there is almost $1.9 billion of cryptocurrency assets circulating or locked in DeFi right now; that may not sound like much when we’re talking about cryptocurrency, but many think it is just the start of the hype and bull run.

The latest trend in this space, yield farming, takes the form of a high-risk incentivized use of borrower-lender “Credit Markets”, particularly one known as Compound, which has shot to the top of the active DeFi charts after it introduced their governance token COMP.

COMP is similar to Uber handing out Uber shares for using their ride-hailing services, except that it’s more than that (and not just because Uber would never do it). They’re a limited-time-only promotion where users can get a piece of Compound’s long term value by gaining token-based governance rights, similarly to how an ICO’s token would reflect the amount of use or value on its protocol.

As the value of a protocol is often reflected by the amount of use it sees and the number of transactions, the token that’s being given out as an incentive also inherits some of this value, enough to make participating in the activity itself worth more than the cost of not participating.

The result? We get yield farmers – people who’ve decided that it’s worth borrowing money from the credit markets on Compound just to earn COMP tokens. They use the borrowed money to loan or find other credit markets to participate in and get obscene yield numbers almost 300x that of traditional saving plans and fixed deposits run by banks.

Before we go any further with the buzzwords, let’s take a step back and try to understand the various terminologies involved and how this even works.

What is DeFi?

DeFi refers to the set of finance applications that are running on the blockchain – these applications rarely require much more than just a basic blockchain wallet to operate. They’re automated services that perform a specific task (a “dapp”), and in this case, the task in question refers specifically to one of the most common use cases for blockchain smart contracts – finance.

The most popular dapps right now are essentially virtual pawnshops, but for cryptocurrencies. Think of a pawn shop in real life; you bring a piece of jewellery or something valuable that you have and leave it with the pawnshop in exchange for a loan. The loan’s value is usually far below that of the item you leave with them, but the beauty of the pawning system is that if you’ve used the loan for whatever you intended to do with it and get some money, later on, you can return to the pawnshop and pay back your loan – with interest – and get your item back.

This system allows the pawnshop to earn interest on your loan if you come back to get your item. And if you don’t, they will take your item and sell it off for a profit, as the amount they’ve loaned you is usually much less than how much the item is worth.

In DeFi, this pawn shop concept goes a step further – because cryptocurrencies have digital values that can be read by computers, you can automate the entire system without needing to handle any tacky jewellery. For instance, if you currently have $20 of Ethereum in your wallet, you can use it as collateral on the Compound platform to take a loan of $10 of USDT (the cryptocurrency equivalent of the USD).

This loan means that you’ll still be exposed to Ethereum even though you now have something easier to use as payment. If Ethereum went back up in price, let’s say to $30, you would be able to pay $11 of USDT (let’s say the interest is 10%) to retrieve the full value of the Ethereum you used as collateral – which is now worth $30!

DeFi applications in the process also don’t need to worry about too much risk – the collateral you put up to back your debt is usually far higher than the amount you borrowed. If Ethereum were to lose value down to $10 in a single day, Compound or whichever platform you used would automatically engage a liquidation mechanism and ensure that they would not take a loss.

In a traditional bank, the bank can give you interest rates on your dollar because they’re using your money and the assets you leave with them to generate money that’s higher than the interest they’re giving you. Liquidity is worth a lot in finance; as the saying goes, the rich get richer, and it’s not for no good reason – money can be used to create value for others, and that value is worth more money than the original sum is worth.

In DeFi, that money and liquidity are still considered scarce. In a similar fashion to fixed deposits and savings accounts, DeFi protocols also have yields and incentives that they offer to their lenders to encourage them to leave assets with them. One type of DeFi application that uses incentives like this are automated market makers or “pools”, one example is Uniswap.

On Uniswap, the price of USDC and DAI is determined by having an exchange system between USDC and DAI. These two tokens are meant to be worth $1 each all the time, and they operate their mechanisms outside of Uniswap to accomplish this.

Uniswap’s concern when it comes to maintaining the ability for people to exchange fairly between the two tokens is that they need liquidity on both sides of the equation for them to be able to function correctly. For example, if someone were to set up a USDC/DAI pool, they should deposit equal amounts of both. In a pool with only 2 USDC and 2 DAI, it would offer a price of 1 USDC for 1 DAI.

However, if someone put in 1 DAI and took out 1 USDC, the pool would have 1 USDC and 3 DAI. Somebody would see this – and because of the mechanisms used in Uniswap (remember, this is an automatic application), they would be able to put in 1 USDC and receive 1.5 DAI (as that is what would bring the pool back to a balanced state). That’s a 50% profit from somebody arbitraging the pool, making the pool owner lose a significant amount of money.

However, if there were 300,000 USDC and 300,000 DAI in the pool, a trade of 1 DAI for 1 USDC would not affect the balance of the pool too much, and somebody would likely step in later to trade 1 USDC for 1 DAI, bringing the pool back to the balanced state. In reality, the operator of the pool earns by taking a small share of the transaction as well (for instance, 1 USDC may only return 0.999 DAI), making it profitable to leave their assets inside of the pool for others to exchange tokens with, and having the pool grow larger over time.

Going A Step Further With Yield Farming

You can put your cryptocurrencies into DeFi protocols and earn a decent amount of yield – most of them already offer much higher interest rates in the 1 to 5% range. Currently, Compound is offering a person ~2.5% returns on most stablecoins like USDC and USDT. Higher than the likes of banks and other real-world finance services.

You could take it a step further by creating a chain of transactions that enable you to act as both borrower and lender on various platforms. For instance, you could borrow money from Compound, and use that money to act as a lender on yet some other platform, and earn the incentive token (remember COMP?) for both platforms. Using strategies like this, yield farmers could see yields of over 10%, even sometimes stretching 20% a month!

Remember how we mentioned Uniswap’s pool might only exchange 1 USDC for 0.999 DAI? Not only do actions like this grow the pool, but ownership of the pool is not determined by a legal contract, but by a token attached to the value of the pool. Tokens, unlike contracts or accounts, are tradeable and liquid in their own right – they have a changing value depending on somebody’s perception of how much money might be inside the pool, as well as how much they could earn in yield by owning said token.

By playing around with how you contribute to various DeFi protocols and “leapfrogging” between each platform to get the highest yields, you are effectively trying to get the most out of your asset, and become a “yield farmer”.

A low-level, beginner yield farmer might just be trying different assets in Compound, getting their assets into the pools that are offering the highest APY for each day or week. For putting their assets inside the pools, they get a tokenized representation of their position within the pool that earns yield and increases their assets when they return it.

But mid-level yield farmers take it a step further.

John, our local yield farmer, might start by putting 20,000 USDT into Compound. The tokenized position they get back is called cUSDT. Let’s say they get 5,000 cUSDT back (doesn’t matter what cUSDT is worth, just know it’s worth something).

They can then take that cUSDT and put it into a liquidity pool that takes cUSDT on Balancer, an automatic market maker that also provides a small amount of profit to the liquidity providers when others use it. In normal times, this could earn a small amount more in transaction fees, creating slightly increased yields.

Let’s go one step further – it’s time for liquidity mining!

The highest level of yield farmers knows that this is the best time to get started and be active in yield farming, because of a new concept and trend known as liquidity mining. Liquidity mining is when a yield farmer gets an entirely new token as well as the usual return in exchange for the farmer’s liquidity.

Compound announced earlier this year it wanted to truly decentralize the product and it wanted to offer limited ownership of the product to the people who made it work in the process of using it. That ownership was developed as the COMP token.

We now have a four-year period where the Compound protocol would give out COMP tokens to users, a fixed amount every day until it was gone. These COMP tokens control the protocol, just like how equity stakes and shares represent control and rights to dividends in publicly traded companies.

Every day, the Compound protocol looks at everyone who had lent money to the application and who has borrowed from it and gives them COMP proportional to their share of the day’s total business. For the first time in the history of finance, a borrower can earn a return on a debt from their lender.

COMP’s value has been massive, hovering at just over $200 since it started distributing on 15 June. Other platforms have also adopted the liquidity mining methodology and issuance of a token; earlier mentioned Balancer, the automatic market maker was the next protocol to start distributing a governance token, BAL, to liquidity providers. Flash loan provider bZx has announced a plan to do the same, while Ren, Curve, and Synthetix also teamed up to promote a liquidity pool on Curve.

In a way, the entire thing looks and feels almost like a Ponzi scheme, albeit one with possibly good intentions. The issuance of COMP itself doesn’t construct a pyramid, but the incentivized farmers taking loans and borrowing from themselves just to earn the token are making it look like one.

One parallel that can be drawn to the liquidity mining mechanism is Fcoin, a Chinese-based exchange that issued a token that rewarded people for making trades. To earn the token, users would trade back and forth with themselves on the exchange, creating impossibly high volumes. Today, Fcoin seems to have gone bust, owing to its users millions in unpaid BTC in an exit-scam like structure.

Yield Farming And DeFi Does Not Come Without Risk

DeFi products, being automated applications with pre-set behaviour, can be easily abused and even affected by malicious activity or users. MakerDAO’s liquidation mechanism was effectively gamed by users earlier this year, resulting in losses of over 5.67 million DAI.

Nexus Mutual, which offers customized insurance solutions that partially cover the risk of using these applications, has reported that its coverage for these liquidity applications is already maxed out. Derivatives solutions like Opyn made markets for people to short COMP, opening up the opportunity for people to time the bubble if it was one.

With all the hype surrounding these systems, those who are averse to risk should be wary. Money doesn’t grow on trees, and sooner or later this trend will die down back to the usual levels (especially once the liquidity provisioned to these markets reach the “too much” point).

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