Yield farming is now one of the most important topics in decentralized finance, and there is a strong chance you have already heard about the insane yields some yield farmers are making. But what is Yield Farming? How did it all start? What are some examples of applications? And what are the risks involved? We will cover all these points in this article.
High-yield agriculture:
So what concept is hidden behind this expression?
Specifically, it is a way to try to maximize capital return rates by leveraging various DeFi protocols.
Yield farmers try to generate the highest yield through several different strategies. The most profitable strategies generally involve at least a few DeFi protocols like Compound, Curve, Synthetix, Uniswap, or Balancer.
If the strategy no longer works or if a better strategy is available, yield farmers move their funds. They can, for example, move funds between different protocols or swap certain tokens for others that generate more yield.
To compare this with traditional finance, you can imagine people trying to find the best savings account with the best APY. APY stands for «annualised percentage yield» and is a common way to compare the rates of return on your money across different products. It is also a common way to express the returns of different yield farming strategies.
When it comes to the annual percentage yield, it is common to see traditional savings accounts show an annual percentage yield of around 0.1 %, while a rate higher than 3 % is practically unheard of nowadays. When it comes to yield farming, the returns can be quite crazy, with some strategies offering up to 100 % APY. So how is this possible and where is the catch?
There are 3 main elements that make such yields possible: liquidity mining, leverage, and risk. Let's examine each of them before covering some common strategies.
Liquidity Mining:
Liquidity mining is a process of distributing tokens to the users of a protocol.
One of the first DeFi projects to introduce liquidity mining is Synthetix, which started rewarding users who helped add liquidity to the sETH/ETH pool on Uniswap with SNX tokens.
Liquidity mining creates additional incentives for yield farmers, as token rewards are added to the yield already generated by using a certain protocol. Depending on the protocol, these incentives can be so strong that farmers may be willing to lose their initial capital just to get more distributed token rewards, making their overall strategy very profitable.
A good example of this is the liquidity mining of COMP tokens introduced by Compound, which initially gave higher rewards to users who borrowed assets with the highest APY. This incentivized farmers to start borrowing these assets, as the value of the minted COMP tokens compensated them for the high borrowing rates they had to pay.
COMP liquidity mining has become very popular and has been the catalyst for a broader spread of yield farming.
Leverage and risks:
The last missing element of double- or triple-digit APYs is the high risk that farmers are willing to take.
The first risk is linked to the previous element we just discussed—leverage. All the loans that farmers take out are oversized and the collateral provided is likely to be liquidated if the collateralization ratio falls below a certain threshold.
In addition to the risk of liquidation, we have the usual smart contract risks, such as bugs, platform changes, admin keys, and systemic risks, for example the sudden loss of Ether's value.
In addition to this, we have some new attack vectors specific to DeFi, for example, attacks aimed at draining certain liquidity pools.
All these risks combined are an additional reason why yield farming returns are so lucrative. It is a high-risk, high-reward game.
