In a single sentence: yield farming is the process of staking assets in the Ethereum DeFi (Decentralized Finance) ecosystem to earn a passive income.
We’ll begin this article by briefly explaining what DeFi is and why it’s important. We’ll then detail what yield farming is, what yield farmers are trying to do, and some of the largest risks of yield farming.
What is DeFi?
DeFi is an emergent ecosystem on the Ethereum platform that provides decentralized financial services to users around the world. These services are similar to what you could expect from a bank or a broker. For example, here are a few of the services that DeFi protocols offer.
- Collateralized lending
- Derivatives trading
- Asset exchange
- Bank accounts that pay interest on deposits
At this point, DeFi provides most of the financial services that the traditional system does. The one major exception is non-collateralized lending, which does not exist in DeFi yet. An example of non-collateralized lending is a credit card, where the loan is granted based on reputation, but there is no asset backing the loan like a car or house.
2020 has been the year of DeFi as we’ve seen exponential growth in the ecosystem. At the beginning of the year there was only a meager $625 million locked in DeFi, which has grown to an incredible $14.5 billion in just 11 months.
As decentralized finance has exploded in popularity, so too has yield farming.
A yield farmer is someone who purchases an asset like DAI or ETH and then locks it up in a DeFi protocol in exchange for a return on their investment. Yield farming gets its name from the fact that investors move their assets from platform to platform to seeking the highest yield. Yield farming is an active process. Over the course of a year, an investor might relocate their assets dozens of times to earn the most profit.
Here are a few examples of the ROI that a yield farmer can earn. Remember, these yields are based on current rates and will change over time. You can use CoinMarketCap to track the yield offered by various platforms.
- DAI-USDC on Compound pays 11% yearly
- Yearn DAI vault pays 12% yearly
- Synthetix sUSD pays 3% yearly
These are “normal” earnings for the basic yield farmer. However, yield farming can also include other incentives like a governance token. For example, many yield farmers staked their assets on Compound to earn the COMP token.
Surprise bonuses are also possible, as when Uniswap announced that they would be airdropping 400 UNI tokens to all of Ethereum addresses that had ever interacted with the protocol.
Yield farmers may also use leverage to increase their earnings. However, this can be risky. For example, $100 million in loans on Compound were just liquidated after the Coinbase price feed for DAI briefly spiked. The DeFi ecosystem is still immature and glitches are unfortunately quite common.
Why Yield Farming is Risky
What’s great about DeFi is that anyone can create and launch their own financial services protocol.
What’s disastrous about DeFi is that anyone can create and launch their own financial services protocol.
When it comes to DeFi, there are no regulators, no laws, no mandatory insurance providers, no verification systems, and no mandatory audits of code. The benefit of this free-for-all ecosystem is that you end up with massive innovation since anyone can launch anything at any time.
The downside of this unregulated ecosystem is that there exists an incentive to launch a flashy and exciting protocol as fast as possible. There is less of an incentive to hire the very best blockchain engineers, carefully develop a protocol, pay for audits of the code, and then gradually roll out the protocol in stages.
The result is that DeFi ends up hosting lots of exciting protocols, but also lots of protocols that are easily exploited. It happens all the time. For example, this website tracks hacks that have occurred in the DeFi ecosystem. The data on this particular website only goes back to September of 2020, yet there are already dozens of recorded exploits!
The most important thing to realize about DeFi is that there’s a reason protocols pay 12% interest at a time when the interest on most bank accounts is 0%. Yield farmers are earning a reward in exchange for taking risks.
The most mature DeFi protocols are just a few years old, while the newer protocols are less than a year old. Not that age is the best indicator of security, but banks like Wells Fargo and Chase have been around for decades, in some cases a century or more.
Yield farmers should understand the risks they’re taking and not put more money at risk than they’re willing to lose. As the recent Compound liquidation has shown, even the most established DeFi protocols are vulnerable.
The Future of Yield Farming
Love it or hate it, yield farming is exciting because it’s the beginning of a brand new financial system. Banks aren’t going away anytime soon. However, as yield farming becomes more popular, we will see a shift towards decentralized financial products.
Many yield farming protocols will indeed fail. They’ll get hacked, people will stop using them, or some of them may be forced to shut down due to regulation. However, out of the carnage there will be some huge winners and these could change the world of finance forever.
Whether you get into yield farming for the profit or because you’re sick of existing financial products, it’s an interesting time to be involved in the space.
For more information about yield farming and other DeFi products, a couple of great resources are the Defiant newsletter, as well as the Bankless newsletter. These publications offer daily content about DeFi, yield farming, and all of the other exciting decentralized protocols built on top of Ethereum.
This content is for informational purposes only and is not investment advice. You should consult a qualified licensed advisor before engaging in any transaction.