Yield farming has experienced a Cambrian explosion of sorts
over the last few months, thanks in part to the emergence of various
decentralized finance protocols. In its most basic sense, yield farming
can be thought of as a process where users provide liquidity to DeFi
protocols and are rewarded with a yield/return, usually in the form of
the platform’s native token offering. 

The concept was first made
popular by Compound, which gave COMP tokens to users who supplied and
borrowed tokens on the platform. The yield offered is usually high and
serves as an incentive for users to provide liquidity to bootstrap the
financial resources of a new DeFi protocol.

That being said, this
novel token distribution method has gained so much traction recently —
partly because the returns are so exorbitant — that a number of copycat
projects, as well as random protocols, have started to abuse this practice
since smart contracts for yield farming distribution are open-sourced,
and there are a number of efficient decentralized applications that can
be copied by almost anyone with the right amount of engineering
expertise.

However, Bobby Ong, the chief operating officer and a
co-founder of CoinGecko — a cryptocurrency tracking platform — believes
that the high yields are temporary and not practically sustainable. He
also believes that as more people become aware of the technology and
start to provide liquidity to various protocols, the rewards will become
increasingly more diluted with the average yield eventually being
driven down, adding:

“Liquidity providers are rewarded in
the form of the DeFi protocol’s native tokens. To receive the actual
yield in USDT, the liquidity provider will need to sell the native token
to USDT for example, thereby driving down the native token price and
yield further.”

How to take advantage of yield farming

When
discussing the concept of yield farming, it is essential to understand
that there are three avenues through which one can harvest a yield —
namely money markets, liquidity pools and incentive schemes.

Money Markets

Simply
put, crypto owners can earn a profit on their existing holdings by
lending tokens via a decentralized money market such as Compound, Maker,
Aave, etc. Additionally, different platforms offer varying return
rates; for example, Aave offers users with both a variable interest rate
as well as a fixed one. However, in the same vein, Compound provides
its native COMP tokens as an incentive to both lenders and borrowers.
While the stable interest rates are more lucrative for borrowers,
lenders usually prefer variable rates.

Lastly,
a unique aspect of DeFi money markets is that borrowers are required to
“over-collateralize” all of their loans. What this means is that
farmers have to deposit more money than they can actually borrow so that
lenders do not end up losing their assets in case a person defaults on
their payments. Simply put, the idea behind making use of an
over-collateralized loan framework allows the lender to efficiently
maintain the “collateralization ratio” at all times to avoid
liquidation.

Liquidity pools

Liquidity is extremely
crucial for most DeFi protocols because it allows them to provide their
clients with a hassle-free customer experience. From a financial
perspective, liquidity pools offer users better returns when compared to
money markets but, at the same time, come laden with certain risks.

One of the most prominent examples of such a setup is Uniswap, an automated market maker
that offers users with various liquidity pools that hold two tokens
each. Technically speaking, whenever a new pool is established, the
individual who first provides liquidity is the one who is responsible
for setting the initial price of the assets in the pool. In this regard,
it’s clear that if the initial token value significantly deviates from
global market prices, an arbitrage opportunity opens up.

Also,
liquidity providers are incentivized through native platform tokens to
put in an equal value of both tokens to the pool, such that their
overall ratio remains constant even as an increasing number of people
start to add their tokens to the pool.

Related: DeFi app overview: How to navigate crypto’s new finance wave

While
Uniswap makes use of the basic aforementioned framework, platforms such
as Curve employ a different algorithm that offers users more attractive
fee rates as well as lower slippage during token exchanges.
Additionally, Balancer enables users to create liquidity pools that can
hold multiple tokens — up to eight — at the same time.

Incentive Schemes

Yield
farmers also have the option to obtain returns in the form of
incentives. For example, DeFi platforms such as Synthetix give liquidity
providers SNX tokens in exchange for their work. Similarly, Ampleforth
allows users to earn native AMPL tokens for their liquidity-related
efforts.

Lastly, in terms of how easy it is to set up a yield farm
operation of one’s own, everything seems to boil down to how much
experience the person has around crypto and DeFi tech. For example, some
yield farming strategies are quite complex and require users to possess
immense, in-depth knowledge of various platforms, as well as a solid
understanding of the financial and technological risks involved.

Thus,
for less advanced users, there are simpler ways to partake in yield
farming, primarily through platforms like Yearn.finance, where all one
has to do is deposit some tokens like Ether (ETH) or stablecoins and collect the yield.

The gray areas

As
things stand, there currently exist a number of yield farming projects
like Kimchi and Pickle that claim to be delivering profits in excess of
3,000%. Thus, it only seems fair to delve into the questions of How is this even possible, and is there a scammy element attached to these schemes?

One
of the main reasons why there are such high returns is because the
governance tokens associated with platforms such as Kimchi act more like
shares — i.e., they represent a claim on the future earnings of the
platform. Also, with most protocols distributing more than half of their
equity worth hundreds of millions of dollars to liquidity providers,
it’s really no surprise that extraordinarily high returns can be
achieved, at least in the short term. Kris Marszalek, the CEO of
Crypto.com — a crypto payments platform — told Cointelegraph:

“Projects
like Kimchi and Pickle are of a different breed to more ‘traditional’
platforms such as Compound or Curve. The fundamental difference here is
that they don’t have an existing product that generates profits to give
their token economic value. Because these tokens derive their entire
intrinsic value on promises of future earnings that may not materialize,
they have to distribute a much higher percentage of tokens within a
much shorter span of time in order to attract users.”

Similarly,
Jason Lau, the chief operating officer of crypto exchange OKCoin, also
believes that these APY percentages are misleading since these figures
are usually based on an expected return, given the rate is sustained for
an entire year. He added that the current returns being offered by
platforms such as Katana, Solarite and Kimchi are based on a combination
of hype, limited access and hidden risks, clarifying:

“The
actual calculation of yield percentages are not transparent, and
farming for any particular reward often only lasts a few days to weeks,
with projects often reducing the reward over time.”

Risks involved

There
are a number of major risks associated with yield farming. For
starters, the annual percentage yield of most such platforms is often
denominated in the reward token that is being farmed — which are
generally quite volatile. Furthermore, once farming starts, there is an
enormous sell pressure upon the reward token, and thus, the APY often
goes down quickly.

There’s also the issue of impermanent or
divergent loss where new projects usually reward those who provide
liquidity into AMM liquidity pools, which require two different assets.
So, if the price of the asset changes relative to the other, there is a
chance that users incur some losses versus holding the underlying tokens
outright. Providing his thoughts on the subject, Joel Edgerton, the
chief operating officer of bitFlyer USA crypto exchange, told
Cointelegraph:

“The most fundamental risk is the software
code could be flawed. It may not perform as advertised or it could be
manipulated or hacked. These projects are still very young and have not
stood the test of time or been stress tested. Also, even though these
projects claim the DeFi mantle, there are still single points of
failure, such as the person that wrote the code could pre-mine the
tokens, pump the price, dump the assets, and disappear with the money.”

From
a security perspective, Lau believes that the smart contracts making up
most yield farming schemes are often launched fairly quickly and thus
remain unaudited. As a result, there could be a chance that these smart
contracts could be prone to certain security loopholes, either
inadvertently, like seen with the first iteration of the YAM token, or deliberately by the creator of the contracts.

Related: DeFi Yield Farming Is Driving Adoption, but Stakeholders Urge Caution

Not only that, owing to the complexity of these protocols, even those that have had security audits done can still face issues, like bZx.
Lau added: “Many of these protocols are actually quite centralized,
with one or a handful of people making and executing decisions.”

Ong
also outlined that protocol developers can tempt users with high yield
to farm tokens — with a Uniswap 50/50 pool involving ETH — only to then
dump their tokens later. Similarly, he also pointed out that developers
may steal staked tokens because depending on certain contracts, users
are sometimes required to send tokens to a separate smart contract,
making the theft easy. Ong added:

“The yield offered is
given at a particular price based on the native token price. When the
price of the native token drops, your yield may go down significantly as
well, and you may not get the returns as intended. Not only that, the
front end may lie or hide certain information that is different from the
contract.”

source link : https://cointelegraph.com/news/earning-with-defi-yield-farming-rocket-science-or-child-s-play