The evolution of information systems technology has given rise to many industries that impact the global financial landscape. Among the most prominent are remote securities trading, the exchange of cryptocurrency assets and the fledgling decentralised finance (DeFi) sector. The latter two arenas are inherently connected to the blockchain.
The blockchain is a digital system for recording data sets that is extremely difficult to alter. Essentially, it is a decentralised public ledger that is disseminated across a broad computer network. Blockchain technology, as well as the blockchain itself, is the framework on which the DeFi and cryptocurrency industries operate.
Within the realm of contemporary decentralised finance, participants seek profitability in a number of ways. A few of the most popular are through the buying and selling of crypto products, non-fungible tokens (NFTs), mining and staking. Among these practices is a discipline known as yield farming.
What Is Yield Farming?
Yield farming is a way of making money on the blockchain where investors "stake" or "pledge" their cryptocurrency assets in return for compensation. In this way, yield farming is similar to purchasing conventional certificates of deposit (CDs) or allocating funds to a savings account.
Since its inception, the popularity of yield farming has grown exponentially in scale. In fact, it is the single largest driver of DeFi and was a premier catalyst for the sector growing to a US$10 billion market capitalisation for 2020.
Although yield farming is a relatively young means of earning passive income, it has become a staple on the blockchain. Reasons for this vary, but may be attributed to the bullish crypto markets of 2020/21 and integration of digital assets into the financial mainstream.
How Does Yield Farming Work?
Also known as "liquidity mining" or "DeFi yield farming," yield farming is a technologically involved undertaking that relies on blockchain networks. It is based on projects designed to execute smart contracts, which facilitate direct person-to-person transactions. In this way, DeFi can eliminate the need for intermediaries, such as conventional banks.
From a practical standpoint, the process is relatively simple. In broad strokes, yield farming participants follow the progression below in the hopes of generating revenue:
- Staking: Investors pledge their crypto assets to a liquidity pool. Typically, this is done by staking them to DeFi protocols focussed on lending or crypto trading.
- Lockup: Allocated cryptocurrency is subject to a lockup period. During lockup, staked coins are unable to be accessed and are borrowed by other investors. Using a decentralised application or "dApp," crypto traders can secure additional coins and speculate on market fluctuations.
- Payout: Investors earn incentives for staking their crypto by way of interest rates or additional coins. Yield farming returns are calculated and expressed as an annual percentage yield (APY).
Ultimately, yield farming offers crypto holders a way to generate passive income while providing liquidity to the market. By staking cryptocurrency to smart contract DeFi applications (dApps), the process is straightforward and seamless.
Even though it is a relatively new mode of investiture, yield farming offers crypto participants several advantages. While certainly different from more mainstream products such as currencies, stocks, or ETFs, yield farming remains an attractive alternative for several reasons. Namely, high returns, extraordinary profits and ease of use.
1. High Returns
As with most things in active trading and investing, people participate in yield farming to make money. Often, returns on such endeavours are above and beyond those found in other modes of trade and investment. The lofty compensation schedules are a product of the appreciation of crypto assets such as Bitcoin (BTC) and Ethereum (ETH) as well as the application of compound interest.
Returns local to yield farming are calculated in terms of APY. APY takes into account the compounded interest rate paid for staked crypto during the lockup period. It also factors in the gains and losses relative to staked cryptocurrency values.
APYs vary from one liquidity pool to the next, but they can far exceed those found at banks or on Wall Street. In fact, VAI mint offers upwards of 20% APY (December 2021), an extremely high return when compared to the U.S. Federal Funds Rate (0.0-0.25%, December 2021).
Given the higher returns, it's possible to generate solid profits from yield farming. This is due to the compounding nature of interest rates, growth potential of DeFi projects and the potential for coin appreciation.
One example of yield farmers making steady profits was in the case of Curve. Curve is a decentralised exchange that facilitates swaps focussed on pegged assets courtesy of a 1:1 ratio. Curve runs many liquidity pools, with the largest being the "3pool" offering that contains DAI, USDC and USDT.
Investors in Curve sustained solid returns for the year of 2021. Due to Curve's reduced fee structure and a 122% spike in its native CRV coin, average liquidity providers realised an APY upwards of 5% for 2021 (4.5% to 9.5% APY). The stable returns made Curve one of the world's premier DeFi platforms and a prominent decentralised exchange.
In the aggregate, Curve has upwards of US$16 billion in total locked value (TVL) on the Ethereum blockchain; at the time of this writing, 3pool alone accounts for US$3 billion in deposits.
For all intents and purposes, staking crypto and participating in yield farming is a straightforward process. All one needs is some cryptocurrency and access to a DeFi platform—the matching algorithms automate the rest.
As an example, yield farming Balancer (BAL) on the Polygon crypto exchange is relatively simple. Balancer is a DeFi application that runs on the Ethereum blockchain. Below is an example of how to to yield farm BAL:
- Open a Polygon account
- Select Balancer
- Choose from the list of Investment Pools
- Connect your crypto wallet to Polygon
- Deposit BAL
- After lock-up, withdraw deposits from the liquidity pool
The automated nature of yield farming makes it attractive to legions of market participants. In only a few steps, one can invest in DeFi protocols in a user-friendly, intuitive fashion.
4. Force A Hard Fork
In the world of cryptocurrencies, a hard fork occurs when a community decides to change a blockchain's rules. Any shift to the blockchain protocol can impact coin values, the execution of smart contracts and functionality of DeFi apps.
Yield farming offers participants an opportunity to accumulate enough cryptocurrency to force changes in the blockchain itself. This phenomenon is succinctly described by Daniel J. Smith, economics professor at Middle Tennessee State University (USA):
"Hard forks enable the holders of crypto to force changes that would, at least in the opinion of the majority of the holders, improve the cryptocurrency going forward. In that way, hard forking gives crypto investors a power similar to what share voting does for stockholders."
At least in theory, staking coins to DeFi projects does offer the possibility of being able to change a blockchain. However, to force a hard fork, the cryptocurrency assets would need to be immense, likely under institutional custody. In addition, these assets would also need to be considered a "governance token."
Risks Of Yield Farming
Like all other modes of investiture, yield farming does come with a collection of risks. Among the largest are market volatility, hacking, scams, impermanent loss and regulation. As with any investment opportunity, it's up to the individual to perform adequate due diligence when selecting a liquidity pool for staking.
The cryptocurrency markets are well-known for their pricing volatility. In fact, the beta measurements for the likes of Bitcoin and Ethereum far outweigh those of conventional asset classes, suggesting much greater inherent volatility.
Accordingly, the swings in crypto pricing are often dramatic, which can rapidly increase or decrease the value of a given liquidity pool. This may lead to sudden spikes or crashes in the value of staked coins, subsequently boosting or detracting from returns.
Unfortunately for aspiring yield farmers, there is a history of fraudulent liquidity pools. These types of schemes typically involve the funding of fake DeFi projects and often resemble traditional ponzi schemes.
One of the most common yield farming scams is known as a "rug pull." A rug pull occurs when developers abandon a project and make off with investor funds. In November 2021, a notable rug pull facing the Squid Game cryptocurrency took place. Following a major run up in Squid tokens, developers pilfered US$3.4 million from investors. Subsequently, the price of Squid tokens crashed from above US$2,800 to US$0.01 in five minutes.
The hacking of smart contracts is a significant risk posed to yield farms. If a smart contract has glitches that make it susceptible for hacking, the entire DeFi project may be compromised.
A high-profile example of smart contract hacking came from MonoX Finance in 2021. Hackers stole US$31 million by exploiting a bug in the DeFi startup's smart contracts. Although such structural inefficiencies can be difficult to account for, increased audits and technological investment can reduce hacking risk.
Impermanent loss is the unrealised appreciation or reduction of staked crypto values. This risk is directly tied to market volatility, but becomes a negative factor when cashing out of the liquidity pool. It is possible for losses taken on staked coin values to exceed the compensation provided to the investor by the liquidity pool.
In many ways, impermanent loss is similar to taking a drawdown on a losing trade. As token prices fall, the aggregate position value is decreased. For decentralised exchanges (DEX) such as Uniswap, impermanent loss is a major consideration in facilitating trade and preserving market liquidity.
Akin to all things in the cryptosphere, enhanced regulation can impact asset values significantly. Due to the fact that yield farming relies on crypto assets, new regulations are capable of restricting the operations of DeFi projects.
In August 2021, U.S. Securities and Exchange Commission (SEC) Commissioner Gary Gensler directly addressed the topic of DeFi regulation:
"There's a lot of lending going on. There's a lot of trading going on. And without protections, I fear that it's going to end poorly."
At the time of this writing, the regulatory environment surrounding yield farming remains fluid. However, if Gensler's statement is any indication, DeFi regulation will continue to evolve into the future.
Yield farming is a mode of investment where individuals pledge or stake cryptocurrency assets to a liquidity pool. After a predetermined "lock up" period, investors are compensated for their assets via a standard interest rate or the allocation of designated coins.
On the upside, yield farming offers investors a way to generate passive income through earning a larger-than-normal annual percentage yield (APY). Also, the process is user-friendly and offers participants a chance to enact a hard fork. Conversely, there are a collection of unique risks involved with yield farming. A few of the greatest are volatility, scams, hacking, impermanent loss and regulation.
From a broad perspective, yield farming remains in its infancy. The endeavour may be new, but many are attracted to the chance at large returns and the low barriers to entry. Ultimately, the responsibility falls upon the individual to decide if yield farming is a suitable means of seeking their financial objectives.
FXCM Research Team
FXCM Research Team consists of a number of FXCM's Market and Product Specialists.
Articles published by FXCM Research Team generally have numerous contributors and aim to provide general Educational and Informative content on Market News and Products.
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