The year 2020 has been a roller coaster ride for cryptocurrencies, stablecoins, and, most significantly, decentralized finance. Earlier in February, before the full-blown pandemic and the aftermath in the digitized world, no one could have predicted that decentralized finance would massively impact the blockchain space as much as it has. With a total value locked of $11b, assets locked in DeFi have increased to almost 20-fold its value in January.
On an immense scale, DeFi has offered multiple users peer-to-peer banking systems to exploit traditional banking services like credit systems on a decentralized basis. Of course, there are many reasons and explanations for the growth of the DeFi space; one recurring topic is yield farming.
Yield farming is a summative term that describes moving crypto assets around to derive maximum yields while underpinning some significant risks. Yield farmers use different strategies that involve borrowing and lending while offering collateral as a "stake."
In most cases, the crypto asset is a stablecoin, and the yield farmer offers his asset to a permissionless liquidity pool; this way, the yield farmer earns passively from the liquidity pool. Unlike traditional banking and finance systems where interest rates are usually less than 1%, some yield farmers have made annual percentage yields of 10,000% on their assets. Profitability in yield farming depends on how quickly you can move your asset and the reward system of the DeFi protocol.
Although DeFi has been around for roughly three years, it gained little attention for most years. However, its popularity quickly rose in June 2020 when Compound started distributing its new governance token, COMP, to its protocol users. With a properly decentralized product, COMP owners began to earn more tokens by providing liquidity to the pool in a process described as liquidity mining.
In the past, some token protocols like Focoin and EIDOS had often rewarded users for performing transactions, similar to liquidity mining protocol. However, COMP'S token was some sort of awakening, and by July 2020, liquidity mining had spurred the use of DeFi and attracted a sea of new users. The total value locked in DeFi assets quickly crossed the $1b mark and then crossed the $10b mark.
Risks of yield farming
Today, there’s a lot of argument bordering around the sustainability and longevity of yield farming protocols. Most of the argument against is directed at the risks undertaken by yield farmers and how it makes them different from gambling. Some of the risks are discussed briefly:
Smart contract bugs: In a harmless attempt to eliminate go-betweens and intermediaries, yield farming protocols are built using smart contract protocols on ERC-20. However, a bug or malicious software can completely ruin a DeFi protocol and is by far the most significant risk of yield farming.
Liquidation risk: When obtaining a loan, collateral is often provided. Similarly, in borrowing a token on a DeFi protocol, the collateral must be maintained above a certain amount; else, the borrower will be liquidated immediately by the smart contract.
Some other significant yield farming risks include increasing gas fees and the risk of strategy.
Yield farming has outperformed our expectations and has brought many new tokens to the limelight. Of course, we can predict as much as we can, but only time will reveal how sustainable these protocols will be. For now, Yield farming has been profitable; investors can sit back and enjoy the ride.