DeFi Farming 101 Guide
DeFi has altered the way we think about finance and investment. Yield farming is a popular activity in the DeFi ecosystem. But what exactly is yield farming and how does it work?
In this guide, we will delve into the fundamental economic interpretation of DeFi farming (yield farming).
To begin and sharpen our fundamentals, let’s address these three key questions:
First, what do yield farmers do?
Second, what do they get in return?
Third, who pays for this compensation, and is it explicit or implicit?
Yield farmers are essential for DeFi protocols and form a part of its core function. Farmers provide services such as staking, providing liquidity to traders, financing borrowers, and more (listed below). The expansion and development of DeFi ecosystems depend heavily on these services.
Second, yield farmers are paid for their services in the form of rewards, fees, and interest rates. These rewards are often higher than with traditional finance and can provide a significant source of income for those willing to participate in DeFi farming.
Finally, the compensation to yield farmers is usually given by the DeFi protocols or by other users of the protocol who benefit from the services provided.
Unlike traditional businesses, where the answers to the above questions are relatively straightforward on a paper contract, yield farming involves a range of activities that may not be immediately apparent. To simplify matters, most farming strategies revolve around a few primary types of economic activity that are performed in a passive or delegated manner.
These activities include supporting network operations by staking, supplying liquidity to traders, providing lending for borrowers, liquid staking, management and composability with other protocols, and enhancing marketing efforts. By examining yield farming through these abstract lenses, we can gain a better understanding of the opportunities and risk profiles associated with it.
Rather than diving into specific strategies that may quickly become outdated, this article focuses on the underlying conceptual foundations that are widely applicable to all farming opportunities.
What Is Yield Farming?
Yield farming refers to the practice of earning interest on cryptocurrency positions through passive strategies. Farmers must continually come up with ideas, manage risks, and rebalance positions. However, these strategies are considered passive because once farmers pay the upfront cost to find an opportunity, they can earn a return with little to no further action.
This framing contrasts with active ways of earning compensation, such as running validator nodes or managing algorithmic market-making strategies that require ongoing technical labor. Yield farming can further be defined with respect to a traditional buy-and-hold strategy, as it represents a way to earn extra returns while holding exposure to those same positions.
Of course, extra returns do not come freely. Yield farmers take on risks and provide a range of passive benefits to the protocol in exchange for compensation. We will now outline the different ways in which they do so.
The first major form of yield farming is for farmers to delegate assets to high-quality validators. These validators must perform reliably and honestly in exchange for a share of the proceeds. If yield farmers allocate to low-quality validators, those validators will face negative consequences; i.e., forfeited collateral. Ultimately, it is the yield farmers who bear that burden.
Yield farmers allocate their holdings to high-quality validators, allowing the network to run more efficiently and securely. Validators then remit a portion of the fees back to farmers as compensation, which are paid by network participants to validators in exchange for using the network.
The second major type of yield farming is when farmers deposit cryptocurrency positions into common liquidity pools known as Automated Market Makers (AMMs). Traders in need of liquidity can swap assets against these pools, often paying explicit fees in addition with spreads to do so.
Yield farmers provide liquidity to those in need, allowing them to enter and exit positions with minimal market impact. Liquidity providers earn these fees and/or spreads by facilitating two-way liquidity, but they also bear the risk of capital losses if the fundamental exchange rate changes (and does not revert). In contrast, active liquidity providers frequently adjust their positions as the exchange rate fluctuates.
The third major form of yield farming is a generalization of the first, where traders can lend cryptocurrency positions to anyone. In this situation, yield farmers place assets in funding pools, and borrowers automatically borrow from those pools using suitable collateral.
Farmers are compensated by borrowers, who pay interest continuously back to farmers (after the protocols’ cut). While some protocols temporarily guarantee fixed interest rates, most use floating rates that allocate supply and demand.
Liquid staking is a yield farming strategy that involves depositing a base asset into a staking protocol, which then mints a synthetic token that represents the deposited asset. This synthetic token can be traded or used as collateral to borrow more assets.
With the synthetic token as collateral, farmers can deposit more assets into the staking protocol and earn even more rewards. This strategy allows farmers to increase their exposure to staking and earning rewards, while still maintaining access to their underlying assets. The process of liquid staking can be complex and involve several steps.
One advantage of liquid staking is that it allows farmers to participate in staking rewards while retaining the flexibility to use their assets for other purposes. As with all yield farming strategies, it is important for farmers to understand the risks involved and only invest assets they are willing to lose.
Management and Composability with Other Protocols
The next opportunity that yield farming provides is managing assets in a passive and delegated manner to power pooled systems. Convex, for example, has been successful in directing liquidity on the Curve platform across liquidity pools. Yearn, on the other hand, has achieved similar success at a higher level by allocating assets across multiple lending and liquidity protocols.
Providing liquidity on Curve through Convex or directly is a yield farming strategy that can deliver value in multiple ways. In both cases, yield farmers earn rewards for providing liquidity. However, with the former, yield farmers earn extra rewards for providing liquidity more efficiently.
Marketing and helping with the reputation of the protocol
Yield farmers enhance visibility and trust through asset allocation, which adds value to the system. Protocols often reward illiquidity as a way of "leasing" attention and usage to maintain that value. This provides them with time to develop and mature. Protocols ask farmers to buy and lock assets in exchange for token distributions, with larger rewards for longer lockups. Locked holders who cannot respond to market conditions bear significant macroeconomic price risks compared with liquid holders, and that is part of the trade-off.
To sum up the fundamental economic value and compensation principles for yield farmers:
Yield farmers increase TVL in a given protocol. This leads to higher awareness and more usage. In return, yield farmers receive compensation from the protocol, which generally offers rewards in the protocol’s native tokens.
In the short term, non-farmers pay for these rewards by bearing the inflationary burden. However, the protocol aims to create value and attract new users in the long term. Later generations of holders pay for the marketing benefits provided by the early (yield farming) generations.
Yield farming is a risky yet potentially profitable economic activity that helps the DeFi ecosystem run more efficiently. Yield farmers earn returns by taking price risks and providing value. However, yield farming is no easy business. It requires finding under-appreciated opportunities, moving crypto positions rapidly, and understanding nuanced risks in smart contracts. Aspiring yield farmers should expect to make mistakes and only invest assets they are prepared to lose.
Yield farming strategies come in many variations, but they all share a simple core. Yield farmers passively provide value to protocols and receive both direct and indirect compensation. Financialization has amplified yield farming opportunities by allowing farmers to transfer assets freely and take generous leverage. This is how many yield farmers can multiply high base yields to even more enticing levels.
While financialization can increase yield farming opportunities, the underlying theory remains the same. Farmers are compensated for bearing risk and passively providing value, while financialization connects different parts of the ecosystem and expands the menu of risk-return profiles.