Yield Farming – The new DEFI Frontier

Ethereum-based credit market Compound started distributing COMP to the protocol’s users in June, 2020. This is a type of asset known as a “governance token” which gives holders unique voting powers over proposed changes to the platform. Demand for the token (heightened by the way its automatic distribution was structured) kicked off the present craze and moved Compound into the leading position in DeFi at the time.

Yield farming is a means of earning interest on your cryptocurrency, similar to how you’d earn interest on any money in your savings account. And similarly to depositing money in a bank, yield farming involves locking up your cryptocurrency, called “staking,” for a period of time in exchange for interest or other rewards, such as more cryptocurrency.

When traditional loans are made through banks, the amount lent out is paid back with interest. With yield farming, the concept is the same: cryptocurrency that would normally just be sitting in an account is instead lent out in order to generate returns. Since yield farming began in 2020, yield farmers have earned returns in the form of annual percentage yields (APY) that can reach triple digits. But this potential return comes at high risk, with the protocols and coins earned subject to extreme volatility and rug pulls

The term farming implies the high interest produced via the liquidity of different DeFi protocols. Along with rewards, DeFi protocols issue tokens that represent user’s share in the liquidity pool, which are moveable to other platforms for increasing their potential gains.

In a DeFi ecosystem, yield farmer performs the role of banks to lend funds for using the tokens to yield maximum returns. The entire ecosystem runs with the help of blockchain-based smart contracts, connecting the borrowers and lenders while handling the investors’ rewards.

Yield Farming is supported by Automated Market Makers or AMMS. So you would wonder what is an AMM after all.

New ways of facilitating finance have been accompanied by the rise of DeFi. Centralized exchanges like Binance and Coinbase enable trading through an orderbook. All orders set by traders are put into the orderbook and matched based on a trader’s desired price and the size of the trade.

A new type of exchange has rippled through DeFi—automated market makers (AMMs). Where a traditional exchange needs a market maker to ensure its orderbook is liquid, AMMs pool liquidity from various users and execute it based on a given equation. This equation varies for each AMM.

To understand liquidity provision, one must first understand how AMMs work

Uniswap is the largest AMM, so we’ll start there. Each Uniswap pool has two assets that equally contribute to the pool in a 50-50 allocation. Uniswap’s pools are designed using the equation of X x Y=K.

X is the quantity of the first token, Y is the quantity of the second token, and K is the product of the two, which is to remain constant. This is aptly named the constant product equation.

Let’s say there’s an ETH-USDC liquidity pool with 100 ETH and 1000 USDC on Uniswap. The constant product is 1,000,00 (100 x 1000) and the implied price is 10 USDC per ETH.

Somebody wants to buy 10 ETH from the pool; X (amount of ETH) will decrease from 100 to 90. So if K is to remain constant at 100000, Y must increase to 1112 (100,000/90).

At the end of it all, there’s 90 ETH and 1000 USDC in the pool, implying a price of 11 USDC per ETH. That one trade caused a 10% increase in the price of ETH through slippage.

Yield farming majorly involves the role of liquidity pools and liquidity providers. A user who deposits the cryptocurrencies in the smart contract is known as Liquidity Provider, while smart contracts are nothing but liquidity pools. These pools exist on specialized decentralized exchanges known as Automated Market-Maker (AMM). For example, the platforms like Uniswap, Curve and Balancer allow traders to swap tokens by depositing one token into the pool and getting the proportionate amount of the other in exchange. They pay a small fee to execute the transaction, which gets distributed into the entire liquidity pool. Liquidity providers earn this fee.

So you may wonder, how much money can I earn via Yield Farming. Let’s use Compound as an illustration. As of January, 2022, a person can put USDC or tether (USDT) into Compound and earn around 3% on it. Most U.S. bank accounts earn less than 0.1% these days, which is close enough to nothing

However everything is not as rosy as it appears. DeFi is a far riskier place to park your money. There’s no Federal Deposit Insurance Corporation (FDIC) protecting these funds. If there were a run on Compound, users could find themselves unable to withdraw their funds when they wanted.

Similarly, a user might get tempted by assets with more lucrative yields like USDT, which typically has a much higher interest rate than USDC. The trade-off here is USDT’s transparency about the real-world dollars it’s supposed to hold in a real-world bank is not nearly up to par with USDC’s.

Yield farmers sometimes use DeFi platforms that offer various incentives for lending to optimize the return on their staked coins. Some of the most popular Yield Farming Protocols are as follows :

If you are a start-up or an established organization planning to build your DeFi yield farming platform, AARCHIK Solutions can assist you in your venture. We offer the most comprehensive DeFi yield farming services – from building a smart contract-driven liquidity pool to solution implementation and deployment. We can help you leverage ingenious solutions to create an exceptional user experience and improve time to market.

The highlights of our process for building Yield Farming App are as follows :