The potential of exponential earnings continue to attract new users to the cryptocurrency space, overall. People have continued to flock to Bitcoin because they believe that its price will continue to increase as its available supply continues to decrease.
With the rise of DeFi, however, a new catalyst for growth has arisen, called “yield farming.”
DeFi users who “yield farm” spend time researching DeFi protocols to develop a complex understanding of how to profit from them, then act on that understanding. Therefore, in a general sense, yield farming is like a trading strategy. If you consider the fact that yield farming has been reportedly making some investors up to 100% annual interest on their investments, then it’s clear that yield farming is a new crypto trend that everyone should understand.
How does yield farming work?
Yield farming sprung from the spread of decentralized lending platforms like Maker and Compound, which continue to be the major catalyst for DeFi growth. Yield farmers game these lending systems by figuring out what cryptocurrencies that they support are the most profitable to borrow.
Using the case of Compound, it is particularly easy to see how.
As you may already know, Compound is a decentralized lending platform with two classes of users: lenders who stake cryptocurrencies, and borrowers who take out loans in those cryptocurrencies. Because no lending system works without enough capital, lenders are incentivized with interest payments in cTokens as well as distributions of Compound’s governance token, COMP.
This, in turn, is where yield farming comes in. Yield farmers do whatever they can to rake as many of a service’s governance tokens as they can.
On Compound, this is made possible by the fact that some assets earn more COMP than others because COMP distributions are based on the interest created by an individual lending market. In other words, assets that have higher interest rates earn more COMP.
Therefore, if lenders choose carefully, they can achieve consistent interest payments, together with the maximal amount of COMP possible.
Since yield farming has resulted in hundreds of millions of dollars of new capital for the DeFi space in a matter of weeks, it would seem that such a strategy is working.
What are the key issues with yield farming?
Even so, the proliferation of yield farming comes with its own problems.
First, yield spikes on platforms like Compound are temporary and therefore, yield farming is akin to speculative trading. Next, if a lending platform offers a potential of 100% interest per year, while its traditional counterparts(like banks) offer much lower interest rates(about 1-2% for high interest savings accounts globally), then shouldn’t the risk of participating in a platform be a lot higher?
Furthermore, smart contracts are generally considered more risky the more complicated they get and it’s safe to assume that for DeFi, complicated is the rule.
Pre-launch audits of complicated contracts tend to cost between $40,000-100,000 or more, which suggests that some DeFi developers could look for cost cuts through using less reliable auditors. This possibility accentuates the fact that exploits in DeFi smart contracts have already been used to hack certain services this year.
These hacks occur both because smart contracts’ code, like any blockchain-based technology, is open-source as a rule and like the crypto space as a whole in 2017, DeFi is exploding in value at lightning speed.
For now, it’s not clear whether yield farming puts DeFi directly at risk for further hacks, but it is clear that the trend could start a dangerous, speculative bubble.
Still, for now, yield farming is showing no signs of stopping.