How Yield Farming works in DeFi Skip to content

What is Yield Farming and how to make money on it

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One of the most popular strategies for earning money in DeFi is so-called Yield Farming. In this article, we will tell you what it is and give you examples of earning this way.

What is Yield Farming

The term «Yield Farming» appeared from comic posts on Twitter. Now this is the name of the earnings strategy, relying on using assets to obtain tokens for DeFi projects. DeFi projects are an ecosystem of applications with functionality similar to traditional financial instruments. Such applications work automatically, using smart contracts and blockchain technology. Therefore, to change a DeFi project, you need to vote. In order to vote, you need governance tokens. Their main function is the voting right, but they have their own value and are traded on cryptocurrency platforms.

Governance tokens can be purchased or obtained for performing certain actions. For example, for locking funds in the protocol at interest or for getting a loan. The exact rules depend on the specific protocol in question. The first effective use of this system was in the Compound project. Every day, the protocol distributes 2312 COMP governance tokens between those who provide loans and take loans in a 50/50 ratio. Distribution between specific users is proportional to the amount of funds locked. The cost of one COMP token as of November 2020 is about $90.

In addition to managing tokens, DeFi projects give users tokens that you can use to get your funds back from a locked smart contract. For example, Aave gives aTokens, Compound gives cTokens, and Synthetix gives sTokens. If you want to return your funds from the liquidity pool, you return these tokens to the protocol. 

Yield Farming means getting the maximum return from using your asset. For example, you locked ETH in Compound and received cETH. While you earn interest, you take cETH tokens and lock them in another protocol and get a return from there. At the same time, you also get COMP management tokens for locking ETH in Compound. Thus, you get the maximum profit from your ETH asset. 

Supply of liquidity to DeFi projects

This is a popular way to earn tokens. Many DeFi protocols need liquidity to work successfully — assets that users lock in the app’s smart contract. Initially, for providing liquidity, the smart contract paid only an interest, the amount of which depends on the specific DeFi project and the locked asset. But the volume of liquidity was insufficient when this model was used. Therefore, developers began to reward supplying liquidity not only with an interest but also with the project’s governance tokens. Thus, a fair system is created — the more liquidity you supply, the more tokens, and therefore votes you get.

Supplying liquidity to DeFi projects is similar to a bank deposit. You also provide your assets in exchange for interest. But there are a few differences:

  • You can withdraw funds from the DeFi protocol at any time and save the interest received during this time;
  • The interest on DeFi projects is dynamic and depends on the asset you are locking and the balance of supply and demand at a given time.

Interest rates are similar to rates of bank savings accounts. For example, the average interest rate in the Aave and Compound protocols is 1-3% per annum.

Application for automation of Yield Farming

With the growing popularity of earning money on supplying liquidity, dedicated applications have appeared that simplify this method of earning money. The first such app was Yearn Finance. This project tracks the yield in the Aave, Compound, and dYdX liquidity pools and automatically moves the user’s assets to the pool where the yield is higher at the moment.

Yearn Finance solved the problem with the dynamic interest rate of liquidity pools. Instead of constantly checking where the yield is higher, the protocol can perform the same actions. Users lock their assets in the smart contract, and then Yearn Finance performs all the work independently. 

The project was created by one developer — Andre Cronje. When he released the project and added YFI governance tokens to it, they showed record profitability. The cost of YFI increased from $90 to $40,000 in 2.5 months, but dropped later. As of November 2020, the YFI token is worth about $10,000.

Summary

Yield Farming is one of the strategies for making money on DeFi projects. Its goal is to earn DeFi projects’ tokens. Governance tokens give the right to vote for changing the project. You can get them for using the app’s features, such as getting a loan or providing a loan.

DeFi projects need user assets — liquidity — to work correctly. In exchange for supplying liquidity, protocols pay interest. DeFi projects work automatically, so the interest rate for liquidity changes dynamically. However, you can withdraw funds from the protocol at any time and save all the interest accrued during this time.

There are DeFi projects dedicated to yield farming. For example, Yearn Finance, which tracks the yield of several DeFi projects and automatically moves the user’s assets to where the yield is higher.

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