DeFi and the Yield Farming Phenomenon
Mahi Sall, Advisor, Fintech-Bank Partnerships, Payments and Financial Inclusivity
January 25th, 2023
Mahi Sall is the CEO & Founder of FinXpair, a Berlin-based strategic advisory boutique firm focu[...]
Intro to yield farming and the latest developments in DeFi
Coinbase Blog | Justin Mart | Jul 24, 2020
DeFi and the Yield Farming Phenomenon
DeFi protocols exploded in all metrics over the last month, passing $3B in Total Value Locked (TVL), triggered by the launch of the Compound governance token ($COMP) and subsequent “yield farming.”
What is Yield Farming?
Most crypto protocols are designed to be decentralized. For base-level networks (like Bitcoin and Ethereum), this is achieved through Proof of Work, where anyone can be a miner and earn some BTC or ETH in exchange for helping secure the network. In so doing, control of the network is more or less democratic (one CPU one vote).
But how do projects built on Ethereum achieve decentralization? One path is to hand over governance in the form of tokens to the users of a protocol, effectively turning users into stakeholders. This is precisely what Compound (an autonomous borrow/lend protocol) pioneered. They are releasing $COMP tokens, which provides governance rights over the Compound protocol, to the users of the network, distributed pro-rata according to how much they use the protocol.
Sounds good, right? Two observations:
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- $COMP governance tokens hold value. Compound is the leading DeFi borrow/lend protocol, and governance rights over this network are powerful.
- Distributing $COMP pro-rata to users of the protocol is free yield. It’s an added bonus just for using Compound.
When $COMP was released, the token quickly appreciated in value owing to Compound’s leading position in the DeFi ecosystem. The community quickly realized that adding assets to Compound and/or borrowing against them resulted in significant interest rates due to the additional $COMP being distributed (topping 100% APY at some points).
Ergo, the practice of using a protocol to earn native platform tokens is known as “yield farming.”
What Happened with Compound
Yield farming drove a flood of capital into Compound — in a single week in mid-June nearly half a billion dollars was added to Compound, driving total value locked (TVL) from $100M to over $1.7 B at the peak. $COMP similarly opened trading around $80 and exploded to over $300.
However, not all metrics are as honest as they appear. With Compound, it’s possible to recursively invest your capital, multiplying your yield. It goes like this:
- Add 100 USDC as collateral to Compound (earning interest + $COMP)
- Borrow 70 DAI against your 100 USDC collateral (paying interest but earning $COMP)
- Trade 70 DAI for 70 USDC (bonus: on a DEX)
- Repeat Step 1
DeFi composability adds another dimension, where it’s also possible to stack your yield across different protocols. For example, you could lock DAI in Compound, and deposit your compound-DAI tokens into Balancer for additional yield farming.
Popular DeFi tracker defipulse.com does some cleaning on reported TVL to account for these effects. As of July 23, 2020 they report Compound’s TVL at $550M.
See: Could Bitcoin on DeFi displace banks? Yes
Yield Farming is Not Without Risk
In efficient markets, increased yield is reflective of increased risk. While DeFi is a largely inefficient market today, outsized DeFi yields are still indicative of additional risk:
- Smart Contract risk: Smart contracts are prone to exploits, with several examples just this year (bZx, Curve, lendf.me). The surge in DeFi has led to millions in value being slammed into nascent protocols, increasing the incentive for attackers to find exploits.
- System design risk: Many protocols are nascent and the incentives can be gamed. (E.g., Balancer, where FTX was able to capture >50% of the yield due to a simple flaw)
- Liquidation risk: Collateral is subject to volatility, and debt positions are at risk of becoming undercollateralized in market swings. Liquidation mechanisms may not be efficient, and could be subject to further loss.
- Bubble risk: The price dynamics of the underlying network tokens (like $COMP) are reflexive because expected future value follows usage, and usage is incentivized by expected future value.
In general, DeFi protocols with significant capital are honeypots for exploits. In just one week, the Balancer protocol was gamed by an exchange, changed its protocol rules, got hacked, and saw the token price go up 3x! In some ways DeFi is still the wild west — be careful out there.
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