What is yield farming for absolute Defi beginner

TL:DR. It’s like deposit your assets in the bank to get interests. In Crypto, you deposit your assets and get other tokens back in return. Different type of yield farming is available, and it involve of different risks. You could get profit or you could lose everything(including principle). It is however the fashion in crypto space as a way of distributing tokens. Crypto is highly speculative.

Like deposit your money in bank and get interests(as money) in return, you can deposit your assets(token or liquidity pair) into crypto projects and get interests back(as tokens). It is a way of distributing tokens to users and involve different level of risks, which a Defi user should definitely be aware of. Token from a Dapp could be worth nothing or vice versa, so you should choose a Dapp that you trust instead of hopping on high APR/APY blindly.

I will be explaining the risk, benefits and logic behind and introduce different type of yield farming.

Purpose of yield farming

As explained, yield farming is to have users depositing their assets, then giving back protocol tokens in return as reward. It is consider one of the major methods to distribute tokens to users, besides private token sales. When a protocol design the tokenomic of tokens, they need to send those tokens to community members that really care and love about protocols. Those users then become members of DAO to vote about changes of protocol design or share the protocol revenue. Protocol tokens can also be called governance tokens, where the valuation is sometimes subjective and speculative. There is absolutely no guarantee how much a token is valued or how it will be valued.

Mind map of a yield farming

Yield farming pool types

There are three types of yield farming as I observed. (1) Single token yield farming (2) Liquidity pair yield farming (3) Pool2 yield farming. The main difference of those three are risks versus rewards. If you take more risks, you will get more tokens. Be reminded, you are getting tokens, and the token value is actually volatile.

  1. Single token yield farming. You can deposit single token to farm “protocol tokens”. Most common tokens that are accepted as “base tokens” for “reward tokens” usually are most valuable tokens, include BTC, ETH, USDT, USDC, BNB, MATIC, Sol. Usually the purpose of this type is to get public attention and boost TVL.
  2. Liquidity pair. This usually includes BTC+stablecoins, ETH+stablecoins, BNB+Stablecoins, or similar combination. The purpose is to get TVL boosted.
  3. Pool2 yield farming. This is a pool that is paired with “reward token” and “base token”(like ETH,stablecoins). It usually gives the highest “protocol token” as rewards but you might suffer greatly due to Impermanent lost. The purpose of poo2 is usually to get liquidity in AMM so people can trade. A good liquidity(large value pair) can ensure a large sell order didn’t suffer from price dump.(AKA slippage is at better rate)
Illustration of different type of liquidity pool

Benefit of yield farming

First we need to know what makes yield farming possible by explaining AMM(Automated Market Maker). On the contrary to AMM, traditional finance use order book design to facilitate a trade, where a trade is only possible when “sell order” match “buy order” in both price and quantity. Unlike order book design, you can always make a trade if there is liquidity pool(reserve) in AMM.

In AMM, a liquidity pair needs to be created as a pool(reserve). The pool includes “A token and B token” where shares the same value of a pool (50:50). The illustration below indicate “100 TokenA” will have the same value as “10 TokenB” in the reserve. When you want to get B tokens, you need to use A token in exchange of B token meanwhile pool ratio still keeps same(50:50). Since the liquidity pool(reserve) is always there, you can always make a trade. Once token can be traded freely in the market, people can start to get financial benefits by selling their tokens to the one who is investing in the protocol.

An example of AMM design (source: Uniswap)

You can refer more detail on the Uniswap website here.

As protocols, there are benefits of yield farming event, which is due to the design of AMM. There will be liquidity pool for the protocol that everybody can trade in the market. Unlike orderbook design in CEX, most Defi DEX use AMM(pioneer by Uniswap) to facilitate token swap(trading).

As community, there are benefits too. (1) Community members can get high APY/APR base on their investment on yield farming, which is base on token standard. It means the dollar value could be potentially unlimited upside as well as downside. (2) Additional reward token could be used for yield farming as well(like pool2 farming), therefore creates new possibilities (3)Participate in DAO to make proposal and to vote proposal, share platform revenue….etc.

Risk of Yield Farming

“Protocol tokens” might bring you gains but has much higher possibility to bring you to unlimited downside if you didn’t choose wisely. There are at least three risks besides the “protocol tokens” price variation (a polite way to say 0). There is few media reporting such sad stories like Rekt.news, you can visit their leader board to know the full background of each major accidents.

Impermanent loss is happened when your token price of “adding liquidity pair” and “removing liquidity pair” is different in relative ratio. We won’t go to the detail here, but you might gain reward token when providing liquidity then losing the liquidity pair(LP) value if the ratio your “entry price LP” and “exit price LP” is different. This is especially serious when you invest in Pool2, since the “protocol token”(reward tokens) price is very volatile during TGE(Token genesis event). If your “protocol token” price plummet, it is very likely all your Pool2 liquidity becomes useless. If your LP TokenA and TokenB rise or fall in same direction with same ratio, there is no impermanent Loss. Please read detail of the Binance Academy again since the concept of impermanent loss is key in Defi farming! Use the impermanent loss calculator and try different factors to feel what it looks like to make sure you understand it!!

Illustration of Impermanent Lost

Rug-pull in crypto space means the project you invested is suspended by the team itself, deliberately, surprisingly. Website, discord, twitter, telegram, all gone. The team plan to steal your investment from the inception, so they make the Dapp, whitepaper, discord, twitter, telegram, everything without really trying to make a long sustainable project. You will lose everything you had invested and there is no way to get it back(due to anon team in Defi, which is common). Luckily some crypto community had show their expertise and pursue legal actions to bring back the lost, but it might not happen in projects you had participated.

Exploit, it means there is flaw in smart contract that hacker can use the loophole to get assets which are stored on chain (through smart-contract). It could be either just transfer assets from protocol to hacker’s wallet or an economic attack that hacker dumps all tokens he got from the smart contract flaw. (So your holding value decrease)

Yield farming protocols

There are two kind of options when participating yield farming of a protocol. First, you can manually harvest your reward and sell it for profit(stablecoins or other coins). Secondly, sell it into the same token as you deposited, and do yield farming with more deposited tokens. You will need to manually harvest/invest daily or regularly which is time consuming. There is a bunch of protocols provide service of yield farming for your.

Instead of manual harvest/invest, those yield farming protocols do the hard work for you automatically with some twist. I define different types of yield farming protocol into categories. (1) Optimal strategy (2) Auto compound (3) leverage compound. Each protocol will charge different percentage on your profit gained as performance fee, which could range between 3.4% to 20% depends on protocols. Two benefits of these protocols include automatic compounding and save gas-fee(since funds are pool together), with down side of additional smart contract risk associate with these platform. If you choose a prestigious platform, those risks will be minimized.

  1. Optimal strategy type. (like Yearn and Convex both in Ethereum)

Just like the bank deposit example we made earlier, users will choose the bank with best interests(means reward) or reputation(means trust) to deposit. Same scenario applies to the crypto space, users tend to seek a balance between risk and reward. Yearn is the pioneer for this type of protocol and leads to the incredible Defi Summer in 2020. You could choose which vault to deposit in Yearn and Yearn has different strategy in each vault that bring users the optimal yield automatically. Some strategy will involve lending, minting and farming while some might be designed specifically for Curve.fi, you can find more detail on YFI document and medium articles. On the other hand, Convex is designed specifically for Curve.Fi which optimise the return based on the mechanism of Curve.fi.

Yearn website

2. Auto compound (like Autofarm in BSC)

This kind of protocol simply performs the harvest/compound task on behave of users. You do not have to do the heavy lifting and the protocol will perform task regularly for users. There are similar protocols on each blockchain or like Autofarm who support multiple chains in the same time. The key to find best auto-compound protocol for you is to check the necessary protocol fees and to find ones with best reputation and to try it yourself to see what user interface works best for you. Some protocols provide portfolio management tool and additional on-chain analysis data for users while some focus on bringing as much options to users as possible.

Autofarm user interface and vaults

3. Leverage compound (like Alpaca in BSC or Alpha in ETH/BSC)

Leverage compound protocol is automatic compound yield farming protocol which integrate lending protocol. Alpaca and Alpha have their own native lending protocol that allow users to deposit their single assets(like BTC, ETH, BNB, stablecoins). The lenders will get “protocol tokens” as incentives besides the lending APR (which is paid by borrower). Unlike other lending protocols(i.e. AAVE) which users can borrow assets, those liquidity in lending pool can only be borrowed by farmers within the platform.

Farmers will then be able to farm with their own capital with additional borrowed assets to farm/generate high return. For example, you can use 100 $USDC out of your pocket and borrow additional 200$USDC from protocol to farm on a capital worth of 300 $USDC. Naturally, your $300 farming position will bring you more profits than your $100 position. When you close your position, you will pay back the loan(with interests)to the lending pool in the same time.

Alpaca and Alpha finance

Leverage compound yield farming is a much more complex concept since you are borrowing and leveraging in the same time. If you farm with more than 2x leverage, your position will be partially “long” and partially “short” depends on your leverage token selection. All leverage yield farming protocol provide comprehensive guideline to help users, but it’s still an advance topic in my point of view. If you didn’t keep healthy safety buffer of your position, you will be liquidated and lost part of your capital.

Where did your yield farming yield come from?

Most common question includes where did the yield I get come from? The first questions to be answered is that Defi yield usually comes from (1) demand from leverage (2) Reward tokens (3) Trading fee share.

Most tricky one is the (2) Reward tokens.

When we talk about the benefit of yield farming, we explained that in AMM design, people can trade as long as there is liquidity pair(If slippage is ignored). In pool2, our KYC Finance provides most of $KYC as rewards to pool2 liquidity pair, i.e. $KYC+$BNB pair. When the liquidity poor is added, community can swap their $KYC into $BNB. Three things will happen that (1)There will be more $KYC and less $BNB in the pool (2)User “sell” their $KYC into $BNB that drives down $KYC price and pushes up $BNB price (3)$BNB can be swapped to other tokens since $BNB is paired into liquidity pools with almost all tokens(includes stablecoins )

When 90% of the community members sell their $KYC tokens, the $KYC tokens become worthless, therefore, people who still have pool2 liquidity will be owning much more $KYC than $BNB to maintain the 50:50 value. If I deposit a $KYC+$BNB into pool2(and still in), I will get only few $BNB back with a chunk of $KYC when I remove liquidity. I will be the one that contributing your yield(My $BNB becomes yours).

Conclusion

Yield farming is a must-learn lesson in Defi. Those protocol tokens were usually governance tokens with value, and it also depends on what kind of problems did those protocol solve. A protocol that really solves the pain can be really valuable while it is sometimes hard for fork projects to survive in the long term. I will recommend you to really understand and use those protocols before you invest but crypto is a wild wild west, who know what happened. Please prepare to lose everything before you join Defi, and maybe maybe you will find gems that no body is aware of yet. One thing to be certain, Defi is here to stay!!

note1: some protocol provide options rather than 50:50

note2: Risky projects tend to sell most of team tokens once there is liquidity. They just want to get money.

Please follow me on my twitter if you find it helpful. I also do Youtube video in Mandarin but with English subtitles, specifically for user who has only experience with Binance or CEX and want to use Defi.

Follow me on twitter https://twitter.com/Graysoncheng1

Follow me on youtube https://www.youtube.com/channel/UCTl8x9Fbt-NxXeubSOk_81g/featured

Join telegram communities to know more about Defi projects

https://t.me/TheDeFiDistrict

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Weave, passionate in Community, Growth. Making mandarine YT content https://www.youtube.com/c/CryptoGrayson/videos

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Weave, passionate in Community, Growth. Making mandarine YT content https://www.youtube.com/c/CryptoGrayson/videos

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