What is Yield Farming?
Updated: Jul 28, 2020
What is “yield farming”? Yield farming is creating ways to put crypto-assets to work to generate higher returns.
At the center of the “yield farming” craze is the Ethereum based money market protocol called “Compound” which has become the top DeFi platform in terms of Total Value Locked (TVL). At the time of writing, there’s $1.7bn worth of deposits and $1bn of borrowing on the platform.
How does one make money on Compound?
First, let’s start with the obvious.
You can lend your crypto and earn a return. An attractive enough interest rate attracts HODlers with idle cryptocurrency to the platform. Compound currently has attractive interest rates of 1.91% on USDC and 2.25% on USDT.
There are no free lunches, so what is that catch?
The attractive rates are accompanied by higher risk given they do not enjoy Federal Deposit Insurance Corporation (FDIC) protection.
This sounds simple. Anything else?
The next level of complexity is when you shop around for the best lending rates. Compound allows trading in 9 cryptos. Interest rates on different crypto assets change continuously. A seasoned investor can move funds across cryptos within to gain maximum yield.
All this is clear but not exciting enough. What is the buzz all about?
This brings us to the most exciting thing about Compound- COMPTokens. The creators recognized that having more users on the platform gives the protocol greater credibility. Therefore to incentivize usage, the Compound platform rewards users (not just lenders but also borrowers) by giving away COMPTokens.
*Yes- You heard right. You can earn money by borrowing
What is COMPToken?
COMPTokens is the governance token of Compound protocol. Governance tokens give the holder the right to vote on future protocol issues. Like a shareholder of a company would. They also have a dollar value and can be traded. At the timing of writing, a COMPToken was worth US$157. Compound has been distributing 2800 COMPToken every day.
So how can yield farmers maximize COMPToken earnings?
To maximize returns, most users both lend and borrow. They follow a strategy of depositing crypto assets in Compound as collateral. then borrowing from Compound on the back of the collateral. Then depositing the borrowed crypto back into Compound and so on and so forth. By optimizing which crypto they deposit and which they borrow, they can maximize their “yield”.
=> The final earnings will be: “+ Interest on deposits - Interest on borrowing + cTokens earned”
What is the risk in this strategy?
The deposit serves as collateral. The collateralization ratio is quite high. If this ratio falls below a threshold then the collateral is automatically liquidated. Given the volatility of cryptos, this is a big risk. To be safe, one would need to have even higher collateral than mandated by the protocol.