One of the hottest areas in cryptocurrency today is decentralized finance (DeFi). Entrepreneurs in the crypto market will recreate traditional financial tools within a decentralized environment, outside of the control of any company or government.
The need for a more transparent and open financial system is the key driver behind DeFi. It is a blockchain-enabled concept that gives progressive and agile tools to users, reducing operational risk associated with a traditional finance model.
The DeFi sector boomed in 2020 with new coins such as UMA and COMP, allowing users to use traditional services such as lending and borrowing (giving rise to yield farming) in a decentralized ecosystem. Several reports point to the excessive growth in the DeFi economy over the last year, with the total locked value currently at $18.09B.
Decentralized and traditional finance have three core differences.
Mutual trust is a big win for DeFi over traditional financing. For example, if you want to borrow from a bank, there is a legal requirement to conduct identity and credit checks to assess whether the borrower can repay the debt. In DeFi, everything is about mutual trust and preserving privacy. There is a possibility that if regulators continue to stifle innovation, there will ultimately be no place for intermediaries in the finance industry.
The first deployment of DeFi was Bitcoin, which enabled people to complete a financial transaction without a financial intermediary. Bitcoin and a few other cryptocurrencies began the first wave.
However, the second wave of DeFi enabled by the Ethereum blockchain added another layer of programmability to the technology. Almost all DeFi applications are built on the Ethereum blockchain, a network that maintains a shared ledger of digital value. The participants within the network control the issuing of cryptocurrency (ether) in a decentralized manner.
Decentralized exchanges (Dexs) such as Uniswap are entirely peer-to-peer, without any company or other institution providing the platform. DeFi services in 2021 include:
The advantage of DeFi is that you can stack decentralized applications (dApps) to maximise returns. For example, an investor might decide to buy DAI and then use Compound to lend it and earn interest. The decentralized nature of DeFi means everything can be done via your smartphone. In the future, it will probably6 be standard to buy property or land using dApps using smart contract agreements. Without the involvement of lawyers and agents, it will make the process a lot faster and cheaper.
Some high profile players are now involved with DeFi. The Interbank Network is being led by JP Morgan, ANZ, and Royal Bank of Canada, where 75 of the world’s biggest banks are trialing blockchain applications. The impact of Covid-19 means that DeFi could offer a much higher return than traditional institutions, with the pandemic driving down interest rates. With a platform like Compound, you can get an APY of 6.75% and the incentive of Comp tokens. DeFi is also the perfect answer for people without a bank account.
Yield farming is the cornerstone concept for DeFi from 2020. In June 2020, the Ethereum-based credit market Compound started to distribute its governance token, COMP, to the protocol’s user base. With the way the automatic distribution was structured, demand for the token initiated a craze and moved Compound into the leading position in DeFi.
With yield farming, the goal is to maximize a rate of return on capital by leveraging different DeFi protocols. A yield farmer will look for the highest yield by moving between several strategies. A profitable strategy is usually one with the fewest DeFi protocols such as Compound, Synthetix, or Curve. When a strategy stops working, the yield farmers will move their funds between protocols or swap coins to those that can generate more yield.
An easier way to explain yield farming might be to compare it with traditional finance. For example, suppose you want a new savings account that offers the highest annualized percentage yield. You would compare the accounts and see which will give you the best return on your money across different products. The returns of different yield farming strategies can be expressed in the same way. However, when you think many savings accounts might have a 0.1% APY, meaning you don’t get a lot for your investment, yield farming can boast as much as 100% APY.
An investor will approach a DeFi platform like Compound, collecting crypto assets, and lending them to borrowers, paying back interest on the loan to the investor. Interest can be either fixed or variable with the rates decided by the individual platform. Compound rewards users with its native token “Comp” for example, along with the interest payment.
In order to borrow some funds from the platform, a borrower will need to deposit double the borrowed amount as a form of collateral before proceeding to the deal. Using smart contracts, the value of the collateral can be checked at any point in time. If it is less than the borrowed amount, the contract can trigger to liquidate the borrower account, and interest is paid to the lender. This means the lender will never be at a loss, even if the borrower fails with repayment.
To understand how such high returns are plausible, you need to understand liquidity mining, leverage, and risk, which are the three core elements of yield farming.
The distribution of tokens to the users of a protocol is called liquidity mining. It creates additional incentives for yield farmers as token rewards can be added to the yield they are already generating. Sometimes, a farmer might be willing to forfeit their initial capital to gain rewards in the form of distributed tokens such as COMP. Their overall strategy will remain highly profitable.
Leverage helps to make high returns possible. It is the strategy of using borrowed money so as to increase the likely returns on investment. A farmer will deposit their coins as collateral to one of the lending protocols and then borrow other coins. The borrowed coins are then used as additional collateral to borrow more coins. If the farmer keeps repeating the process, they leverage their initial capital multiple times and generate cumulative returns.
Yield farmers are willing to take high risks to hit double or triple digits APY returns. The loans they take are overcollateralized and susceptible to liquidation if it drops below a certain collateralization ratio threshold. There are also risks with the smart contract, such as bugs and platform changes or attacks that try to drain liquidity pools.
A yield farming strategy aims to generate a high yield on capital. The steps will involve lending, borrowing, supplying capital to liquidity pools, or staking LP tokens.
A straightforward way of getting APY on your capital is through lending and borrowing. For example, the farmer can supply a stable coin like DAI on a lending platform and start to get some returns on their capital. With liquidity and leverage, they can then take that to the next level.
By supplying coins to one of the liquidity pools, a yield farmer can be rewarded with fees that are charged for swapping different tokens. With liquidity mining, they can boost that return again to gain extra tokens. With Balancer, for example, they can get extra BAL tokens, which increase the APY.
Some of the DeFi protocols will incentivize the farmer even more by allowing them to stake their liquidity provider or LP tokens representing their participation in a liquidity pool. It gets a bit more complicated here, and it is worth reading this more in-depth tutorial on staking to understand how it works.
Each of the strategies can work together to yield even higher returns for the farmer. Like most financial markets, a strategy can quickly become obsolete due to changes in protocols or incentives, so it is essential to keep on top of it every day and amend your tactics as appropriate.
A governance token is a token that a developer creates to allow token holders to decide on the future of a protocol. They can influence new features or change the governance of the system itself.
Yield farming can attract more people to DeFi protocols and increase user adoption, despite still being an immature strategy. It is yet to become an efficient market, meaning there are many opportunities to find a high return rate compared to traditional finance. It is a complex strategy, so while we have offered an overview here, you will need to look at more detailed guides before venturing into the yield farming world.
Disclaimer: The author of this text, Jean Chalopin, is a global business leader with a background encompassing banking, biotech and entertainment. Mr. Chalopin is Chairman of Deltec International Group, www.deltecbank.com.
The co-author of this text, Robin Trehan, has a bachelor’s degree in economics, a master’s in international business and finance, and an MBA in electronic business. Mr. Trehan is a Senior VP at Deltec International Group, www.deltecbank.com.
The views, thoughts, and opinions expressed in this text are solely the views of the authors, and do not necessarily reflect those of Deltec International Group, its subsidiaries, and/or its employees.
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