Yield Farming

- explained by the CUTcoin team
This article is practically a spin off of the DeFi topic we started covering recently. You can find our first article here.
Yield farming is attracting both crypto enthusiasts and amateurs towards the world of decentralized finance. So, what exactly is yield farming? It is a mechanism that allows crypto investors to earn rewards on their crypto investments. Many may also know yield farming as liquidity mining. To put it simply, it means locking up cryptocurrencies and getting rewards — somehow similar to staking, but the matter is quite tricky here.

Indeed, the staking concept is at the center of yield farming. In yield farming, funds are held in a crypto wallet. It enables one to transact on the blockchain network. The user whose funds are held in the wallet earns returns on it. On the other hand, the liquidity providers hold liquidity mining funds in the liquidity pools.

Liquidity Providers — What is their Role?
There's no yield farming without the liquidity providers. Are you thinking why is it so? It is because liquidity providers are the ones who actually add their funds to the liquidity pools. Hence, there won't be any funds in liquidity pools without the liquidity providers. They are also known as market makers in terms of business.

Any guesses about why liquidity providers are also called as market makers? The answer to that question is quite straightforward. They supply what both buyers and sellers want to trade. Hence, liquidity providers are also known as market makers.

Now, the question is how exactly does a platform use the market makers to achieve this? They put up money pools so that the sellers and buyers can do transactions quite conveniently. These platforms make it easy to swap tokens as well. But it does get quite challenging and risky, too, to locate an individual seller or buyer on these platforms.

There is a big role of smart contracts in yield farming. Do you know what part of the yield farming process acts as a smart contract? The pool! Yes, it is the pool that acts as a smart contract. The buyer-seller agreement is coded in the pool.
How to Calculate Your Yield Farming ROI?
The annual method of computing for earning the expected interest is the most popular way for calculating the yield farming ROI. You can use the annual percentage rate and annual percentage for ROI calculations in yield farming.

  • Annual Percentage Rate
Annual percentage rate, popularly referred to as APR, is imposed on the borrowers. But instead of being paid to the borrowers, it is paid to the capital investors. In the annual percentage rate method, the interest amount is not added back to the investment scheme for earning more interest.

  • Annual Percentage Yield (APY)
Annual Percentage Yield, popularly referred to as APY, is paid to the capital borrowers. Yet, it is the capital borrowers that are charged an annual rate of return in APY. There's only one difference between APR and APY. In APY, there's a possibility to plow back the interest income to earn more on investment.

When did Yield Farming Takeoff?
The laurels of starting the frenzy for yield farming goes to Compound, a popular DeFi project. It is because the frenzy began with the launch of the Compound's governance token — COMP. What's the role of COMP tokens in the Compound Finance ecosystem? The COMP token holders will get governance rights.

But there's a problem with governance tokens! How does a DeFi project distribute the governance tokens? This question arises because distributing these governance tokens may be a hindrance to achieving the status of true decentralization. There's a common solution to this problem.

The DeFi protocol could opt for algorithmic distribution of their governance tokens. But they must offer liquidity incentives for it. It will attract liquidity providers who will farm the new tokens and in return, they will provide liquidity to the protocol.

Of course, Compound Finance wasn't the one to invent yield farming. Yet, the yield farming got the dose of popularity after the distribution of COMP tokens only.

Yield Farming — How Does it work?
There's a direct correlation between yield farming and the automated market maker model (AMM). It is because both of these include liquidity providers and liquidity pools.

It all starts with the liquidity providers. They are the ones that add funds to liquidity pools. These pools are connected with a marketplace as that is where the users lend and borrow tokens. What's in it for the liquidity providers? Well, the marketplace charges fees for each trade and the liquidity providers receive their share of the fees on the basis of the number of shares they hold in the liquidity pool. This is how the automatic market maker model works.

There can be few differences when it comes to the implementation of the AMM model in yield farming. It is because the technology itself is quite new. We may, very well, see changes in the current implementation of the AMM model in yield farming in the near future.

So, is the opportunity to earn a part of exchange fees the most attractive proposition for the liquidity providers? No! The real opportunity lies with the distribution of the new tokens. The price appreciation of the new tokens is the most attractive thing for the liquidity providers.

There are no set rules regarding the distribution of the new tokens. It depends on the implementation of the protocol as every protocol has a unique way of distributing the new tokens.

Leading Names in the Yield Farming Space
Now, we know about yield farming and how it works. So, what DeFi protocols are leading the yield farming race today? There are not a lot of them but there are a few. We will know about them now. Compound Finance, MakerDAO, and Synthetix are the three most popular names in yield farming today. Let's know more about them.

#1. Compound Finance
Compound is the most popular name in the yield farming space. They are an algorithmic money market. All Compound users can lend and borrow assets on its platform. One only needs an Ethereum wallet to start supplying assets to the liquidity pool of Compound Finance. In return, liquidity providers are rewarded through compounding. The rates fluctuate on the basis of supply and demand for respective assets and this whole process is algorithm-backed.

#2. MakerDAO
One of the most dominant players in DeFi, MakerDAO is also quite prominent in yield farming. It is a decentralized credit platform. Maker supports its community for the creation of its stablecoin, known as DAI. Its value is pegged to the US dollar. Anyone can start generating DAI on MakerDAO after locking in collateral assets like USDT, ETH, WBTC, or BAT.
The collateralized asset also incurs interest and this is known as stability fees. The decision about the rate of stability fee rests on the MKR token holders. If yield farmers want to mint DAI, they can use Maker and implement the yield farming strategies.

#3. Synthetix
Have you heard about Synthetix? It is a synthetic asset protocol. Anyone who is interested in minting synthetic assets can do it by staking ETH or the Synthetix Network Token as collateral. The interesting thing about this is that almost anything with a reliable price feed can become a synthetic asset. Hence, almost any financial asset can be turned into a synthetic asset and added to the platform.

Privacy in DeFi
In a year's time, between 2020 and 2021, the capitalization of the DeFi market has grown from $686 million to $15.6 billion. Several subdomains are growing together in DeFi. These subdomains include wallet and asset management, payments services, asset tokenization, stablecoins, lending and borrowing, exchanges and marketplaces, and more.

We expected a further penetration of security & privacy protocols into DeFi in general and yield farming in particular. With that in mind, we're building a privacy focused DEX with updates coming soon. A short leak: CUTcoin DEX will make use of liquidity pools as described in this article. Watch this space for more!