Yield farming allows cryptocurrency holders to earn rewards — typically other crypto tokens — in exchange for lending out their coins.
It’s helpful to think of yield farming as the crypto equivalent of investing in interest-bearing loans. But while the basic concept is the same — you lend your funds to somebody else and get paid a premium for it — there are two key differences.
Firstly, the process is completely trustless and permissionless.
The person who holds the coins, called a ‘liquidity provider’, locks up the coins in a smart contract, called a ‘liquidity pool’, that lives on a decentralized finance app.
The smart contract has a set of rules encoded into it. And both the coins and rewards are released automatically only when a series of mathematical calculations confirm that those rules have been met. There are no human gatekeepers to decide who can pay into a liquidity pool or who can borrow from it.
Secondly, while the size of the reward partly depends on how much the liquidity provider has paid — or staked — into the liquidity pool, the reward itself isn’t necessarily interest. It can be a cut of the underlying fees the decentralized finance app charges to execute the smart contract. Or something else altogether.
The reward is also not necessarily paid in the same cryptocurrency. It could be a utility token, or even a token that hasn’t been released on the open market yet.
Liquidity pools — and yield farming in general — can get extremely complex. And the process can vary quite widely, depending on the type of smart contract and how its rules have been encoded.
Users can also diversify by investing their rewards into different liquidity pools that reward them with different tokens.
Yield farming exploded onto the crypto scene in June 2020 with the launch of COMPOUND, a protocol that makes it possible to lend and borrow crypto tokens.
The protocol was an instant success, accumulating almost $6 billion worth of funding in under 2 months. So several copycat protocols quickly followed. Popular ones include MarketDAO, which lets users use crypto as collateral to borrow DAI, a USD-pegged stablecoin, and Uniswap, which also functions as a crypto exchange.
Alongside interest and other rewards, most yield farming protocols distribute governance tokens to liquidity providers. These tokens can be traded on exchanges. They also give the holders a say in how the yield farming protocol is governed.
For example, users who hold at least 1% of the total supply of COMP, COMPOUND’s governance token, can vote on proposals to change the protocol
The vast majority of yield farming protocols live on the Ethereum blockchain. But work is underway on technologies that could allow liquidity pools to run on any blockchain that supports smart contracts.
Want to know more?
This white paper explains the rationale behind COMPOUND — the protocol that made yield farming possible. In particular, COMPOUND’s creators Robert Leshner and Geoffrey Hayes argue that limited borrowing mechanisms and investment opportunities have contributed to volatility and crypto assets being wrongly priced.
The leading metric for quantifying the growth of yield farming is TVL — total value locked. This represents the total value of assets in a particular liquidity pool. But this article argues that, while growing TVL is a good sign, it can be misleading.
The METACO view
“Yield farming is an exciting development. It’s the proof of concept for a trustless, permissionless, and more democratic way to raise funding and unlock liquidity. And it makes it possible to generate passive income at significantly higher rates of return than you’d find on traditional markets.
“The flipside is that, at the moment, it’s still highly complex and unpredictable. But as the market matures, the mechanism will become more efficient, which will in turn attract more users.“