🌾 What The Heck is Yield Farming? — Issue No. 104

Decentralized Finance, or DeFi, has long been the dominant narrative in the Ethereum ecosystem. Over the last couple of months, it's become the leading trend in all of the crypto world. This is not that surprising. The most interesting experiments in crypto have been happening in DeFi for quite some time.

What is a bit surprising is the driver for this surging enthusiasm. This wave of hype is centered around “yield farming,” wherein investors chase massive profits by supplying liquidity to various interlocking on-chain financial protocols.

What exactly is this trend about? How does it work? How can investors possibly be earning 1,000% APY’s? Is it real innovation, or just “ICO madness version 2.0.” We’ll try to answer some of these questions in this edition of Build Blockchain, and we'll start by examining the protocol that kicked off the yield farming craze: Compound Finance.

On Chain Lending

The story starts with the creation of an on-chain financial primitive that’s relatively easy to understand: collateralized lending.

Imagine you’re an ETH investor who wants to get liquidity on your holdings without having to sell them. One way to do this would be to take out a loan with a centralized lender and provide your ETH as collateral. You’d repay the loan with interest, and if you defaulted, the lender would seize your ETH. This concept is as old as money itself. Link.

The Compound Finance team implemented this system in a semi-decentralized way using smart contacts. Instead of a centralized escrow service, borrowers lock crypto assets in smart contracts, and take out loans in stablecoins. Instead of a single lender, there’s a pool of liquidity. Anyone can contribute to the pool, become a lender, and earn interest.

This system has been live on Ethereum's mainnet for nearly two years. It provides an on-chain primitive for earning interest and lending assets. All other things being equal, though, we wouldn’t expect interest rates in Compound to be much different than a normal bank. Aside from some premium for smart contract risk, why should they be?

So how do we end up with so-called yield farming from this system, which just provides simple loans and interest? To understand this, we need to add the next layer of the system: governance.

Governance Tokens and Usage Based Distribution

Compound is an on-chain lending protocol, but it’s not fully autonomous. There are still certain parameters that can be adjusted— like the oracles, the assets listed, and the fees charged.

Historically, the Compound team has set these parameters themselves, occasionally judging the community's sentiment by taking on-chain polls. In these polls, they used an interesting method to weight the voting: users’ voting power was proportional to their usage of the protocol, as measured by interest earned or paid in the past.

Earlier this year, the Compound team announced they’d be decentralizing the protocol’s governance by using a token weighted voting system. The governance token, called COMP, would be distributed to users in a way similar to those weighted polls of the past. COMP would be distributed based on use of the protocol, either as a lender or a borrower. Link.

It’s this mechanism that kicked off so-called yield farming craze. Users began intentionally lending or borrowing on Compound with the explicit goal of earning, or “farming,” COMP. This drove up the usage of Compound, making COMP ownership seem even more desirable.

Here’s where things start to get crazy. Since you’re paid out in COMP for both lending and borrowing, users quickly realized they could leverage their assets to dramatically increase their “farming” yields. If you escrow ETH to take a loan in a stablecoin, you earn COMP. You can then lend the stablecoin to earn even more COMP. Now this farming is starting to get more lucrative— and a lot more risky.

But things get way crazier from here. COMP’s usage-based token distribution was soon copied by many other projects, each with another type of on chain financial primitive. Balancer, Ren, Synthetix, Curve, Ampleforth, Yearn and others have all adopted similar schemes. Because of this, there are near countless ways to combine usage of these various protocols, usually with stack leverage and risk, to farm ever greater quantities of protocol governance tokens.

What’s more, some of these projects are actually BUILT ON each other. Yearn’s YFI, for example, actually provides claims for the COMP token farmed by the protocol. So you farm a token that farms tokens. What could go wrong? Link.

Bubble, Innovation, or Both?

If all of this doesn’t feel sustainable to you, well, I can’t say I disagree. In fact, it feels like a house of cards. What's made it possible so far is high demand for the base governance tokens of protocols like Compound. Is this demand justified, or just speculative FOMO? I’m not sure, but the market sure feels frothy to this non-investor’s eyes.

What's going on clearly can't last for long. Even in the best case scenario, demand for these governance tokens must eventually level off as they reach a fair market valuation. At that point, the farming of tokens like COMP should no longer be profitable, and the wild yields that are currently attracting speculators will disappear. In the worst case scenario, governance token valuations correct sharply, and this all implodes like a house of cards.

Still, it's hard to deny that what's happening is fascinating. It's fun to watch permissionless innovation play out in real time. This whole craze was kicked off by Compound's experiment, and has accelerated as more projects tinker and build. As long as people are free to build what they want, and others are free to invest as they please, we should expect speculative "mini-bubbles" to crop up— pun very much intended!

I do hope we keep in mind that real people stand to lose real money if this ends poorly. There's far too much casual risk taking with other people's funds for my taste. And there is a major hazard for the future of the ecosystem if DeFi collapses and $4 billion evaporates: a permanent loss of confidence. I'm excited about the innovative experimentation, but nervous about the pace and lack of care. Whether you're building, investing, or both, please proceed with caution and care.