Perhaps the most notable trait of the cryptocurrency space is its ability to reinvent itself every couple of years by introducing novel concepts that the world never knew could exist. Decentralized finance (or DeFi) is one such innovative application of blockchain technology that has become the poster child of the crypto Wild West in recent times. DeFi has enabled the implementation of real-world financial instruments (like loans) using cryptocurrencies as collateral, so now anybody in the world that has a smart phone and an internet connection, can get a loan in just a few minutes without the need to complete a dreadful list of banking formalities. This particular use-case of blockchain is leading the cause by truly putting the power of finance in the hands of the underbanked.
Built using Ethereum smart contracts, DeFi projects are also witnessing immense interest from speculative investors flocking the space to capitalize on the rewards offered by projects such as Compound Finance, Balancer, Curve Finance, and Synthetix. As of this writing, the DeFi market has seen just over USD 9 billion in Total Value Locked according to DeFi Pulse.
Before we delve into yield farming, it is essential to know the mechanics of projects like Compound. At the core of it is a borrowing and lending framework that lets users take loans after staking the required collateral in the form of digital currencies (usually in USDT, USDC, or ETH). It is quite similar to taking a loan from your bank, minus all the paperwork, identification proofs, and assurances you need to provide. Essentially, you borrow money and pay interest on the principal amount, or you become the lender and earn interest on the amount you lend. However, one added benefit for participants in this economy is that these projects offer rewards for providing liquidity to the borrowing or lending pool. In other words, regardless of whether you are a borrower or lender, you are eligible to earn what some might call free money. For instance, Compound recently started giving out its governance token called COMP to users of the platform. These tokens can be immediately exchanged on the market for USDT, or they could be used to vote in policy changes to improve the protocols on which the Compound eco-system functions.
To illustrate what exactly is happening behind the scenes, let us look at an example of how one can start earning interest on their investment and multiply the total “yield” they receive. Suppose you deposit 10,000 USDT into Compound and receive an equal amount of the native cUSDT as a token for having staked your USDT as a lender. While you earn interest on your staked USDT, you have the option of lending out the cUSDT token on a different liquidity pool like Balancer and start earning interest there as well, and this in addition to the BAL token you receive from Balancer as a reward. As more people start using the service, the underlying asset (like COMP or BAL) will go up in value, which incentivizes more people to participate in the network, thereby adding utility and driving up the value of the underlying token even further. To put that in context, the price of COMP token hit an all-time high of $272 and is currently hovering around the $150 mark only 3 months since its inception in June 2020.
The lucrative idea of generating exponential yields using a single investment has driven many investors to look at creative ways of putting their crypto assets to work. This act of constantly moving assets to chase whichever pool offers the highest APY yield is called “Yield Farming” and it has become the biggest fad in the cryptosphere today.