DeFi Yield Farming Explained
Through the power of DeFi’s permissionless composability, Chainlink’s decentralized oracles, and new financial primitives such as Yield Farming, smart contract developers across the world have been rapidly building, iterating, and deploying new decentralized applications at an unprecedented pace. Year to date, DeFi has already grown 10x from less than $0.7B USD to now over $8B USD in total value locked from user deposits, with $3B+ directly secured by Chainlink Price Feeds.
Fueling this growth is the high speed nature of development and innovation within DeFi. It has led to many new financial primitives that previously couldn’t exist due to the inefficiencies and counterparty risk present in today’s traditional financial system. The most recent innovation taking the DeFi space by storm is Yield Farming, also referred to as Liquidity Mining.
Yield Farming rewards users for provisioning liquidity or providing other value-added services to a decentralized application’s ecosystem. Yield Farmers are paid pro rata in an application’s native governance token, granting the user a higher Annual Percentage Yield (APY) on their provisioned liquidity. The rewards from Yield farming are in addition to any built-in revenue streams inherently generated, such as trading fees within a decentralized exchange and/or interest from lending in a money market. Some projects also include yield farming rewards for other services, such as user participation on the platform or supporting community, marketing, or developer initiatives.
Yield Farming is often implemented with two primary goals in mind:
- Incentivize users to deposit and lock up their liquidity into a DeFi application, growing the Total Value Locked (TVL) and bootstrapping the supply side of the ecosystem. More liquidity decreases slippage for users, and fosters growth in the demand side of the ecosystem by creating a superior offering relative to competitors.
- Fairly distribute a DeFi application’s governance token to protocol users who take on the opportunity cost of not depositing their funds elsewhere (e.g. impermanent loss). The fair distribution of tokens allows for decentralized governance from day one since none of the supply is set aside for privileged entities.
Different DeFi protocols take different approaches to Yield Farming depending on the exact goals they aim to achieve, which may include one or both of the above objectives. Recent token launches that have followed this model include a wide range of applications from decentralized exchanges to money markets and beyond. These projects have benefited from creating a network of early users who actively participate in the protocol’s governance, even while each project’s use cases are quite different from one another.
In this article, we will cover the advantages Yield Farming brings and how projects have successfully bootstrapped liquidity and token distributions through this new financial primitive. Please note that this article is meant to purely showcase the value proposition that can be created from yield farming, but not to advocate in a positive or negative manner for it.
Bootstrapping Liquidity Within DeFi
The initial version of Yield Farming was employed to directly boost the liquidity of a specific asset within the DeFi economy. The earliest pioneer of Yield Farming was Synthetix, a decentralized derivatives protocol powered by Chainlink price feeds. Synthetix launched a liquidity mechanism in mid 2019 to reward sETH/ETH liquidity providers on Uniswap. Users who staked their tokenized sETH/ETH liquidity pool shares from Uniswap into a staking contract earned a proportional amount of SNX tokens (Synthetix’s native token) to their share of liquidity provided.
In effect, not only did liquidity providers earn extra yield on top of Uniswap trading fees (helping limit impermanent loss), but the barrier to entry was lowered for new traders entering the Synthetix ecosystem as there was now a way to seamlessly convert ETH into sETH (Synthetix’s ETH synth) at much lower slippage rates. Users who acquired sETH could then enter the Synthetix ecosystem and acquire other synths that provided exposure to commodities, fiat currencies, cryptocurrencies, indices and more. While this exact yield farming program has been discontinued, Synthetix has since launched numerous other incentive mechanisms to grow the liquidity of other synths, including sUSD and sBTC.
While Synthetix was truly a pioneer in this regard, the current iteration of Yield Farming widely seen around the market today was largely popularized by Compound, with the launch of its governance token in June 2020. This launch kickstarted an explosion of DeFi projects who employed Yield Farming strategies in new and innovative ways. With each successive launch, various flavors of Yield Farming have been tested in real-time to gauge their effectiveness and improve upon ineffective strategies.
The continual evolution of Yield Farming includes:
- Selection of different DeFi tokens to be staked (attracting specific token’s communities)
- Support of multiple different types of liquidity pool shares (e.g. Uniswap and/or Balancer)
- Varying pool distributions of the staked liquidity pool shares (e.g. 98/2 vs 50/50)
- Reward boosts for certain staking pools (incentivizing deposits of a specific token)
- And much more
The result is a wide array of decentralized applications, each providing its own unique value proposition and iteration upon the original design.
The current evolution of Yield Farming has also led to the creation of new nomenclature within the DeFi community regarding the different types of pools supported by these Yield Farming projects, namely the terms pool 1 and pool 2. Pool 1 is the Yield Farming pools that allow users to stake various pre-existing tokens that already have a liquid secondary market (e.g. ETH, stablecoins, etc). Pool 2 refers to Yield Farming pools that require exposure to the governance token being farmed, which directly bootstraps liquidity for said token so users have the option to take profits on their yield. With the speed at which DeFi evolves, it is likely we will continue to see Yield Farming change and evolve in the value it can provide.
The Importance of Liquidity and Network Effects
To further comprehend why DeFi protocols are willing to distribute tokens passively to users, it is important to understand the key importance of liquidity within DeFi. As decentralized applications are fully open-source, their primary defensive moat becomes their community and deposited liquidity. A long lasting protocol doesn’t focus solely on its business logic, but also how to bootstrap a lasting network effect. A network is about more than just the code itself, it’s about adoption, users, community support, value being generated, and more.
It is for this reason that protocols have decided to employ Yield Farming as a means of directly incentivizing the creation of liquidity in the hopes that it will generate a superior user experience and thus greater adoption. As more and more liquidity (supply) is added to a DeFi application, the more users it attracts (demand), who then pay fees to the supply side, attracting more user deposits, resulting in a virtuous cycle of growth. This cycle is designed to propel a protocol to a market leader by continually absorbing liquidity like a black hole, as users and liquidity providers alike naturally gravitate toward applications with the lowest slippage and highest rewards.
While liquidity in this fashion can be seen as a defensible moat, it is not totally insurmountable. Yield Farming incentives can actually be used to siphon liquidity from other protocols, potentially leading to a “flippening” effect, where if enough liquidity migrates over, the liquidity-based network effect may efficiently switch over from the old protocol to the new. This approach is known as vampire mining. While it’s unknown whether this approach is long-term effective, it does show the importance of not only a protocol’s liquidity, but how Yield Farming can be leveraged to wage a liquidity war. In the end, Yield Farming is simply a tool that can be used to achieve a multitude of goals.
The tokens generated from yield farming incentivize users to deposit liquidity; they can also provide users a claim on a portion of the fees the DeFi application generates and encourage governance participation regarding the future development of the protocol, such as voting on the addition of new yield farming pools. However, in order for governance of these DeFi applications to be truly decentralized, tokens need to be distributed across a wide array of independent users. This is where the secondary feature of Yield Farming comes into play.
Fair Token Distribution and Creating a Community of Stakeholders
Although not the original goal of Yield Farming, it can also serve as a fair distribution model for tokens. Instead of allocating large tranches of tokens to a select few investors and insiders, tokens are given directly to the community through an equal access model based on users providing specific contributions. The distributed tokens allow the community to own the protocol and organically make collective changes/additions to it as needed.
Projects that utilize yield farming for fair distributions are able to ensure that not only is the token supply distributed among many parties, but that tokens are given directly to the users who provide value within the protocol’s ecosystem. In effect, this can create an extremely strong community of token holders who are highly incentivized to grow the protocol and increase the value of their tokens. Stakeholders with strong incentives are much more likely to stick around for the long term and continue providing value to the ecosystem.
A prime example of this is YFI, the native governance token of yEarn Finance — a smart contract protocol designed to automate the provisioning of liquidity in DeFi applications based on the best yield opportunities at the current moment in time. In July of this year, yEarn minted and openly distributed 30,000 YFI tokens to liquidity providers for a variety of pools over the course of two weeks when Yield Farming as a concept was still very new. The majority of YFI was farmed by individuals who had a deep understanding of the DeFi ecosystem and have since grouped together to form the YFI community. These YFI tokens have since been deposited into numerous other DeFi applications, showing users are not just holding, but actively using their tokens to further the liquidity of the yEarn ecosystem.
With a fair token launch, it was possible for a community to organically form in a democratized manner and further the growth of the ecosystem due to community members having a direct financial incentive in the future of the protocol. While yEarn’s Yield Farming mechanism generated a large amount of liquidity for yCRV (a basket of stablecoins earning yield from yEarn), the fair distribution of YFI had a large, if not greater effect on the project’s current and ongoing success. In essence, Yield Farming enabled yEarn to simultaneously bootstrap two very important components to any DeFi protocol: grow a network effect of expansive user-driven liquidity and create a passionate community to drive the protocol forward.
Chainlink Powered Yield Farms
To further boost the liquidity incentivization and fair distribution of tokens enabled by Yield Farming, smart contract developers can leverage additional infrastructure to further improve upon these goals. One such piece of infrastructure is Chainlink and its widely used Price Feeds powered by decentralized oracle networks. Chainlink Price Feeds are already being used in a multitude of ways in Yield Farming, along with many new opportunities not yet explored.
- Token Lockups – Polkadot-based protocol, Plasm, is distributing tokens to liquidity providers based on both the value of the staked assets at the time of rewards distribution and the amount of time the staked assets were locked up in the protocol. This is meant to incentivize liquidity provisioning with a long-term outlook.
- Proportional Pool Rewards – DeFi protocol StrongBlock has integrated Chainlink Price Feeds in order to calculate the total USD value of staked assets in a multi-asset pool, and distribute rewards proportionally. This allows StrongBlock to cultivate a large pool of different assets, with greater rewards going to users who provide more valuable liquidity.
- Auto-Adjusting Rewards – A Chainlink price feed can be launched that delivers the market price of a Yield Farming token on-chain. This allows for unique opportunities such as autonomously adjusting the amount of tokens minted according to its market wide price, potentially stabilizing the Yield Farming return for users. The price feed can also be used by other dApps to quickly create new DeFi-based financial products that support the token being farmed, such as when Chainlink launched its YFI/ETH price feed to support Opium Protocol’s derivatives products.
The possibilities are truly limitless, with an infinite amount of combinations that can be created.
Yield Farming is a new financial primitive within DeFi that has proven its ability to provide a two-fold effect of both incentivizing liquidity and allowing for the fair distribution of tokens. DeFi stakeholders have greatly benefited too, as Yield Farming has lowered the slippage for token swaps across numerous DeFi applications and fostered the growth of exceptionally strong communities that otherwise wouldn’t have existed. It has also enabled countless projects to bootstrap their growth to now secure hundreds of millions to billions in user funds, often in an accelerated timespan.
In this video, Chainlink Co-founder Sergey Nazarov discusses how the traditional financial system will lead people to DeFi because it has superior transparency, trust guarantees, and yield:
It remains to be seen how Yield Farming will change and evolve into the future, and whether the current forms are well equipped to support long-term growth. However, what is certain is that innovation within DeFi isn’t stopping, and yield farming as a financial primitive is likely to stick around even if not in the same form as today. As DeFi continues to grow, we at Chainlink will continue to empower developers with the decentralized oracle infrastructure they need to build decentralized applications that meet any desired use case, including yield farming.
If you’re a developer and want to start building a Yield Farming application using Chainlink Price Feeds, check out our quick-start tutorial for a step-by-step guide on how to get started.