Yield farming is a high-risk, high-return investment strategy. Also referred to as "liquidity mining,” yield farmers seek high yield opportunities in exchange for loaning out digital assets, such as stablecoins or bitcoin, to emerging DeFi projects or exchanges. In turn, farmers contribute to the overall health of a developing DeFi project or exchange by providing beneficial liquidity.[1]
Yield farmers use smart contract platforms, decentralized applications, or DeFi exchanges to lend digital assets. In return for loaning, or "staking," valued digital assets, farmers earn interest or fee payments–often in the form of ‘governance tokens’ native to the lending platform. A governance token is a project-specific digital asset issued to farmers by a protocol or project developer. The design of governance tokens incentivizes token holders to govern decisions concerning the protocol competently. Token reward structures help ensure farmers and other token holders have a stake in the project's success.
Interest rates are generally dependent upon the utility of, or demand for, the asset on loan. Demand to borrow a digital asset often correlates with its use cases and popularity in addition to the Layer 1 or Layer 2 solution it fuels. If a farmer receives a digital asset reward in its infancy and the price appreciates significantly, yield farmers may experience significant gains.[2] Experienced, successful farmers deploy complex farming strategies to compete for the best opportunities, or "crops", and maximize returns.
The Origins of Yield Farming
In June of 2021, yield farming emerged as an investment strategy when the credit market ‘Compound’ began distributing its COMP governance token on the Ethereum blockchain.[3]Compound nurtured demand for its native COMP asset by creating a distribution structure that generously rewarded lenders COMP in return for providing meaningful liquidity. COMP holders were empowered to leverage governance token earnings to vote and propose improvements to the network. Compound’s farming community thus became additionally invested in ensuring the venture's success.Demand for COMP markedly increased and thus fueled Compound’s remarkable gains while paving the way for yield farming as an attractive investment strategy within DeFi.[3]
The Pros and Cons of Yield Farming
Yield farming allures adventurous investors.The potential for high annual percentage yields (APY) attracts investors hoping for returns that outperform traditional investments.[2] High-yield, complex farming strategies incur significant risk. If demand for allocated reward tokens collapsed, gains would be lost, and liquidations would likely follow.
Market manipulation is also a valid concern. Farmers who enter a community early have the potential to accumulate sizable token holdings and thus manipulate the market price of a governance token. Known as ‘whales’, these farmers can throttle worthwhile returns for smaller investors or community late-comers. Farmers or whales can also create artificial demand via lending and subsequently borrowing back the same digital currency, thus inflating that token’s market price. In the future, many expect that the U.S. Securities and Exchange Commission will find ways to regulate yield farming as a securities offering.In the future, many expect that the U.S. Securities and Exchange Commission will find ways to regulate yield farming as a securities offering.[4]
DeFi yield farming continues attracting adventurous investors seeking returns that outperform securities within the traditional financial sector. This investment strategy is thriving despite the absence of safety nets (like the FDIC) available to TradFi investors. Yield farmers look to DeFi for unparalleled investment opportunities in which to park assets and maximize yields. Emerging DeFi projects look to yield farmers to help bolster platforms and to provide liquidity crucial to nascent projects. We expect this enterprising sector to rapidly innovate and define creative rewards pathways within DeFi.
