When you put your money in a bank account to save it, you’re effectively loaning your money to the bank with the hope of getting an interest in return. Traditional banks, at the end of that saving period, at most pay you only a quarter per cent on your initial deposit but with cryptocurrencies, this number is usually greater —a lot greater. Some cryptocurrencies pay you as high as 20% or even more for locking your money with them. Locking your funds means that you believed in their decentralized finance (DeFi) protocol and paying you that much interest is their way of saying thank you for that belief.
Read: The wild west of DeFi: Yield Farming in Liquidity Pools to understand Liquidity Pools, Liquidity Provider Tokens, Automated Market-Making Mechanism and APRs.
The process described above is known as Yield farming. Also known as liquidity harvesting, yield farming involves a Crypto user lending their cryptocurrencies in return for some percentage of interest and in some cases, fees. A craze that kicked off in June 2020 when Compound, the Ethereum-based credit market, started distributing its governance token, COMP, to users of its protocol. Because of the way COMP’s automatic distribution was structured, the heightened demand for the token has moved Compound into a leading position in DeFi. As of today, Compound is one of the largest lending DeFi services and currently has about $10.14 billion in funds, according to tracker Defi Pulse.
There’s a lot of money being put into the decentralized finance industry and as of when this piece was written, a total of $92.8 billion in crypto assets is locked in DeFi, according to DeFi Pulse. However, when it comes to yield farming, the real money is made when the coin you’ve locked your funds in sees a rapid increase in its prices. Unlike some already established currencies with lots of circulation going for them, a new cryptocurrency has to offer some specific services and options to be able to grow. When there are incentives to issue new units like with yield farming, then enough people will use a new currency.
How does it work?
To get started with locking funds in DeFi yields, a user must first know what a decentralized application (dApp) is. To use co-founder of Ethereum Vitalik Buterin’s analogy, if Bitcoin was a small-sized calculator, then platforms, where dApps are built, will be our smartphones. But these smartphones are the kinds where automated programs run without any central operating system. Many of these dApps make use of the Ethereum blockchain. So, a user can lend digital currencies like Tether or DAI (stablecoins) through a dApp like Compound. This dApp then lends the currencies to users who are looking to borrow them to use for speculation most of the time.
Interests on the funds borrowed will vary with demand, but as most often is the case, for participating every day in the Compound network, a user gets a new COMP coin in addition to the interest and other feed acquired. If the COMP token appreciates, the lender’s returns appreciate it as well.
The threat of the SEC
The US Securities and Exchange Commission (SEC) has for a long time now argued that a range of tokens falls under its jurisdiction. Based on a legal theory known as the Howey Test that was laid out in a 1940s Supreme Court case, the SEC has consistently—for over 4 years now—asserted that many digital assets are investment contracts or securities. In September, crypto exchange Coinbase said that following its plans to let its customers earn interest with some digital tokens, the SEC has threatened to sue them. Coinbase product (although not yet open to investors) had promised to let customers earn 4% annually by lending out their USDC tokens but according to the SEC, USDC is a stablecoin and it is among a range of tokens that fall under their jurisdiction.
This tussle with the SEC became public when Coinbase’s chief legal officer Paul Grewal said that their product ‘Lend’ involved “a security, but wouldn’t say who or how they’d reached that conclusion.” He added that the agency had told Coinbase that “if we launch ‘Lend’ they intend to sue,” and this has made the company shelve the product until October at least.
The risks involved in yield farming
Apart from the crackdown by regulators on whether reward tokens are or could become securities, there’s the risk of losing your money through theft. The money a user lends out on these dApps are held by software and hackers are always on the prowl trying to find vulnerabilities in codes they can exploit. There’s the risk of the coins you’re farming losing value and when early investors who most often hold large amounts of the reward token decide to sell, it could have a huge impact on prices and cause the entire system to come crashing down. There’s also the risk of being liquidated. A lot of high-yield farming strategies, because of volatility, carry the risk of liquidation.
Yield farming continues to look attractive because of its obvious perks but there are always obvious risks attached to them. A lot of users see the product as an opportunity to just save their money and a lot of others see it as a juicy opportunity to get rich over a short period. Regardless of the divide you fall in, if you’re not afraid of seeing your token lose 20% or more of its value at any time, then DeFi yield is a crypto investment you should pay close attention to.