over 2 years ago • 11 mins
In this episode of Insights we’re going to be investigating one of the newest areas of crypto investing: yield farming, or the process of generating an income from your crypto holdings.
Our guest today is Sid Shekhar, who is blockchain research manager at the cryptocurrency exchange Coinbase and before that co-founded the blockchain analytics startup TokenAnalyst. Because Sid’s role means he’s responsible for keeping up with the bleeding edge of crypto trends and technologies, he’s perfectly positioned to explain the sometimes baffling worlds of blockchain and DeFi.
Sid began by explaining to Finimize analyst Andrew Rummer how he defines this concept of yield farming.
Sid Shekhar: Yield farming, in essence, is hunting for yield with crypto holdings that you have. So the previous paradigm in crypto in the last market cycle was to "HODL" – or to hold on to your crypto for dear life. And the prototypical action was to buy bitcoin and just sit on it. And now in this market cycle, a lot of things have changed. Specifically, the rise of this new set of apps – decentralised applications – called DeFi, which is decentralized finance. And what a lot of these decentralized finance apps started to enable is activities that are currently performed in the financial system, but in a decentralised manner. So there are some fundamental building blocks such as decentralized exchange, which is characterised by DEXs, or decentralised exchanges – such as Uniswap and SushiSwap. And then decentralised lending and borrowing – and the leading apps in that space are Compound and Aave.
Maybe a good example of this would be: say a new token comes out in the market a new project is launching, they'll typically launch a yield farming program where users are expected to pair their token, whatever the token may be. Let's say you launch a new project, Andrew, you call it Rummer token. You would ask your users to pair your token, Rummer, along with USDC or along with ETH on one of these decentralized exchanges. And then stake that proof of your liquidity on their platform. And, just for context, every time you provide liquidity to one of these DEXs, you get another token back in return. This says that there's some sort of proof that you provided us liquidity. And essentially, what that enables is now they've essentially made a market for that token, arbitrarily, just as a result of users providing the liquidity. And what do these users get for providing liquidity? They will typically get more Rummer tokens awarded to them, because they provided liquidity for the Rummer/USDC pair on Uniswap, for example. So that's just a brief example. And essentially, there's hundreds and hundreds of these different yield farming opportunities that have popped up over the past year, where users can provide liquidity of some sort and get rewarded in tokens, in interest, in various different forms rewards – that essentially give some passive yields for holding and using crypto assets.
Andrew Rummer: So this is one of the ways where this world departs from traditional finance. Because a lot of traditional stock exchanges will pay people who provide liquidity onto that exchange. But this part around rewarding people who provide liquidity with this special token makes less sense to me. So in this example I would get rewarded in Rummer tokens. Why do I want more Rummer tokens? What can I do with them?
Sid: So, typically, the use cases of most of these tokens is, they call them “governance tokens”.Usually you have a large protocol – Compound is a prime example of this, it that actually kind of kickstarted this yield farming boom in summer of 2020 – where users are asked to provide liquidity to the Compound lending and borrowing pools, and they were rewarded in COMP tokens. And the COMP token basically allowed people who held it to exert an influence over the development of the protocol itself. So they could vote, for example, for new assets to be added to the lending and borrowing pools. Suppose they have their own favourite assets, they can vote for that – because now they're gaining governance power by holding more of the COMP token. So that's usually the primary use case. In recent times, some of these tokens have also developed a kind of fee-sharing type structure. So the more of a token you hold, the greater the percentage of the protocol fees flow back to you.
Andrew: Is this something you do with your own money, your own crypto tokens?
Sid: Oh yeah, 100%. Almost all of my crypto investments are currently in some sort of yield farm or another – primarily because it makes my crypto productive. Rather than just holding my crypto and hoping for price appreciation or depreciation, I can essentially earn passive yield on it and – just for context – these yields range anywhere from 5% per year to well over 1,000% in very risky cases. The huge benefit of this really, that I utilize as much as possible, is you can earn yield on stablecoins, which is amazing. A stablecoin – again, for context – is essentially you can think of it as the equivalent of the US dollar. In most cases, most stablecoins are pegged to the US dollar. And so effectively you can deposit US dollars, say, to Coinbase, get USDC, which is the US dollar-pegged stablecoin, and then withdraw it into the wild, into the DeFi ecosystem and earn yield on your USDC. And I think the minimum right now is like 2-3%, which is still well over what you would get in a savings account or any other traditional form of yield.
Andrew: Before we go too much further, can you explain the concept of stablecoins for us in a bit more detail?
Sid: In the previous market cycles, bitcoin and ethereum were the dominant crypto assets. So most of the other tokens that sprang up were paired with bitcoin or ethereum on most exchanges. So those were the primary trading-pair base assets. But over the past two or two and a half years, there's been a huge rise in these various stablecoins. The leaders amongst them are USDC and USDT , respectively. And these stablecoins are actually backed by real US dollars that sit in banks. So the typical workflow is an institution or a large player who wants to mint stable coins and deposits US dollars into the bank of the stablecoin issuer. And the stablecoin issuer then mints these stablecoins on the blockchain and rewards them to the person who deposited that US dollars.
So these are kind of “centralized” stablecoins – because you're trusting these folks to hold these US dollars in a bank. There's controversies around USDT and auditing of that bank account, etc, etc. And then there's this whole new branch of decentralized stablecoins – which aim to maintain a peg to the US dollar through algorithmic means, through game theory, through various different forms of on-chain mechanics.
And why is there so much yield on these stablecoins? The primary reason, over the past two years, has been traders seeking leverage, basically. Because crypto is so volatile – and because there's so much money to be made, still, in the in the Wild West that is crypto – the typical workflow is for a trader to obtain leverage, to borrow on his holdings and then to buy more or sell more – whichever direction he or she is trending toward. So the liquidity that you provide – which is in the form of stablecoins – is basically borrowed on and the trader pays interest for the benefit of borrowing these tokens, these stablecoins.
Andrew: So if the main driver of these yields is from traders borrowing crypto tokens to beef up the size of their bets through leverage, have those yields declined as the price of most cryptos have fallen in recent months?
Sid: Yep, 100%. You’re on the money there. Yields have significantly come down. There's a website called loanscan.io where you can check historical yields. But just speaking from what I've been seeing, at the height of the bull run – at least this year, around the Coinbase IPO – yields were averaging – just plain stablecoin yields on Compound, which is probably one of the safest DeFi applications out there, battle-tested, DeFi apps – was ranging anywhere from 7-9% on USDC per annum. And right now that's hovering close to 2% per year, so definitely affected as a result of the market.
Andrew: So we've talked a lot about the benefits of yield farming. But what are the risks? What can go wrong here?
Sid: You go up the risk curve, the greater the yield is – naturally. So very low on the risk curve is just depositing stablecoins on Compound or Aave and just getting passive yield for them. This is, as I've mentioned, around 2-3% right now per year. And you go further up the risk curve. I think the medium portion of the risk curve is providing liquidity on one of the major DEXs. So you pair your stablecoins with something else. There are stablecoin/stablecoin liquidity pairs as well – for people who want to trade in and out of USDT/USDC, DAI/USDC, etc, etc. And that basically generates a bit more yield. Right now, it's around 9-10% a year. And then further along the risk curve you go, you get into exotic tokens or volatile tokens and you pair them with stablecoins. Here, the risk is the value of the volatile token fluctuates so wildly that you are left with a different amount in USD terms than what you deposited.
Andrew: So with all those caveats in mind, if people listening to this want to get involved with yield farming, how do they go about it?
Sid: It's very easy to start, to get your feet wet. The first step would be getting ahold of some crypto. If you're risk averse, just get ahold of some stablecoins – just do it via Coinbase. You can deposit fiat – pounds or dollars – and get ahold of USDC. And you can then withdraw it into a wallet where you can interact with DeFi. Popular wallets out there are MetaMask, which is a browser-based wallet, and Coinbase Wallet, which is on your phone and it's now on your desktop as well. And you can then interact with some of these big DeFi applications. Aave and Compound are two of the top ones where you can provide your liquidity and start earning yield passively. You can do this, you know, within 5-10 minutes you can get this whole thing set up and start earning 2-5% on your stable USDC per year right now. And if you want to be a little more riskier, you can start exploring Uniswap for some of their stablecoin-to-stablecoin pairs – which are earning anywhere from around 9-10% per year right now. That's a little bit more complicated because you have to provide an even amount of each of these stablecoins and deposit that into Uniswap. But you could totally get started there as well.
Andrew: I have one final question for you. We've had this sell-off in crypto prices since April. Where's everything going now? What's your take on the current crypto market?
Sid: I think the difference between this cycle and the last cycle is the presence of Defi and the presence of yield farming. In the previous cycles, people couldn't do anything with their crypto: they had to basically hold it or sell it – and would you hold a depreciating asset? Most likely not. And so you'd sell it. And the presence of stablecoins wasn't all over the market, and so people sold it into fiat and they got out of the market.
Right now, you have the option of selling into stablecoins and earning passive yield on your stablecoins, which is amazing. And usually the yield is earned in tokens of some other form or shape. So people are essentially staying and the applications are a lot more sticky. So people are staying in these pools, earning yield. There's still hundreds of millions, even billions, in these pools earning yield right now. And so I don't think people are actually leaving the market like they did last time. So my take is we likely don't see a long, drawn-out, multi-year bear market like we did last time. You might have a small bear, which we're going through right now – but because the people are still in it, all that's needed is a match, a few catalysts, something to light the fire again, and we'll be off to the races.
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