While the yield farming frenzy has drawn some resemblances with the ICO craze of 2017, it’s important to note the striking differences. Instead of selling wild dreams in a white paper to disperse tokens, protocols are now issuing tokens to users who utilize these protocols, that have actual working products and add some form of value to the ecosystem.
It’s a More novel way of token distribution compared to ICOs and a better mechanism for bootstrapping initial growth. It’s served as rocket fuel for a growth cycle in DeFi, driving more participants to the ecosystem and setting the stage for deployment of capital funds and development of new innovations into the ecosystem. Similar to startup growth marketing programs, token based incentive programs aim to achieve similar objectives with user acquisition for crypto projects. Pioneered by Synthetix, there are now over 20 liquidity mining programs each with its own strengths and weaknesses.
While the popular answer early on was to say that yields would quickly compress, there is such a large increase in new projects and yield opportunities that aggregate yields still remain high. The flood of new data has led to market asymmetries. However, yield farming aggregators are quickly evolving, and on a longer time horizon one would expect yields to gradually compress.
We give an overview of the farming market to go along with pros/cons, what protocols need to do in order to increase the retention of users, upcoming opportunities and more. Liquidity mining has highlighted the need for composability in dApps. One of the most interesting trends has been the immense ancillary effects of liquidity mining on project across dex, lending, aggregator, insurance, etc
The bigger theme here is that going forward we could see these incentive programs becoming a cornerstone of growth strategies. As more case studies of yield farming programs play out, each with their own successes and shortcomings, we identify what to look out for and provide a market overview. In just the span of a few weeks , a flurry of yield aggregator entrants are emerging and at this rate we’ll see a quick evolution to farming 2.0: with more democratized access and better efficiency for these liquidity mining campaigns.
The Unique Value of Yield Farming or Liquidity Mining
Yield farming or “liquidity mining” is essentially the act of leveraging different protocols to earn a yield or return on assets. Most importantly, it signifies a shift in the framing of how projects think about distribution to users. Unlike ICOs, they require an actual working product.
For AMMs, liquidity mining can be thought of as a maker rebate with rebates on top of pool fees helping to subsidize LPs against impermanent loss.
Lending /borrowing markets with farming programs can best case create greater lock-in effect given introductions to feature rich product sets with the added incentives of opportunity to govern the protocol.
While farming can certainly be lucrative, one must take into careful consideration how they deploy capital and risks associated. By selling out of ETH to use stablecoins to farm, one would have missed out on the recent run-up in ETH. Borrowing against ETH as collateral to use stablecoins to earn interest is also effective but carries more risk. With the right strategy, yield farming can be immensely profitable for users while helping projects scale up.
The Hunt for Yield
As seen on the left, in a low interest rate environment coupled with low volatility in crypto and increase in product offerings, there’s been an insatiable demand for yield. Before jumping into the protocol level projects, we wanted to highlight the benefits from an institutional standpoint as well, given yield farming provides another avenue for profits.
Genesis Capital on Q2 markets – “One interesting note is the interaction between USD rates, basis, and yield farming. Without implying any causation, there is a flow in the market when DeFi platforms offer high enough subsidized rates on depositing USD, crypto holders will sell their spot holdings, buy futures, and yield on the cash generated from the spot sale. Effectively holders can long basis, maintain their crypto exposure, and participate in the high yields on dollars.
This flow contributes to a widening basis, although it is unclear how significant the impact will be. Since yield farming became popular in mid-June, we have seen a spike in September basis from below 5% annualized to over 8%.”
Yield Farming Market: Cheat Sheet
We are witnessing an influx of new liquidity mining programs being introduced on the back of Compound’s massive success and don’t expect this to change anytime soon. In fact, we wouldn’t be surprised to see at least 3x growth in the number of offerings by the end of the year. Remember though, more doesn’t always equal quality (See 2017 ICOs). With many options comes more crop rotations to the highest yields and increases in usage of yield aggregators.
Incentives programs are being seeded across a diverse group of segments like lending, DEXs, derivatives, personal tokens, prediction markets and NFT marketplaces. This is leading to sustained congestion on Layer 1 resulting in high gas costs and it feels inevitable that a natural solution to increase Layer 2 adoption would be to encourage usage from liquidity mining. Despite flaws with user lock-in and long term approach, the design space is very new and will improve quickly.
Pros vs. Cons of Yield Farming
Here are the pros of yield farming or liquidity mining :
- Supercharges growth *
- Strong marketing effect and impact on brand awareness
- Earn for actual usage of protocol rather than less fair ICOs
- Attract liquidity to the platform, creates better trading venue on protocol users
- More fair distribution better for decentralization
- Lucrative opportunity to stack yields across protocols
- Allocation of capital to users which could have gone to other more smart contracts are involved stakeholders like investors and team
- Foster growth of community
- Reduces burden from regulatory standpoint
The Cons of liquidity mining
- Expensive campaigns for user acquisition (especially if poor retention afterwards). Similar to inefficient startup marketing blitzes
- Perverse incentives attract profit seeking users who farm and dump
- Hasty governance on the back of short-term oriented voters/farmers
- Composability increase various technical and financial risks as more and more smart contract are involved
- With liquidity mining it’s a race to the bottom as tokens get distributed.
- The tax ramifications become much more complex with every transaction being taxable
- Favors capital intensive efforts to grab as much early as possible
Short Term Trend of Yield Farming
- Increased gas costs of yield farming strategies are pricing out smaller players
- Liquidity mining rollouts generally are bullish catalysts for price
- Post the COMP kickoff, TVL in DeFi is up from $1.1bn to $6.2bn. DEX volumes are exploding, hitting ATH of $4.4bn in July and at $3.9bn MTD…
- User Growth – Compound 30.3k to 47k (57% growth), Curve 2.3k to 11k (378%)
- With the flood of governance tokens, the lack of robust governance amongst the project’s communities is being exposed
- Stickiness of the liquidity is quite low for most of the projects. As soon as incentives dry up or better opportunities emerge, capital typically flows out
- Liquidity risk emerges with farming low liquidity tokens that are highly reflexive
- Deeper liquidity has been a boon for regular traders
- Who will win? Organic, open-source communities (YFI) vs centralized, VC backed projects (MTA). There’s an increased desire for community first approaches
Long Term Trend in Yield Farming / Liquidity Mining
- Yield farming makes non-productive assets useful (secular trend)
- Growth of aggregators (i.e linch for DEX, yearn.finance for lending)
- Users are protocol agnostic, no need to interface directly
- Protocols will need liquidity incentives long term too to keep users. As
tokens accrue value from underlying operations, long term projects may need to have a small amount of dilution to offer incentives
- Protocols early on offer higher APY % where later on offer more
value as protocol matures. This is to keep capital inside protocols
- Protocols are shifting to community owned (fair distribution)
- Incentivized testnets like what The Graph is doing are more effective in bringing long term users
- Beweary of faltering projects pivoting to ride the farming wave.
- Positive feedback loop in this hot market with awareness attracting buiiders which leads to more projects with a wider array of yield opportunities and demand
- Farm valuable assets that are worth the time and have higher upside with mechanics to tie protocol growth to token value
- Liquidity mining programs should and will evolve to have varying time periods to reach growth targets, and different sizes of subsidies/discounts tailored to target users
- There is no such as thing as free lunch in DeFi. Keep in mind the risks involved: technical, smart contract risk, liquidation risk, impermanent loss, composability risk.
- In these liquidity mining schemes, protocols have different intermediary steps and what we are seeing is that an increase in volume isn’t necessarily proportional to value
- accrual. Depends on value capture mechanism of token. Liquidity itself as demonstrated with yield farming is not sticky and follows the best yield opportunities
- Timing of the launches by projects is key to as users opportunistically jump around to highest yields
- With the influx of governance protocols and tokens, we’ll see more demand for governance aggregator dashboards and pools to more easily manage protocols.(i.e. Boardroom, a governance dashboard and SDK for protocols & Power Pool, a protocol enabling the lending of governance tokens for voting power)
- Liquidity mining programs will be more dynamic over time and take into account: quality of capital provided, time-weighted distribution, hard caps, voting rights tiers, etc.
- Similar to CEX offerings of VIP perks, DeFi projects will compete amongst one another for market share and even offer bonus incentives to create stickiness