Decentralized finance (DeFi) applications are a hot topic, and yield farming represents one way to make it profitable, but it is important to understand the implications of these activities.
Creating a truly open source financial infrastructure and payment system, the goal and aspiration of many blockchain and crypto proponents, is undergoing a revival as DeFi applications increase in popularity. Open source lending and financing options create opportunities for new, non-incumbent, and decentralized organizations, but that in and of itself is not sufficient. One of the other components required to create and sustain a decentralized and distributed financial system is the ability for individuals and institutions to finance themselves.
This is where yield farming comes into play.
There are any number of terms and ideas being discussed, and while yield farming might sound like a bit of an odd label, it does communicate the concept quite well. Liquidity mining is also a term that is used in conversation. In essence, what yield farming allows crypto holders and investors to do is to make money on money; a requirement of any mature and liquid capital system.
Let’s break down some of the basics of yield farming, and some of the implications this trend has for financial professionals.
All yield farming is not the same. There are any number of yield farming options and organizations that have entered the marketplace. Some may resemble deposit and lending plans, others may involve the issuance of governance (or other) types of new tokens, but there is generally a consistent theme of using crypto holdings to earn returns outside of normal capital appreciation.
Staking, mining, and farming are related. At the risk of diving too deep into the details, it is important to point out that many of the concepts being discussed are indeed connected. Whatever label is used, the point is that crypto holders and investors are looking to augment or enhance returns outside of price appreciation. Specifics, of course, will vary greatly, but the point is the same. That said, it is critical to always read and understand the terms and conditions of the specific activity in question.
Lending is not always lending. It can be tempting to try and simplify or generalize all crypto lending options as simply equivalent to current fiat lending programs, but that is an over-simplification. One of the most important differences to understand is that virtually every crypto lending concept is based on an over-collateralization model. Although increasing liquidity is one of the ultimate goals of mining, farming, or staking, the collateral required does play an important role.
For example, a 200% collateralized crypto lending protocol would necessitate that to withdraw or otherwise use 50 USD of value in the form a specific cryptocurrency, 100 USD of value will have to on deposit. This is radically different to how current fiat lending and banking systems generally operate.
Crypto lending is a group effort. One other layer or nuance that should be understood when assessing any crypto lending program is that crypto pools have an important role to play. From the initial organization of the crypto farming or mining operation, to the growth and maturation of the ecosystem growing up around it, to the actual market for the service itself, pools of liquidity (and governance) feature prominently.
In other words, crypto mining and liquidity generating events require collaboration with others; this also leads into another point that should be not be relegated to the back burner.
Risk still exists. Clearly there are always risks with every business venture or idea, but there are two specific blockchain related risks that potential investors should be aware of. First is the idea that, basically, the entire crypto lending or income generating market are reliant on smart contracts. Smart contracts are simply programmable and executable code written into a blockchain, and as with any programing language there is always the risk of errors and unethical actors exercising outsized influence. Especially since many DeFi applications and ideas are built with interoperability in mind, the ripple effects of such errors could be catastrophic.
One other consideration to point out, and while it might seem obvious, is that the lack of comprehensive regulatory, taxation, and reporting guidelines or authoritative guidance can make managing these projects quite murky. To that end, it is always advisable to work with experts who, in addition to subject matter expertise, also have experience contending with blockchain and crypto specific issues.
Whether it is called crypto lending, mining, staking, or farming, the blockchain and crypto marketplace is maturing and developing different services to create a truly self-sustaining financial system. Any financial system needs incentives to attract and retain both capital, and it looks like the marketplace is delivering those incentives in the form of these new blockchain applications.