Unraveling the Sources of Crypto Yield Farming

Yield farming has become one of the most popular and intriguing concepts in the decentralized finance (DeFi) space. This practice, which involves lending or staking cryptocurrency assets to generate returns, has attracted billions of dollars in crypto assets. But where exactly does this yield come from? In this post, we'll dive deep into the sources of yield farming rewards, providing examples to illustrate these concepts.

Protocol Token Emissions

The most common source of yield farming rewards is through the distribution of a protocol's native token. Many DeFi platforms issue their own governance tokens and distribute them to users who provide liquidity or engage with the protocol in other ways.

Example: Compound Finance (COMP)

Compound, a lending and borrowing protocol, distributes COMP tokens to users who supply or borrow assets on the platform. The amount of COMP received is proportional to the user's activity on the protocol. For instance, Alice supplies 10,000 USDC to Compound's lending pool, while Bob borrows 5,000 USDC from the pool. Both Alice and Bob receive COMP tokens as rewards, in addition to the interest Alice earns on her deposit and the interest Bob pays on his loan. The value of these rewards comes from the market price of COMP tokens, which represent governance rights in the Compound protocol.

Trading Fees

Many decentralized exchanges (DEXs) and automated market makers (AMMs) share trading fees with liquidity providers as a form of yield.

Example: Uniswap

Uniswap, a popular DEX, charges a 0.3% fee on all trades. This fee is distributed to liquidity providers proportional to their share of the liquidity pool. Consider Charlie, who provides liquidity to the ETH/USDC pool on Uniswap, contributing 10 ETH and 20,000 USDC. His contribution represents 1% of the total pool liquidity. Over a week, the pool generates $10,000 in trading fees. Charlie earns 1% of these fees, or $100, as yield. This direct share of trading activity provides a tangible source of returns for liquidity providers.

Interest from Lending

Lending protocols generate yield by charging interest on loans, which is then shared with the lenders who supplied the capital.

Example: Aave

Aave is a decentralized lending protocol where users can deposit assets to earn interest or borrow assets by providing collateral. Diana deposits 100,000 DAI into Aave. The current supply APY for DAI is 3%. Over a year, Diana would earn 3,000 DAI in interest, assuming stable rates. This yield comes directly from borrowers paying interest on their loans, creating a straightforward mechanism for generating returns on idle assets.

Liquidity Mining Programs

Some projects offer additional rewards to liquidity providers in specific pools to incentivize liquidity for their token.

Example: SushiSwap's Onsen Program

SushiSwap, another DEX, runs the Onsen program where they offer SUSHI token rewards on top of regular trading fees for selected liquidity pools. Frank provides liquidity to the ETH/XYZ pool, which is part of the Onsen program. He earns regular trading fees from the pool, but additionally, he receives SUSHI tokens as extra rewards. These rewards come from the SushiSwap treasury and are designed to attract liquidity to newer or less liquid trading pairs, benefiting both the protocol and the liquidity providers.

Leveraged Yield Farming

Some protocols allow users to borrow assets to farm yield, potentially increasing their returns (and risks).

Example: Alpaca Finance on Binance Smart Chain

Alpaca Finance allows users to borrow assets to provide liquidity on PancakeSwap, amplifying their yield farming rewards. Grace deposits 1000 BUSD as collateral on Alpaca Finance. She borrows an additional 4000 BUSD, giving her 5000 BUSD total. Grace uses all 5000 BUSD to provide liquidity on PancakeSwap, earning trading fees and CAKE rewards. She repays the loan with interest but keeps the extra rewards generated from the larger liquidity position. The additional yield comes from leveraging borrowed capital, but this strategy also increases risk, highlighting the balance between potential returns and exposure in DeFi.

Rebasing Tokens

Some tokens automatically increase in quantity in holders' wallets, creating a form of yield.

Example: Ampleforth (AMPL)

AMPL adjusts its supply daily based on demand. When the price is above $1, additional AMPL is distributed proportionally to all holders. Harry holds 1000 AMPL. The AMPL price rises above $1, triggering a positive rebase. After the rebase, Harry now holds 1050 AMPL. The yield here comes from the token's supply expansion mechanism, providing an interesting approach to value accrual that differs from traditional fixed-supply cryptocurrencies.

Governance Rewards

Some protocols reward users for participating in governance decisions.

Example: Curve Finance

Curve finance offers additional CRV rewards to users who lock their CRV tokens for voting rights (veCRV). Isabella locks 10,000 CRV for 4 years, receiving veCRV. She now earns a share of trading fees from all Curve pools and boosted CRV rewards on her liquidity provisions. This yield incentivizes long-term commitment and active participation in the protocol's governance, aligning the interests of token holders with the long-term success of the platform.

Conclusion

Yield farming rewards can come from various sources, each with its own mechanisms and risk profiles. From token emissions and trading fees to lending interest and leveraged strategies, the DeFi ecosystem has created numerous ways for users to earn yield on their crypto assets.

However, it's crucial to remember that higher yields often come with higher risks. Smart contract vulnerabilities, impermanent loss, token price volatility, and other factors can all impact returns. As with any investment strategy, thorough research and careful risk management are essential when engaging in yield farming.

As the DeFi space continues to evolve, we can expect to see even more innovative yield generation mechanisms emerge. Understanding where yield comes from is the first step in navigating this exciting but complex landscape.