by Jake Wengroff
Liquidity farming (often also referred to as yield farming) is essentially the practice of lending crypto assets in order to generate high returns or rewards in the form of additional cryptocurrency. Liquidity farming is currently the biggest growth driver of the still-nascent DeFi sector, helping it to balloon from a market cap of $500 million to $150 billion in 2021, according to CoinGecko.
Liquidity farming protocols incentivize investors, known as liquidity providers (LP), to lock up their crypto assets in a liquidity pool, based on smart contracts created using DeFi protocols. These incentives can be a percentage of transaction fees, interest from lenders (who loan funds to borrowers), or a token (see liquidity mining below). As more investors add funds to the related liquidity pool, the value of the issued returns decreases accordingly, because more investors need to share the same amount.
Liquidity farmers, and most protocols and platforms, calculate the estimated returns in terms of annual percentage yield (APY). APY is the rate of return gained over the course of a year on a specific investment. Compounding interest, which is computed on a regular basis and applied to the amount, is factored into the APY. In this way, liquidity farming resembles more traditional investment vehicles offered from financial services providers.
Liquidity Mining: Even Greater Incentives
Liquidity mining occurs when a liquidity farming participant earns tokens as a reward or additional compensation for contributing their funds to the liquidity pool.
“Liquidity mining supercharges yield farming,” notes Brady Dale in CoinDesk.
Liquidity farming started when investors would give money to miners, or when the miners themselves would stake well-known stable coins. However, the most popular DeFi protocols evolved, and they offer these additional “governance tokens” for liquidity mining as a form of additional compensation. The governance tokens are farmed in these liquidity pools, in exchange for investors providing liquidity to platforms and decentralized exchanges (DEXs).
Most liquidity farming protocols now reward liquidity providers with governance tokens, which can usually be traded on both centralized exchanges like Coinbase or DEXs like Uniswap.
The Risks of Liquidity Farming
Liquidity farming can be incredibly complex and carries significant financial risk for both borrowers and lenders. There are further risks of impermanent (temporary) loss and price slippage when markets are volatile.
Liquidity farming is susceptible to hacks and fraud due to possible vulnerabilities in the protocols’ smart contracts. These coding bugs can happen because new contracts and features are often unaudited or even copied from predecessors or competitors, multiplying the risk.
Examples of vulnerabilities that resulted in severe financial losses include the Yam protocol (which raised more than $400 million in days before a critical bug was exposed) and Harvest.Finance, which in October 2020 lost more than $20 million in a liquidity hack, according to CoinMarketCap.
Liquidity Farming with Greater Ease and Security
While some liquidity farmers have earned triple-digit returns, there is still potentially high risk, with the protocols and coins earned subject to extreme volatility and “rug pulls,” wherein developers abandon a project and make off with investors’ funds.
DeFi protocols are permissionless and dependent on several applications in order to function seamlessly. If any of these underlying applications are exploited or don’t work as intended, it may impact the whole ecosystem of applications and result in the permanent loss of investor funds.
As the blockchain is immutable by nature, most often DeFi losses are permanent and cannot be undone.
The industry needs market-driven solutions that can keep up with the marketplace of DeFi protocols and DEXs. TransitNet is creating the industry’s first third-party title registry that demonstrates proof of ownership of crypto assets, to add a layer of protection for investors, regardless of which platform they use for liquidity farming or mining.
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Jake Wengroff writes about technology and financial services. A former technology reporter for CBS Radio, he covers such topics as security, mobility, e-commerce and IoT.
Sources
Business Insider – Yield farming: An investing strategy involving staking or lending crypto assets to generate returns
CoinMarketCap – What is Yield Farming?
CoinDesk – What Is Yield Farming? The Rocket Fuel of DeFi, Explained