EP 15: Yield Farming Economics. Good Bad Ugly

Last week, we talked about the possibility
of going back to the international gold standard by replacing gold with Bitcoin. Today, we
are talking about the agrarian culture 2.0. I guess history really does repeat itself Today, we are talking about yield farming,
the modern day agriculture. Instead of harvesting crops, we are going to be harvesting tokens. Today, we will be covering a few things, but
mainly It’s going to be the economics of yield
farming. But before I dive into the economics and how you can
apply it to your project, I’ll start with the projects using yield farming and some
basic tips and tricks.

The good, bad and ugly, so you get to judge
for yourself if yield farming is right for your project. Part 1: what is yield farming? Yield farming is token distribution and network
effects to get your user base into your protocol or
into your project. In 2017, we had ICO. Using tokens as a fund-raising
mechanism and distribute tokens to funders. In 2019, we had IEO. Also using tokens to
fund-raise and distribute them via an exchange. Today, we have yield farming. Using tokens
to encourage transaction on the platform, where the token has utility in a later date. It is not so different from exchange tokens.
Check out our episode on the economics of BNB tokens.

Basically, you are rewarded with native tokens
by using executing trade on the various protocols like Compound, Synthetix, Balancer, Curve. At
the end of the day, it’s only attractive because the returns are good. Yield farmers
can earn as much as 100% of returns on a good day. Losses can be steep, but the 100% returns
is so attractive that it is attracting millions of dollars into the market. Does it work?
Absolutely! This native token is an incentive for liquidity providers. That is exactly what
exchange platforms are doing with their native tokens too, by incentivising market makers. Yield farming incentivises both borrowers
and lenders to trade and transact on their platform. It works for users because they are rewarded
with extra tokens.

It works of the platform because they are
onboarding new users. Why do people love it?
As mentioned before, people love it because you receive your usual returns like interest
rates and extra tokens. Think of it like buying a buy 1 get 1 deal
on pasta. And they also throw in a bottle of pasta sauce for free. The pasta sauce is
the extra native tokens. This is really nothing new.

Exchange platforms
have been doing similar things like Binance, Bitmex and Coinflex. Synthetix was probably the first to look at
more mechanism for users to earn extra tokens. They have various liquidity pools where you
can get extra SNX tokens by staking there. Users can earn interest on the various liquidity
pools like Uniswap, Curve, Balancer. And get SNX tokens. Why? To increase liquidity for the token.
In this case, sETH on Uniswap. Whoever adds liquidity to the pool stakes
their sETH. They receive trading fees when people use sETH on Uniswap and get SNX tokens.
The high liquidity attracts investors. So this gamification attracted more sophisticated
users, not just retail. The underlying incentive for SNX is to increase
liquidity in the asset. It worked. The sETH pool makes up ⅓ of Uniswap
liquidity. Curve Finance facilitates trading between
assets pegged to the same value. For example, there is a Curve pool with USDC, USDT, DAI,
and sUSD: all USD pegged stablecoins. There’s also a liquidity pool with sBTC, RenBTC, and
wBTC: all pegged to the price of BTC. Instead of trading with people, curve allows
people to trade with the pool.

The USP is low-slippage trades for assets. You earn fees
by contributing to the pool. And the pool is also being lent out. By contributing to the pool, users get to
earn interest rate when money is lent out and earn transaction fees on trade. How does Curve get an action on this yield
farming? Firstly, everyone is trading more and requiring liquidity, so that’s where
Curve comes in. Secondly, liquidity providers are earning
returns from #1 AND extra tokens in the form of SNX, REN, BAL, CRV. CRV is
the native token of Curve.

Again, it is a governance token.
And they are distributing it to LP. Compound is probably the protocol with the
greatest transaction. The total assets under Compound has surpassed Maker, the top DeFi
app. It is the primary market for a decentralised money market. Compound is a protocol to clear borrowing
and lending on various digital assets. They issue COMP tokens to lenders and borrowers.
Anyone that lends or borrows on Compound earns a certain amount of COMP. 2,880 COMP is issued
to Compound users per day. Looking at $250 per COMP, that is $720,000 in giveaway. This resulted in 1b new assets flooded into
the lending protocol to take advantage of the incentive. Balancer is an automated market maker and
users get to earn returns by providing liquidity. Users get to earn native tokens when transacting
and supplying liquidity into any of their 427 pools.

This also worked when the total locked value
soared. Before the distribution, volume had generally
been under $2 million. Since the distribution, it has generally been around $4 million. But
on Sunday, June 28, volume shot up to $14 million, though this aberrant growth likely
relates to an unexpected attack on Balancer using non-standard ERC-20 tokens on Sunday. In general, there is a fixed amount of tokens
minted daily by the smart contract. Then, it is distributed accordingly to the volume
of each trader or user. So the more you trade, the more native tokens you get. Of course,
It depends on what actions the project want to incentivise users. For example,
1) providing liquidity in synthetix 2) Encouraging trade on curve
3) Borrow and lending on Compound 4) Providing liquidity on balancer It uses digital assets to do this. Initially,
it started off with stable coins and assets that were super in demand to earn in the interest
and native tokens and you reduce your volatility exposure.
As the space became more crowded as more yield famers came into the space, the returns dropped.

So that drove investors to transact on other
less liquid assets to earn the interest and native tokens, like BAT, WBTC, ZRX. How do users increase exposure? Using the
magic of leverage. They use leveraged loans to borrow tokens and increase yield on the
native token. The fun thing about defi is that when you
find a loophole and maximise your trade, you are called a hacker. In centralised finance,
you are rewarded with a huge bonus. So here are 2 hacks I’ve found by Degen
Spartan, DeFiDad, SNX Professor, amongst the plenty other ones:
1) Earn 20% APY in SNX, by providing liquidity in smaller markets with less saturation and
earn yield: Take stablecoins to reduce your volatility exposure.

Add it to sUSD curve
pool. Take the native token and deposit it into the synthetix mintr incentive contract
and mint SNX. 2) Switch to assets based on market volume:
Borrow USDT (again, to reduce volatility of token price) and lend back USDT. Use Instadapp
to increase leveraged borrowing if you want. If you are interested is more risk, BAT currently
gives out more COMP on Compound so close USDT (stable) position and switch to BAT. At the end of the day, there is no free lunch
in economics. This is not all rainbow and butterflies with free money being thrown around.
There are risks to it. The good is easy. Projects like these are way beyond the stage
of just a white paper. We have a working product that can be used and this is the first step
towards getting a user base.

Call it creative growth hacking, if you want. However, this is still a short-term incentive
that is not sustainable. What happens when the hype of trading is gone? Or when transaction
fees are too expensive and it makes no economic sense to trade? Or when tokens are all given
out? At the end, it’s a way to increase network
effects and participation. It’s like PayPal or uber giving away $10 when you invite someone
to join. Instead of a referral link, it is the collective hype movement to encourage
someone to join this farming frenzy.

OR It could be a possible ponzi, maybe a longer
and more elaborate one, if you think about it. So far, it seems like the yield is a zero-sum
game. If you dont know how to play, you should not participate. It may change in the future
by increasing the size of pie, but for now, it is a beautiful zero sum. It means do not
be the last sucker standing because you are going to suffer all the losses. If you don’t
have insider knowledge or strategic advantage, you are not earning yield. You are the yield. The real ugly part is the hidden string attached.
Due to all the trade going on on ethereum, gas fees have shot through the roof. I was
looking at some COMP tokens and to add them to my metamask wallet, it costs $9 in transaction
fees! That’s expensive. So beware of gas fees, slippage fee, asset
volatility. I also talked about leveraged borrowing just
now. I don’t want to dive too much into that in this episode, because this podcast
is not for traders, but for crypto-entrepreneurs and long-term investors.

Leveraged trading
can be good to secure greater upsides, but the downside can also be quite steep, especially
since market is so volatile and you can get squeezed out quickly, if you have all your
liquidity tied up in the the defi apps. Check out this tutorial by Defi dad to reduce liquidity
risk. Also, you can read all about the 100% APY,
but remember that there is no yield guarantee. The protocol developers cannot guarantee that.
The crypto-influencers cannot guarantee that. The market decides and the market moves quickly.
So this is risky. Finally, this is something more in the long-run.
You know economists. Always looking at things in the long run.
Because there are so many transactions (that may or may not be inflated), the transaction
fees have soared. So, Ethereum is looking to increase the block size. This is great
for validators in the short run to increase their returns, but this is ugly risk in the
long run because ETH can be more vulnerable to attacks on the network Since yield farming is part of token design,
we will only look at the token design column.

This is not exactly something brand new. We
see similar models in the physical fiat world. Churning of credit card to get CC points
Frequent flyer points hack, that you always read about online At the end of the day, this is a self-reinforcing
mechanism. The token incentives create liquidity which starts a feedback loop. Trading volume up -> MM profits up -> capital
dedicated to MM up -> liquidity up -> tighter spreads up -> repeat How the loop works:
Users lend an asset to receive yield. 10-30% depending on the market
Borrower must pay interest. But they also get COMP token
COMP token increase in value Value keeps increasing because the market
perceives an economic value being generated in the compound platform and the token is
a way to extract this economic value to monetary terms
So the returns in COMP is more than the interest paid (and ideally transaction fees) so that
is how people earn and farm more It becomes a loop At the end of the day, this method just encourages
network effects without providing any real economic value.

For protocols and projects
to succeed, it depends on builders and users to stay on the platform for a long time, and
not just during this movement does it work? sure, it seems to be working
in the short-run now, as it was designed to do. a short-run incentive. COMP token has
increased from $16 to $230 upon listing. so it is a feedback loop of people wanting farming
(mining) more COMP tokens. And the highest point of $350. This also led to funds in COMP locked up valued
at $400m, up from $100m in 1 week. But is this sustainable? There is a downward
pricing of COMP At the end, this is a token supply increase,
or supply inflation. It is also distributed to users with the highest volume.

The supply
inflation is usually decided by the protocol founders like COMP distributed 2880 tokens
per day. And BAL issuing 145,000 BAL per week. That could perhaps change in the future since
COMP is a governance token. We shall see in the future. Instead of people paying for tokens, it is
earned via the platform. Since it is technically free (it is free if you use it for the purpose
and not to speculate and inflate the yield returns), people are using leverage to increase
their trading exposure to mine more tokens. These tokens are not exactly free. early investors
of the tokens have invested and receive tokens.

They are happy for tokens to increase in value
to cash out their returns. unless you have a strategic plan for using tokens to gain
returns, you are just part of the plan. Compare this to IPO. Usually in IPO, there
is an IPO pop where value of the stock increases when stocks are listed. And people trade it.
If you have no idea how to use that to your advantage, maybe rethink your position on
joining the game. It might be even worse in DeFi since tokens are not equity and there
is no mandate to ensure that the tokens work for the investors. It might be better with
governance tokens, since they come with a flavour of equity stock, but it is not the
same borrowers are willing to pay more. because
they think they can make more money with what they borrowed than the cost paid to borrow.
Borrowing fees are basically subsidised with the native tokens since there is a value to
it Instead of a cashback on spending like a credit
card, you get a token back reward of a native token.
This native token cash back can be worth more than the fees paid
This means people are incentivized to borrow just to "farm" the cashback.

This increases
demand for loans and subsequently increases how much lenders can earn.
lenders: more interest earned, more cashback received.
people are paid to borrow. lenders take the money they deposited and borrow more. So it
becomes APY of 100% This is a typical method for issuing tokens
based on transaction volume, as we see in exchange tokens. Check out the BNB episode
for the economics of that. Yield farming is a growth hacking way to achieve
network effects. It uses short-term incentives to drive user growth. At the end of the day,
we are looking at the bigger game. In the long-run, how sustainable will the platform
be. The real economic value comes from building products that benefits users in
a sustainable manner, not with hypes and pumps. That means actual financial
activity for DeFi protocols, so that monetary value increase is not just driven
by "sophisticated leveraged speculation" but real value-add.

If you want more details about how to build
a token economy, check out our course. We are
currently having a discount. It is a 15h course with 10 episodes that you can pick and choose. See you in the course, and see you next week!.

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