Yield Farming

What to Know

When yield farming at lending protocols, the platform’s prevailing rates (APY) are paid to the user for the duration of the deposit. APY’s float, based on supply and demand and they are typically paid in the same coin as the deposited collateral. In addition, platform governance tokens are distributed to depositors, which carry an exchangeable value on CEX/DEX’s. Subject to a Loan-to-Value (LTV) ratio (‘Collateral factor’ at compound), users can also borrow against their deposit. LTV ratios are calculated based upon the volatility of the coin being deposited. So for example, depositing a stablecoin as collateral might allow a user to take a higher LTV borrow, since stablecoins typically experience little to no price volatility in USD terms.

Once a user borrows a coin against their deposited collateral, they have to pay prevailing rates for the borrow. Like deposit rates, apy borrowing costs fluctuate with demand for that specific coin. Often, users will take borrowed coins and use them for levered positions.

Why it Matters

Lending is a key financial primitive that helps expand liquidity in any economic system. Protocols like Aave and Compound are important pieces in the DeFi ecosystem, as they have engendered trust in smart contracts, built a demand-based lending system and ingeniously implemented a governance token protocol that serves as a model for others to pool liquidity in DeFi. 

As previously mentioned, governance tokens accrue benefits to the user such as voting rights, revenue sharing and other benefits. This critical innovation has attracted liquidity, which in turn has provided for a range of new token trading pairs, new governance token issuance and schemes, and other innovations. The realization of key financial primitives in a DeFi setting sets the table for even more innovation as liquidity grows and more complicated products are built on top of the strong structural foundation.