Understanding Crypto Yield Farming
Making crypto from crypto | DeFi, Liquidity Pools, Governance Tokens and more..
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Hey folks!
Happy Monday! I hope you have a fantastic week ahead. I am back after a two week hiatus. I wanted to cover the OYO Rooms IPO and started researching and writing, however I ultimately ended up scrapping the post as it just wasn’t up to the mark.
Over the past few weeks, I have been trying to learn more about blockchains and Web3. Starting from the basics I worked my way up to yield farming. The concept is so simple, yet so fascinating. The protocols that enable yield farming form the fundamentals of DeFi. Let’s dig in.
Crypto Yield Farming
The traditional form of investing in cryptocurrencies is buying them off an exchange, holding them in a digital wallet, and then if you’re lucky, selling them for a higher price than what you paid for it. There is nothing wrong with it, this is how most people also invest in stocks. But, imagine, a way that your crypto could make money while you hodl it.
You probably have some money deposited in a bank account. The bank lends out the money to people who need it and charges interest on it. This interest is then given out to you and others like you who have an account with the bank.
You very likely understand how a bank works – depositors deposit; borrowers borrow; borrower pay interest; depositors get interest. In the end, for the depositors, their money makes them more money. That’s the whole idea behind banks – to not have money sit idle. Yield farming or liquidity harvesting is essentially the same thing with cryptocurrencies, except it’s decentralised and you get more than just interest on it.
Decentralised
In the example above, everything revolved around the bank. It was up to the bank to accept deposits, match them with borrowers, accept interest from the borrowers and then hand out the interest to the depositors. The complete opposite of that, as enabled by cryptocurrencies, is DeFi (Decentralised Finance). Under DeFi, all the elements of a bank are smart contracts (self-executing programs) that exist on a blockchain. The type of smart contract that enables yield farming is called a ‘liquidity pool’.
Liquidity Pool
Simply put, liquidity pools are a digital stockpile of funds. They are permissionless – anyone can deposit funds in these pools. Users, called liquidity providers (LP), deposit two different tokens (coins) of equal value in this stockpile. For example, in a liquidity pool made up of Solana (SOL) and Ethereum (ETH), you would have to deposit an equal amount of SOL and ETH to the pool.
What’s the use of the pool? Continuing the previous example, say someone holds SOL and wants to do a transaction on the Ethereum blockchain. Now this person can go to an exchange, sell his SOL and buy ETH, paying high gas prices (transaction fees) each time, or he could just go to a liquidity pool and swap his SOL for ETH, paying only a minor transaction fee. (The latter is also faster).
What’s in it for the liquidity providers (LP)? As you could guess, the transaction fees that someone pays to access the liquidity pool is paid out to the LPs. But that’s not all, additional rewards are paid to the LPs in the form of governance tokens.
Governance Tokens
Governance tokens, came into prominence when compound.finance started issuing COMP tokens (coins) to its users for every day’s participation in Compound’s services. Remember, a currency only has values if a large enough group of people use it. Soon, the value of COMP skyrocketed and yield farming became a thing. As an LP, you can then speculate and trade the value of the tokens you receive. Here’s the crazy part - you can pool these governance tokens too!
A lot can go wrong
Liquidity protocols are highly susceptible to price manipulation. To create artificial demand for a coin, someone can lend out funds in the liquidity pool and borrow them back and so on. This strategy also results in the person getting a higher share of the governance tokens.
That’s raised concerns that early adopters who have accumulated large holdings, often called whales, are manipulating price movements, a common accusation in a range of crypto markets.
These protocols could soon face heavy regulatory scrutiny. The US securities watchdog, SEC has been arguing for years that regulating these tokens falls under its purview. The Howey test laid out in the 1946 Supreme Court case says that any contract, transaction or scheme that gives an investor expectation of a return can be labelled as an “investment contract” or a security.
In September, Brian Armstrong, CEO of Coinbase, said that SEC threatened to sue the company if they proceeded with the launch of the new feature that would let its customers earn interest on their tokens.
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Liquidity pools are the mainstream application of DeFi. The speed and the efficiency at which they empower lending, borrowing and generating yield is truly astonishing. I do believe that will serve as the building blocks for the new decentralised world we are heading towards just like how banks sit at the foundation of the modern financial world.
Tech This Week
PayPal is looking to buy Pinterest for $45b. Link.
Google lowered its Play Store commission from 30% to 15%. Link.
Facebook is planning to change its name. Link.
Donald Trump is launching a new social network called Truth Social. It got hacked even before launching. Link.
Apple’s advertising business has more than tripled its market share in the six months since it introduced privacy changes that obstructed its rivals from targeting ads at customers. Hmm, maybe monopolies are bad. Link.
New products from Google (Pixel phones) and Apple (MacBooks). Both are powered by processors designed in-house. Google. Apple.
Oh, and the world is running out of the colour blue. Link.
Trivia
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Nihal C was the only one to get the answer for the last puzzle. I expected more people to get it since it was the simplest trivia so far of the newsletter. The answer? Reddit.
That's all for this week folks. See you next week!
Shobhit (@ShobhitJethani)
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