DeFi and the Yield Farming Phenomenon

DeFi protocols exploded in all metrics over the last month, passing $3B in Total Value Locked (TVL), triggered by the launch of the Compound governance token ($COMP) and subsequent “yield farming.”

What is Yield Farming?

Most crypto protocols are designed to be decentralized. For base-level networks (like Bitcoin and Ethereum), this is achieved through Proof of Work, where anyone can be a miner and earn some BTC or ETH in exchange for helping secure the network. In so doing, control of the network is more or less democratic (one CPU one vote).

  • Distributing $COMP pro-rata to users of the protocol is free yield. It’s an added bonus just for using Compound.

What Happened with Compound

Yield farming drove a flood of capital into Compound — in a single week in mid-June nearly half a billion dollars was added to Compound, driving total value locked (TVL) from $100M to over $1.7 B at the peak. $COMP similarly opened trading around $80 and exploded to over $300.

  1. Borrow 70 DAI against your 100 USDC collateral (paying interest but earning $COMP)
  2. Trade 70 DAI for 70 USDC (bonus: on a DEX)
  3. Repeat Step 1

Yield Farming is Not Without Risk

In efficient markets, increased yield is reflective of increased risk. While DeFi is a largely inefficient market today, outsized DeFi yields are still indicative of additional risk:

  • System design risk: Many protocols are nascent and the incentives can be gamed. (E.g., Balancer, where FTX was able to capture >50% of the yield due to a simple flaw)
  • Liquidation risk: Collateral is subject to volatility, and debt positions are at risk of becoming undercollateralized in market swings. Liquidation mechanisms may not be efficient, and could be subject to further loss.
  • Bubble risk: The price dynamics of the underlying network tokens (like $COMP) are reflexive because expected future value follows usage, and usage is incentivized by expected future value.

DEX Volume explodes, begins to rival Centralized Exchange volumes

DEX volume rocketed upwards over the last month, and has begun to rival some centralized exchanges.

DeFi Stablecoins see strong Q2 growth

Stablecoins used within DeFi (notably Dai and USDC) saw record Q2 growth, as these are preferred yield-farming assets owing to their low volatility which prevents liquidation risk. Both USDC and Dai market caps saw >50% growth, moving from $700M to $1.1B, and $100M to $150M respectively since the launch of $COMP.

The market cap of all ETH tokens recently surpassed the market cap of ETH itself. While driven mostly by a few assets (LINK and CRO), this is still an intriguing flip showing how the ETH ecosystem is expanding in value faster than the base native asset.

Ethereum Suffers Periods of Congestion; Highlighting Scaling Challenges

Predictably, DeFi activity produced a rise in median gas prices, ranging between 40 and 70 Gwei today. A single ETH transfer costs ~$0.35, but more complex operations like swapping assets on a DEX or entering and exiting multiple yield-farming positions can be substantially more expensive (at times >$10 per transaction).

Other DeFi projects surge

  • Wrapped BTC Projects: Wrapped BTC projects create an Ethereum ERC-20 token that is redeemable 1:1 for BTC on the Bitcoin blockchain, thus marrying the BTC and ETH chains and bringing BTC’s balance sheet into DeFi. These projects rose substantially as users sought out more capital for yield farming. BitGo’s wBTC and Ren’s rBTC are notable standouts, with ~$140M BTC locked between them (and wBTC the clear leader with $130M).
  • Balancer: A liquidity provider and DEX similar to Uniswap launches with a yield farming governance token, and quickly grows to over $200M TVL.
  • Aave: A borrow / lend protocol similar to Compound, but with added flash-loan capabilities, a native $LEND governance token, and differentiating loan products. $LEND value has increased significantly following $COMP’s rapid rise, and Aave’s TVL has similarly exploded to over $450M.
  • Synthetix: A synthetic-asset protocol on Ethereum with similar yield-farming mechanics, Synthetix has also seen incredible growth. Their synthetic dollar sUSD has captured volume amidst the stablecoin explosion.
  • yEarn Finance: A suite of DeFi products, including a robo advisor that allocates your deposits to the highest-yielding protocols. They released a governance token over the weekend ($YFI) with unique properties in that it has no previous owners and no outside funding, a fixed supply, and is earned through yield farming. Upon launch, capital rushed toward farming and yields went as high as 1,000% APR.
  • Infrastructure: Chainlink, aiming to become the oracle bridge powering the suite of crypto and DeFi Dapps, surges to ATH above $8 and cracks top-10 by market cap; InstaDapp surges to nearly $200M in TVL as a simple platform to easily manage yield farming positions.
  • Others: Ampleforth’s unique “uncorrelated token” surges; UMA releases a synthetic COMP token (yCOMP) to enable shorts, and a yield-dollar for fixed-interest loans; mStable holds token sale for their stablecoin protocol standard; bZx jumps on with uniswap offering of their governance token.

Implications: Is this activity genuine?

For all the impressive metrics, the rise in asset valuations, and meteoric growth in value locked, is it really genuine activity?

Are the valuations and returns sustainable?

Taking a step back, we can see a clear cycle:

  1. Total Value Locked (TVL) increases as users farm governance tokens
  2. Governance token valuations increase on the back of skyrocketing TVL and metrics
  3. Yield farming incentives increase, repeating step 2

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