Decentralized finance (DeFi) is one of the fastest growing and emerging financial technology in the crypto space. This network does not allow the involvement of any third party for the verification of transactions.
It is instead done by the distributed ledgers present in the network. To challenge the limits of the traditional centralized finance (CeFi) system that relies on mediating bodies to operate correctly, the decentralized finance (DeFi) system was developed.
In the past two years, DeFi earned about 400 million dollars in total value locked (TVL) worldwide, reaching nearly 2 billion dollars in the year 2022. However, the main factor that helped in the growth of DeFi in the industry is its flexible nature despite being decentralized and permissionless by nature.
In addition, the numerous platforms also add up to this uptrend by providing services like lending, exchange, or yield farming.
Here is a comprehensive guide article to help readers understand the concept of yield aggregators and yield farming. Moreover, it will also explain its working and the pros and cons integrated with yield aggregators.
What is Yield Farming?
When crypto investors move their tokens to smart contracts that generate yield and earn rewards; as a result, using the decentralized financial protocol, it is known as yield farming. During yield farming, smart contracts containing cash are the liquidity pools, and the investors are the liquidity providers.
Another essential component of the yield farming network is the automated market maker. Using this network, the users do not need to trade in the traditional market comprising sellers and buyers. Instead, they carry out the trade using an automated system integrated with liquidity pools.
Mechanism of Yield Farming
The creation of COMP led to the rise in the popularity of this concept. COMP is the governance token of the DeFi lending Protocol Compound. Whenever the participants use borrowing and lending services in the liquidity mining process, they are rewarded with newly minted COMP tokens as a reward by the protocol.
In addition to receiving interest as a reward while lending and a fee for providing liquidity to the pool, the governance tokens are given as rewards to the participants in yield farming to encourage them to active participation and adaption to the platform conveniently.
However, the foundation for DeFi aggregators was laid down by these several rewards given to the users in token distribution, interest, and fees.
What is a DeFi Yield Aggregator?
By providing a combination of decentralized finance protocols, such as smart contracts and the strategies that are required to maximize profits for an investor, yield aggregators are playing an essential role in the economic build-up of yield farming. Yield aggregators are also known as yield optimizers or auto compounders.
They are basically a collection of smart contracts that facilitate to pool of the crypto assets such as tokens of the investors. Moreover, by using strategies that can be executed automatically and are pre-planned, these tokens are invested in the portfolio of products and services, producing yield.
This is the same method where the portfolio of an investor is looked after by a fund manager, and the best crypto staking opportunities are provided through DeFi in order to earn maximum profits.
There are a number of yield aggregator options available for investors that are almost similar. The difference between them is usually technical, which may be due to the blockchain they operate on or the smart contract they utilize.
However, the interest rates offered by them, or the fees may differ for each of them; therefore, these factors should be looked upon by the investors before finalizing their choice.
Why are Yield Aggregators Needed?
The tokens that are involved in yield farming also consist of governance tokens usually issued by protocols. The users can utilize these tokens to incentivize their activity and permit the holders to propose a change and vote for it.
When a token is used on a platform, it generates fees and higher yields for deposited tokens. Therefore, the more the token is used, the more the yield will be generated.
One can generate auto-compounding results by staking the tokens or generate rewards by swapping them with underlying assets. In addition, the tokens bearing interests can also be used as it generates fee for the users participating on the platform. However, further tokens can be bought using this fee which results in an increase in buying pressure for these tokens.
However, the analysis of farming opportunities proves that yield aggregators provide the projected total value locked and profitability to the investors even if the value of the underlying asset or the reward generated through them is declining.
In the conditions during yield farming, where the tokens are issued in a limited number, aggregators still try to provide the best returns to their users.
Yield farmers usually deploy complex investment strategies to maximize their profits. The tokens are staked in a chain protocol in multiple steps to help the farmers generate a maximum yield from their investment.
Working of Yield Aggregators
The participants in yield farming are usually expected to lock up their funds or stake them during the process. In order to produce the highest possible yields, the farming process is then automated by the yield aggregators. Here is given the detailed working procedure of yield aggregators.
In daily life, the term farm is referred to the place where crops are grown and harvested to produce a particular yield. Similar is the case in yield farming using the decentralized finance protocol, where the traders invest their assets and gain profits in return.
By using various strategies, the investments earned by different crypto investors are collected to facilitate the profit-earning procedure.
The yield aggregators do not require the farmer to work; instead, they carry out all the functions and accumulate all the income earned passively through automated services. Investors can move their tokens around multiple platforms using these strategies and use the auto-compounding phenomenon to optimize yields.
Without any need to perform the task manually, the stakers can claim and stake their rewards again using this procedure. There are specific governance tokens that are used in yield farming that are required by the participants to influence the management decision through voting.
In order to provide incentives for the activity done by the network, to propose an idea, or to vote for the changes to be made, the governance tokens are issued by the protocol. This leads to higher deposits in token yields by the generation of more fees by such incentives.
- Yield Strategies
Providing liquidity to decentralized exchanges (DEXs) is one of the most commonly known yield strategies. The decentralized exchanges replace the traditional order book with liquidity pools, as liquidity is a critical component of a decentralized financial system. Using this liquidity pool, crypto assets that need to be traded are provided by the participants.
If instant trades are sufficient using this liquidity, a share of the transaction fee is provided to the liquidity providers as a reward. On the other hand, these dividends and gas fee payments should be claimed manually by the investors as these decrease their annual percentage yield (APY) and affect their overall profit.
Whenever tokens are deposited on any platform, annual percentage yield (APY) and annual percentage return (APR) are the leading factors that decide earnings made throughout the year. The compounding interest of the asset is included in the annual percentage yield and not in the annual percentage return.
These indicators are based on trade volume and may vary from time to time. It helps in the generation of fees in the liquidity pools and in the total value locked for the considered smart contract. The annual percentage yield will be decreased if there are more participants in the vault, as the rewarded tokens will be distributed among a more significant number of people.
However, the transaction fee earned by the liquidity providers may not be enough incentive for them. Therefore, there is another strategy for the investors to earn rewards in yield farming known as staking. The participants have to deposit their tokens on the farm, and they will be paid a reward in return in the form of tokens.
By staking the LP or single tokens available in the wallet, the users can automate the process and retain their gas fee. These tokens can be claimed again automatically, converted into assets that bear interests, and then deposited in the farm again to make profits.
Due to the redistribution of the accumulated vault fees and sharing of the rewards earned by staking the protocol tokens in the vault of aggregators, the value of the token increases. The rewards in the vault are auto-compounded at definite intervals, such as every ten minutes, etc., compared to the ones at the farms.
As a result, the rewards are automatically harvested by the vaults due to auto compounding. These rewards are then invested in the pool again, and the total new amount makes up the yield. The process of staking, collecting rewards, or reinvesting them on behalf of the user is automated in case one uses the yield aggregators.
If this process is carried out in multiple intervals and the gas fee is shared among different participants, it can decrease the upper costs and lead to earning maximum profit.
Spiral lending is another important yield farming strategy. Using decentralized exchanges, short-selling crypto assets may become difficult sometimes; therefore, the investors do it through lending protocols.
These protocols usually offer the investors unbalanced pools at quite reasonable rates that may become a flaw for the yield hunters as the protocol takes the risk of losing assets on themselves.
However, the investors can again use the liquidity provision tokens that they had earned through providing liquidity to other pools or platforms. In this way, as one builds more making positions through a single source of investment, a spiraling effect is created. However, the only risk is that one may lose all his funds if a minor inconvenience occurs at any point in the chain.
- Yield Aggregator Platforms
Sometimes it becomes challenging for the users to keep up with the services and upcoming projects as new technological advancements happen in DeFi. However, a wide range of higher interest rates and lower fees is offered by different platforms as the competition between them increases. Some of the commonly known yield aggregator platforms are mentioned below.
Ethereum and Polygon: Ethereum and Polygon are the most commonly used networks for deploying yield aggregators in DeFi. It is essential for the investors to confirm that the blockchain they choose for hosting their assets is compatible with the network they are opting for, producing the maximum yield.
Yearn.finance: One of the popular yield aggregators based on Ethereum is Yearn.finance. It can be conveniently accessed through Arbitrum and Fantom.
This platform combines different strategies such as liquidity pool staking, yield farming pools, crypto lending, and the newly added Ethereum staking for optimization of yield by the users. The platform is known for its versatility due to producing optimal APY rates for carrying out crypto staking.
Convex Finance: This platform is different from Yearn.finance as it only provides liquidity staking options to the users. However, the Curve (CRV) staking method is used by the platform. The liquidity providers over the platform are provided access to the yield boosts.
The Convex liquidity providers can earn a trading fee and claim for the CRV without locking any funds as Convex Finance is an automated market maker. It can be used to leverage the assets.
Harvest Finance: It is also an automated market maker that uses its farm liquidity mining program and offers a yield containing the compounding interest.
Beginners and non-professional traders can quickly adapt to this platform and earn passive income as it is convenient and easy to handle. Moreover, it also saves the time and effort of the participants by automating the collection of capital from different yield farmers.
Are There Any Risks Involved with DeFi Yield Aggregators?
The primary purpose of yield farming and yield aggregators is to provide the opportunity of earning rewards to crypto investors. Moreover, it also permits them to increase their tokens instead of just keeping those tokens in wallets in dormancy and waiting for the increase in token value in the market.
However, by providing great opportunities to the investors for earning passive income, there may be some risks integrated with yield strategies.
The system is composed in such a way that there are multiple protocol layers involved in the yield process. This gives rise to various chances of threats, such as scams or hacks, that could make the total worth of the token negligible.
Moreover, it is essential to consider the factors like liquidation risks and impermanent loss when choosing yield aggregators during yield farming. One might lose all his holdings if any of these events happen.
When the prices of the underlying assets change, an impermanent loss can also decrease the return value. Moreover, when investing borrowed funds, a liquidation risk might occur as the value of the asset integrated with the token may fall below the set boundary.
Let’s consider that professional traders have significant control over the market mechanism, and they can conveniently manipulate market prices. It increases the risk for small-scale investors to a greater extent. Moreover, if the cost of the underlying asset falls in the market, the loan may not be paid back to the small investors as it gets liquidated more easily than to professional traders.
The users should regularly audit the platform they opt for to avoid such risks. Crypto farmers are provided with the facility to earn passive income using the yield aggregator tools and help them earn some income passively to overcome any potential loss faced during trading.
However, it is mandatory that the investors keep a check on their earnings, and if needed, they can exit a pool and enter another one according to convenience.
In a decentralized financial system, yield farming and aggregators are considered entirely operating systematic tools. However, many applications are still to be discovered. But one cannot predict anything about where the new advancement in the crypto space may take us in the coming times.
In addition, no matter how much profit one gain and how much attractive it may appear, crypto investors should always be prepared for any loss if they choose a wrong or insecure network.
Cybercriminals and hackers have looted multiple investors due to security issues, rug-pulling, and other scams. Therefore, it is always advised to opt for a safer approach and not invest all holdings in one place.
As the crypto space is rapidly growing, it becomes difficult for investors to select the best approach in DeFi technology. New advancements are making their way every other day, and the present ones are upgrading themselves to survive in the competitive market.
However, investors and traders also look forward to better opportunities in the DeFi space to earn maximum profit using the present applications.