Yield farming is a cryptocurrency investment strategy that holds out the hope of bigger returns than most conventional investments are offering these days. It could be a chance for the bold to win big, or for the holders of new currencies to manipulate prices.
The US Securities and Exchange Commission (SEC) has put the industry on notice that it has reservations, in particular over whether the practice should be regulated as a securities offering.
1. What is yield farming?
When you deposit money in a bank, you are effectively making a loan, for which you get interest in return. Yield farming, also known as yield or liquidity harvesting, involves lending cryptocurrency.
In return, you get interest and sometimes fees, but they are less significant than the practice of supplementing interest with handouts of units of a new cryptocurrency. The real payoff comes if that coin appreciates rapidly. It is as if banks were luring new depositors with the gift of a tulip — during the Dutch tulip craze. Or a toaster, if toasters were the object of wild speculation and price swings.
2. Really?
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It may sound strange, but you have to remember that unlike established currencies that have lots of money in circulation, cryptocurrencies have to perform a tricky balancing act to grow. A new currency only has value if enough people use it, so there’s an incentive to issue new units to grow a user base. But flooding the market would make the currency less valuable.
Remember, so far cryptocurrencies are sought after more for their value as a commodity whose price may rise with demand than for their usefulness in making real-world transactions, which is the main function of the dollar, Euro or yuan.
3. So how does it work?
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First, do you know what a dapp is? That is shorthand for a decentralised app. Ethereum co-founder Vitalik Buterin explains the concept through this analogy: If Bitcoin is a pocket calculator, platforms with dapps are smartphones, but ones on which automated programs run without a central operating system or server. Many of them make use of the Ethereum blockchain, a digital ledger.
4. OK, so how does it work?
The most basic approach is to lend digital coins, such as DAI or Tether, through a dapp such as Compound, which then lends the coins to borrowers who often use them for speculation. Interest rates vary with demand, but for every day’s participation in the Compound service, you get new Comp coins, as well as interest and other fees.
If the Comp token appreciates — and it is more than doubled in value since midJune — your returns skyrocket as well.
5. What is the SEC doing?
In September, Coinbase Global said the agency threatened to sue if the exchange lets customers earn interest on some digital tokens. At issue is Coinbase’s Lend product, which had not yet been opened to investors but promised to let them earn 4% annually by lending out their USDC virtual tokens.
USDC, which is offered by a consortium of firms including Coinbase, is a stablecoin — a fast-growing corner of the crypto market that allows traders to easily convert their digital assets into cash and vice versa.
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Coinbase’s tussle with the SEC became public when Paul Grewal, the company’s chief legal officer, said the SEC determined that Lend involved “a security, but would not say who or how they’d reached that conclusion”.
Grewal added that the agency told Coinbase “that if we launch Lend they intend to sue,” prompting the company to shelve the product until at least October.
6. What is the issue?
Despite Coinbase’s bewilderment, the SEC has long argued that a range of tokens fall under its jurisdiction. Over the past four years, the SEC has consistently asserted that many digital assets are investment contracts or securities based on a legal theory known as the Howey Test laid out in a 1940s US Supreme Court case.
The regulator’s stance is that almost anything that gives investors the expectation of profiting from the work of others can be labeled an investment contract. The industry has countered that the SEC’s view is too vague and unsuitable for virtual coins. The move is also likely to cause concern among companies like BlockFi, Gemini Trust and Celsius Network that already offer services that let clients earn interest for lending out their tokens. New Jersey is among the states that have ordered BlockFi to stop marketing some products.
7. What other kinds of coins are involved?
Compound, which was launched in June, is one of the largest such services and currently has about US$11 billion ($14.7 billion) in funds, according to tracker Defi Pulse. Other major players in this game are Balancer, Synthetix, Curve and Ren Synthetix pioneered the idea.
Today, these services hold more than US$90 billion in locked user funds, which are funds that are used in lending.
Supposedly, the holders of coins like Comp can participate in the governance and improvement of these networks. But the vast majority of people using them currently are speculators, trying to earn fairytale-like returns.
8. What are the risks?
Beyond regulatory crackdowns there is theft, for one. The digital money you lend out is effectively held by software, and hackers seem to always be able to find ways to exploit vulnerabilities in code and make away with funds. Some coins that people are depositing for yield farming are also only a few years old at most, and could potentially lose their value, causing the entire system to crash.
Furthermore, early investors often hold large shares of reward tokens, and their moves to sell could have a huge impact on token prices. Finally, regulators are yet to opine on whether reward tokens are or could become securities — decisions that could have a big impact on the coins’ use and value.
9. What else could go wrong?
Many high-yield harvesting strategies also carry the risk of liquidation. To maximise returns, many users are adapting complex strategies.
For example, some investors have been depositing DAI tokens into Compound, then borrowing DAI using initial tokens as collateral, then lending out the borrowed funds. The idea is to get a greater portion of the allocated rewards: Comp tokens. A move in the wrong direction in a token’s value could wipe out all gains and trigger liquidations.
10. What is new about this?
People have been able to earn interest by lending their cryptocurrencies for several years through apps like BlockFi, as part of a trend of decentralised finance, or DeFi, in which middlemen like banks are replaced with the automated protocols of dapps. What is different about new ventures like Compound are the tokens handed out to lenders and borrowers, often with implied future rights to cash flows. The idea was to give people who use these apps some “skin in the game,” by creating an incentive to participate in governing and improving the networks.
11. What about market manipulation?
When someone who has lent a cryptocurrency through a DeFi service like Compound then borrows it back, they are creating artificial demand for the coins — and thereby inflating the coins’ prices.
That has 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. Small traders should beware that yield harvesting “has become a game for whales who are capturing the vast majority of rewards,” according to crypto research firm Messari.
12. Why did this get so hot right now?
A couple of reasons: Amid the Covid-19 pandemic, all cryptocurrencies — generally viewed as an uncorrelated asset in the long-term — have seen a surge of interest in light of high volatility in many traditional assets.
What is more, many of the yield-harvesting products only debuted this summer, offering highly attractive tokens as rewards and boasting of high-profile backers like Andreessen Horowitz and Polychain. — Bloomberg Quicktake
Photo: Executium on Unsplash
