Alluo Academy | Yield Farming and Liquidity Pools
Introduction
Welcome back frens. This is the second in the Alluo Academy series and today we’re talking about yield farming.
You can find the rest of the Alluo Academy series here. But read on for more about Yield Farming 👨🌾.
TL;DR
Yield farming is a way to make more crypto from your existing crypto 🚀.
It involves you lending your funds to Liquidity Pools using smart contracts and being rewarded for doing so. Simples, right?
Well yes and no.
If taken as described above, Yield Farming sounds a lot like DeFi lending we talked about in part one of our Academy series. However, Yield farmers typically don’t stay put for long. Farmers often regularly move their assets between different lending marketplaces to maximize their returns and there are a heap of factors to consider before you ape in.
Where did it start?
Whilst they didn’t invent it, Yield Farming became much more mainstream after Compound started giving out its governance token, COMP, to its users to help kickstart token distribution.
Governance tokens grant governance rights to protocol token holders. To be successful and secure, protocols are keen to have a broad distribution of tokens so as to make the network as decentralized as possible.
One way to do so (which Compound did very well) is to distribute these governance tokens algorithmically, with liquidity incentives. This attracts liquidity providers to “farm” the new token by providing liquidity to the protocol.
Since then, other DeFi projects have devised many more innovative schemes to attract liquidity to their ecosystems.
Tell me more
As outlined above, Yield farming is a way for people to earn money by staking their crypto assets in smart contract-based liquidity pools. As it’s driven by smart contracts, it started on the Ethereum chain using ERC-20 tokens. But any chain that supports smart contracts can, and will, see similar strategies emerge over time (as is already the case on Polygon, BSC, Avalanche, other EVM chains, and beyond).
The liquidity pools offer rewards in a variety of ways; e.g. in the form of a percentage of transaction fees, interest from lenders, or governance tokens. However, on Ethereum, the rewards are pretty much always a type of ERC-20 token.
What makes a good pool/yield farm?
There’s no one size fits all answer to this as everyone’s expectations of risk and return are different. Below are a few things to consider.
Pool size and number of transactions
Pools with high liquidity and volume of transactions will provide more stable rewards when rewards are based on swap fees. Furthermore, the greater the liquidity the higher likelihood of the credibility of the pool/team behind the project which may (but not always) mean that there is a lower risk of smart contract hack.
OGs
Another way to minimise this risk is to look for pools that have been around in their existing state for a long time. OG protocols such as Curve Finance are seen as well battle-tested in the space given their contracts cannot be upgraded.
Rewards
The type and liquidity of rewards play an important part too. For example, the more “blue-chip” crypto the rewards are (e.g.ETH, BTC, CVX, CRV, etc.) the more confidence you may have in the long-term asset value. This would be important if you want to hold onto or compound your rewards.
Similarly, if the rewards are locked for a period (i.e. you cannot access them until sometime in the future) you are more likely to want to be confident in the predictability of the asset’s future price.
Pool tokens
Pools with assets that are well correlated will have a lower risk of Impermanent Loss (see our Academy IL article here for more) and pools with a well-balanced split between the constituent tokens are also likely to be more stable than those that are heavily skewed one way or another.
How to calculate rewards?
Regardless of the reward, the amount you can earn is typically displayed as an annual percentage return (APR) or annual percentage yield (APY). APY includes the effect of compounding i.e. reinvesting rewards issued to generate more returns. However, be aware that APR and APY are often used interchangeably.
It’s also worth noting that DeFi moves quickly and the value of rewards in a pool decreases as more people add funds to the pool. So tantalising APY/APRs may not entirely be as they seem and are best treated as temporary estimations and projections in many cases.
Even short-term rewards are quite difficult to estimate accurately — so it pays to understand the pools you’re entering into and pick the ones that best meet your risk/reward profile.
Conclusion
In many ways yield farming is the lifeblood of DeFi.
Allowing users to earn passive income on their idle cryptocurrency, incentivises people to provide liquidity to liquidity pools, which in turn underpins decentralised lending and borrowing. The various incentive strategies deployed by a number of protocols have also helped them grow in a broad and decentralised manner helping strengthen the ecosystem.
Whilst Yield Farming offers the potential for significant rewards, it can carry risks, so it may be useful to look to protocols like Alluo to help you find an appropriate risk/reward ratio.
- Alluo automates the time-consuming and often costly process of staking, harvesting and compounding
- Rewards are paid back in the underlying farm asset or blue-chip CVX/ETH tokens
- The fixed-rate pools are a great way to de-risk volatility as rates are guaranteed for two-week periods at a time
- You can also check the long-term rate of all Alluo pools (including the variable BOOST pools) by looking at the fact sheet at https://app.alluo.finance
How do I find out more and get more involved?
Check out our Blog for more Alluo Academy articles and jump into Discord to talk to the team and community for more insight.
Those that have more to say and want to contribute to the Academy can also hit us up there and make some suggestions!
