Yield Farming

Yield farming is the practice of putting crypto to work inside decentralized finance protocols in order to collect the rewards those protocols pay, and moving it when a better-paying opportunity appears. A subcommittee presentation to the CFTC's Technology Advisory Committee sets out the vocabulary precisely: participants who deposit assets in a liquidity pool lock their assets and often earn fees and automatically receive digital assets in the form of governance tokens; the practice of submitting assets to a protocol is increasingly referred to as liquidity mining, and the process of earning fees and governance tokens is referred to as yield farming. That presentation is a subcommittee product and does not necessarily reflect the views of the advisory committee, of the CFTC or its staff, or of the United States government, and it dates from December 2020, so it is reliable for the vocabulary and the mechanics rather than for anything about today's market.

The word yield does a lot of work in the name, and it is worth separating from what the word means elsewhere in finance. A bond's yield is a payment promised by a borrower. A farming yield is a share of trading fees plus a quantity of a token the protocol prints, and neither component is promised by anyone.

The mechanics are the same in every version. A depositor supplies assets to a pool governed by a smart contract. The pool uses those assets to provide a service, usually swapping between two assets or lending them out. Users of the service pay fees, which are shared among depositors in proportion to their share of the pool. On top of the fees, many protocols issue their own token to depositors on a schedule, which is the part usually described as farming, and which is also the part that ends.

The reward token is where the arithmetic of a headline rate breaks down. An advertised annual percentage rate on a farming position is generally computed by taking the current rate at which the token is being emitted, valuing that token at its current price, and projecting both forward for a year. Neither assumption survives contact with reality: emission schedules are set by the protocol and are commonly reduced, and the token's price responds to the fact that everyone receiving it is receiving it in order to sell it. A rate that looks like an interest rate is therefore a snapshot of a distribution, and a position earning a nominal 40 percent in a token that loses 60 percent of its value over the same period has lost money while the advertised rate was accurate the whole time.

Supplying two assets to a trading pool adds an effect that has no counterpart in ordinary investing and that catches people who expected only the risks they could name. A pool priced by an automated formula holds both assets, and when the market price of one moves, arbitrage traders buy the now-underpriced side out of the pool and sell the overpriced side into it until the pool's price matches the market. The result is that the pool always ends up holding more of whichever asset fell and less of whichever rose. A depositor's share of the pool can therefore be worth less than the same two assets would have been worth if they had simply been held, even though nothing failed and no fee was charged. The market's name for the gap is impermanent loss, a piece of vernacular with no official definition and a misleading adjective: the loss reverses only if prices return to where they started, and it is realized in full if the depositor withdraws while they have not. The fee and token income is what has to cover that gap before a farming position is ahead of doing nothing.

The incentive structure behind the advertised rates is a fact about how these products are distributed, and it is the most useful thing a newcomer can know. Emissions are a customer-acquisition cost. A protocol with no track record cannot attract deposits by being trusted, so it attracts them by paying more, and the rate it pays is set by how much it needs to attract rather than by what it can sustainably earn. That is why the highest rates cluster in the newest protocols, and why a rate that is high relative to everything else is information about risk rather than about opportunity.

The risks also stack, which is the property that makes these positions hard to size. A single farming position can involve a smart contract that may contain a flaw, a stablecoin that may not hold its peg, a pool whose other participants may leave, a reward token that may fall, and a protocol whose operators may abandon it. Each of these is a separate failure with a separate cause, and the reward is compensation for all of them together rather than for any one. Receiving reward tokens is also an income event for United States tax purposes, and the fact that no form arrives does not change that.

A farmer connects a wallet to a protocol, approves the contract to move the assets being supplied, deposits them, and receives a token representing a share of the pool. Fees accrue to that share automatically. Reward tokens are either distributed continuously or claimed manually, and claiming is itself a blockchain transaction with its own network fee. Withdrawing means returning the share token and receiving back whatever the pool now holds in proportion, which is not necessarily what was put in.

A hypothetical shows the pool's re-weighting on its own, before any reward is counted. Ana supplies a pool that holds one volatile asset and one dollar-pegged asset in equal value. She deposits 10 units of the volatile asset, quoted at $100 each, and $1,000, so her position is worth $2,000. The pool prices trades by keeping the product of its two balances constant, the design described on the decentralized exchange page.

The volatile asset's market price then doubles to $200. Arbitrage traders buy it out of the pool until the pool's own price matches, which leaves the pool holding about 7.07 units of the volatile asset and about $1,414. Ana's share is now worth 7.07 multiplied by $200, or $1,414, plus $1,414 in the pegged asset, which is $2,828.

Had she simply held the two assets, she would have 10 units at $200, or $2,000, plus her $1,000, for $3,000. She is $172 behind, about 5.7 percent, purely from having supplied the pool. Nothing was hacked and nothing was charged.

Now add the rewards. If fees and reward tokens over the same period were worth $120 when she sold them, her position is $2,948 against $3,000 for holding, so the farming was still the worse choice by $52. If they were worth $260, she is ahead by $88. That subtraction, rewards received minus the pool's shortfall, is the calculation a farming position actually turns on, and an advertised annual rate does not show either side of it.

What yield farming offers

• Fee income is real. A pool that gets used pays its depositors a share of what users pay to use it, and that part does not depend on a token's price.
• Access is open. There is no minimum, no account approval and no gatekeeper between a wallet and a protocol.
• Governance tokens can carry a genuine right to vote on how a protocol operates, which a depositor in a traditional pooled product does not get.
• The positions are visible. Pool balances, emission schedules and contract code are public, so the arithmetic can be checked rather than taken on trust.

What it costs

• The advertised rate is not a return. It is a current emission rate valued at a current token price, and both can fall sharply and often do.
• Supplying a two-asset pool produces the shortfall described above, and the fee and token income has to exceed that gap before the position beats simply holding.
• The rates are highest where the protocol is newest, because emissions are how a protocol without a record buys deposits.
• Failures compound. Contract flaws, a broken peg, an abandoned protocol and a collapsing reward token are separate risks that can reach the same position.
• Every deposit, claim, swap and withdrawal is a blockchain transaction with a network fee, so rotating between protocols is expensive and small positions are eaten by it.
• Reward tokens are taxable income when received, and no protocol sends a tax form, so the record-keeping falls entirely on the depositor.