Crypto: Five Forms of Yield Farming for DeFi Players

Summary
⦁ This article examines yield farming from a fundamentals perspective, the operation of cryptoassets for compound returns. It clarifies the most basic exchange of value throughout the mining process.

⦁ DeFi investors passively provide value in five forms: operating the network, providing loans, providing liquidity, managing protocols, and promoting protocols.

⦁ DeFi Investors Rewards for these activities are provided jointly by protocol owners, users and investors.

introduce
Warren Buffett once warned people to "never invest in projects you don't understand". Investors, therefore, may see a yield farming: a world of fleece ("airdrops") and scams ("carpet smuggling"), ruled by characters who call themselves "old gamblers" and "surge fighters," Then they retreat as soon as they make money.

However, upon closer inspection, yield farming is just a commercial activity, and DeFi investors provide value by taking risks. People are easily deceived by the frenzy of new protocols, false slang, and hot money flowing in the market. Yield farming is actually a reward for entrepreneurs who put in effort to build a new platform.

In this article, we explain yield farming through basic economic principles. In particular, we conduct research with two questions:

⦁ What core value have DeFi investors created? And get rewarded for it?

⦁ Who paid the reward, either overtly or covertly?

For many traditional businesses, the answer is simple. For example, our local sandwich shop offers a range of services - sourcing quality ingredients, assembling sandwiches and wiping tables - which diners pay directly for. Yield farming is not complicated. Jargon aside, most yield farming strategies involve DeFi investors passively and delegated participation in five types of economic activity:

⦁ Operate the network, e.g. verify transactions.

⦁ Lending to market users.

⦁ Provides liquidity to token holders.

⦁ Governance and Governance Protocol.

⦁ Promote agreements, increase awareness, and strengthen marketing effectiveness.

This article examines yield farming through these simple, abstract lenses to help current and potential investors understand their opportunities and assess their risk profile. Since specific strategies are constantly changing, we will avoid delving into the mechanics of any particular trade. Instead, we'll explore the underlying fundamental concepts that are broadly applicable to current and future yield farming.

What is yield farming?
The term "benefit farming" is used repeatedly in many contexts. Our first step was to establish a specific and precise definition. Yield farming is a passive management strategy for earning a clear yield position in cryptocurrency. [1]

Managing Passive Strategies: Participating in yield farming is hard work, and investors must constantly find strategies, manage risk, and adjust investment positions. However, we consider these strategies to be passive, as once a suitable mining opportunity to participate is found, the invested assets are rewarded with little to no follow-up operations. This framework is in stark contrast to aggressive ways of getting paid, such as running validator nodes or managing algorithmic market-making strategies, which require ongoing technical maintenance.
Well-defined interest: To make our definition more precise, we focus on strategies with well-defined interest payment schedules. Well-defined interest schedules come in many forms: fixed and floating, simple and complex. The timetable itself is used to differentiate yield farming from simple buy-and-hold strategies (such as buying tokens or NFTs in hopes of appreciation), as these do not have any clear interest schedule.
Relative to the traditional buy-and-hold strategy, yield farming can be further defined as a way to earn additional returns on holding the same position. To help better understand this definition, compare some examples from traditional finance.

Investors who put cash in a bank account are not yield farming because it is routine and involves no management strategy. But investors who keep opening new high-yield savings accounts, earning bonuses and discounts will be yield farming.
Similarly, regular credit card use consumers are not yield farmers, but consumers who actively manage a portfolio of credit card benefits to maximize miles, bonuses, and other rewards. In this case, the underlying asset will be a line of credit.
Stock-only investors don't count as yield farming because it's a default buy-and-hold behavior that doesn't yield a clear yield. But investors who earn interest by lending their shares to short sellers would be yield farming.
Investors who buy and hold, earning only fixed income, are in an awkward position. If we consider cash as the underlying asset, then investors who lend cash to borrowers are really yield farming because interest can be passively earned from borrowing. But in many cases, we tend to think of fixed income securities (such as bonds) as the underlying asset, in which case investors don't get any additional income.
Of course, additional gains come with risks. To get these benefits, DeFi investors take risks and provide a range of value services to the protocol. We counted five types of value services made by investors.

1. Network operation

The most fundamental function in an encrypted network is to operate the network properly and securely. This is done by node operators, often called node validators, who process transactions in exchange for network-native tokens. While many networks rely on being computationally intensive to incentivize operational behavior ("Proof-of-Work" networks), many rely on validators for collateral ("Proof-of-Stake" networks). If a validator performs poorly or misbehaves, this collateral may be partially or fully forfeited.

Therefore, the first major form of yield farming is where investors delegate tokens to high-quality validators, i.e. reliable and honest validators, in exchange for a share of the yield. If investors allocate tokens to low-quality validators, those validators may face negative consequences, i.e. confiscation of collateral, which investors will bear.

There are many examples, but two common ones are easier to understand. For example, traders on Coinbase can choose to stake their ETH on the platform, i.e. entrust their ETH to Coinbase as it participates in the upgrade of the Ethereum network to Ethereum 2.0 in exchange for approximately 5% annualized interest (based on rates at the time of writing). Alternatively, Terra traders can use the app to stake their Luna by delegating their Luna tokens to one of several different validators handling the Terra network in exchange for a reward.

Now consider two questions: What economic value does the investor create, and who pays them?

DeFi investors distribute their assets to high-quality validators, allowing the network to run more efficiently and securely.
Rewards are paid by network participants, who pay fees to validators in exchange for a stake in using the network, who then remit a portion of these fees back to investors.