What is Yield Generation?

Key Takeaways :

• DeFi offers users a wide variety of opportunities to generate yield on digital assets, either through staking, lending, or yield farming;
• Staking refers to the act of depositing tokens into a smart contract in order to contribute to the security and operations of a distributed protocol or application;
• Lending refers to depositing tokens into a smart contract for the express purpose of lending those funds out to borrowers at an algorithmically determined interest rate;
• Yield Farming refers to an activity that requires investors to continually shift capital across yield generation opportunities in pursuit of the highest yield which can come in the form of protocol rewards, revenue share, interest payments, staking rewards, and more.

Introduction

Amidst ever increasing adoption of cryptocurrencies throughout global financial markets, the ability to earn yield on digital assets is gaining major traction amongst investors. Like yield generation in traditional markets, DeFi yield opportunities allow investors to earn passive income on their digital assets instead of waiting for the investments to appreciate in the open market.

Unlike its centralized counterpart, in which financial institutions oversee and can intervene in the entire lending & borrowing process, yield generation in DeFi occurs in a completely decentralized and autonomous manner via immutable smart contracts.

In this article we will dive into three methods which form the building blocks of yield generation in the DeFi market:

1.  Staking

2.  Lending

3.  Yield Farming

When utilized properly in one’s portfolio, these techniques can effectively reduce many of the risks associated with investing in highly volatile assets.

What is Staking?

Staking refers to the act of depositing digital assets into a smart contract as a means of contributing to the security and operations of a blockchain network or decentralized protocol. In return for taking on the risk of staking, participants are rewarded with regularly distributed coins and tokens. Staking is most commonly used in reference to staking tokens on a Proof-of-Stake blockchain, such as Tezos, Solana, or Ethereum 2.0, where stakers are offering their tokens as collateral during the block validation process. In contrast to staking to secure a blockchain network, decentralized protocols can encourage users to stake assets in order to gain access to voting rights, a share of protocol revenue, or some other form of utility.

When an investor stakes their digital assets to secure a specific blockchain, a smart contract locks their holdings and moves these tokens out of active circulation while simultaneously sending the user a new token that represents ownership of their staked tokens and all future rewards. Whenever an investor chooses to unstake, the tokens are released back to the investor along with all earned profits. In the traditional finance world, crypto staking is equivalent to the use of a long-term certificate of deposit, in which funds are deposited into an account which is locked for a fixed period, providing a bank with additional funds for lending and the account holder an above average return on their investment.

Staking has numerous advantages for stakers, blockchain protocols, and non-staking investors. First, staking limits the supply of a cryptocurrency by removing a portion of supply from circulation, thus increasing demand and elevating prices. Second, staking often gives investors the right to govern their blockchain or protocol as voting power increases based on the number of tokens staked. Lastly, unlike traditional markets, crypto staking takes place in a completely decentralized system in which “stakers”, and not a centralized governing body, have absolute control over their money.

Staking can be a great way to earn passive income on crypto holdings while simultaneously letting the investment appreciate over the long term. Furthermore, crypto staking offers significantly higher interest rates than any average banking institution can offer.

What is Decentralized Lending?

Decentralized lending is very similar to the concept of lending and borrowing in traditional financial markets. Like a collateralized loan one may take against their home or portfolio, decentralized lending uses digital assets as collateral for loans. Additionally, unlike traditional markets, in DeFi markets individuals can assume the role of both a lender and a borrower.

Suppose you’ve been holding your cryptocurrency for an extended period and have no need for short-term liquidity. In this case, you can lend your crypto holdings to generate passive income by depositing your tokens into a lending pool smart contract governed by an autonomous lending protocol, such as Compound Finance. Upon depositing assets to a Compound lending pool, you will receive a token, called a cToken, representing a claim over your deposited assets as well as all accumulated interest payments. Interest rates are algorithmically determined based on the percentage of assets being borrowed from the lending pool; as the percentage of assets borrowed increases so does the interest rate earned by lenders and subsequently paid by borrowers, and vice versa. Interest is collected by the lending pool with every block that is mined and is immediately added to a lender’s token balance, allowing lenders to compound their returns approximately every 15 seconds. 

On the other hand, you may need to borrow money but don’t wish to liquidate your digital asset holdings. In this case, you can deposit your digital assets as collateral and borrow against those assets, and unlike in traditional financial markets, there is nobody you need to ask for permission to take out a loan. DeFi lending and borrowing markets are completely autonomous and permissionless, allowing anybody to have access to this critical financial service.

Although there are numerous benefits delivered through decentralized lending and borrowing, there are a few potential pitfalls to keep in mind. First, a lender cannot use collateralized tokens until the loan has been closed or liquidated. Second, should the value of collateralized assets fall swiftly, a lender may lose a portion of their deposit. And lastly, in the case of loan default, a borrower may have their collateral liquidated and be charged an additional default fee. 

What is Yield Farming?

Yield Farming refers to the process of continually searching for and exploiting the highest yields possible on tokens across all DeFi protocols, oftentimes coming in the form of inflationary protocol rewards. There are three main steps in the process of yield farming:

1. Investor will stake or lend token(s) on a DeFi protocol;
2. Liquidity Pool (LP) or governance tokens are rewarded to the investor;
3. Investors can then take LP or governance tokens and reinvest them on another DeFi protocol to boost yields.

Despite the significant yield opportunities available through yield farming, including 1,000%+ APY offered on by DeFi protocols, there are a number of risks associated with the act of chasing high yields. One of the most common risks is the potential decrease in value for your investments while yield farming across the DeFi platforms. In the event that one of the tokens drops in price unexpectedly, the investor could face a situation where the value of the tokens withdrawn is less than the value initially deposited. Concurrently, it’s important to verify the legitimacy and security of the yield farming platform. Given the rapid growth of decentralized finance, the number of platforms offering yield farming has exploded and it’s important to confirm that the platform has been audited by a trusted third-party, such as CertiK or ConsenSys.

In Summary

With the increasing growth of decentralized finance, including its gradual adoption by “traditional” financial firms, the number of opportunities for investors to earn higher yields on their digital assets continue to increase. Investors have a wide selection of active and passive investing options across DeFi platforms that suit their risk tolerance, time horizon, and desired returns. Despite all of the advantages, it’s critical for investors to properly research all of the risks associated with each yield-generating platform and opportunity.