DeFi Yield Farming Shifts Focus to Sustainability After 2022 Crash

Yield farming, a key component of the decentralized finance (DeFi) ecosystem, involves users depositing their crypto assets into liquidity pools or DeFi protocols to earn higher returns. This practice incentivizes users to lock up their assets, thereby contributing to the growth and liquidity of DeFi platforms [1]. Yield farming gained widespread popularity during the “DeFi Summer” of mid-2020, marked by the rise of platforms like Uniswap, Aave, and Compound, which introduced novel ways to generate passive income in the crypto space [1]. During this period, heavy incentivization through governance tokens and venture capital support led to the perception that high yields were sustainable [1].

However, the DeFi yield farming bubble burst in 2022 following the collapse of Terra Luna, which exposed the inherent risks and volatility associated with incentivized yields. The Terra Luna disaster highlighted the fragility of DeFi protocols and led to a significant decline in Total Value Locked (TVL) across the sector [1]. As a result, yields have since normalized, and the focus has shifted from high-yield promises to more sustainable and secure DeFi practices [1].

In 2023, a new trend emerged known as airdrop farming, where users perform specific activities on blockchain platforms to position themselves for potential token airdrops. Optimism and Arbitrum, two Ethereum Layer 2 solutions, pioneered this trend by distributing governance tokens to users who engaged with their networks [1]. Airdrop farming has since become a prevalent strategy, with some platforms introducing points systems to track user activity and prioritize airdrop recipients [1]. Unlike traditional yield farming, airdrop farming does not guarantee returns but offers an additional avenue for users to enhance their total returns [1].

Yield farming typically involves liquidity provision, staking, and lending. Liquidity providers deposit tokens into pools, allowing traders to execute trades on automated market makers (AMMs). In return, they earn trading fees and sometimes governance tokens. Staking involves locking up tokens to secure a blockchain network and earn rewards, while lending allows users to earn interest by depositing assets into money market protocols [1]. Each method carries different levels of risk, with impermanent loss being a primary concern for liquidity providers [1].

Impermanent loss occurs when the value of assets in a liquidity pool decreases relative to their value at the time of deposit. This loss becomes permanent only when assets are withdrawn, and it is influenced by price volatility and market conditions [1]. Users must also distinguish between Annual Percentage Yield (APY) and Annual Percentage Rate (APR), as APY accounts for compounding effects, potentially creating misleading expectations for yield farmers [1]. While high APYs may suggest strong returns, they often require frequent compounding to achieve, which can be costly due to transaction fees [1].

Leverage yield farming, or “looping,” involves borrowing assets to increase yield potential. While it can significantly boost returns, it is a high-risk strategy due to the risk of liquidation and market volatility [1]. Users must carefully monitor their positions and understand the risks involved before engaging in leveraged strategies [1].

Despite the potential for high returns, yield farming is associated with several risks, including smart contract vulnerabilities, rug pulls, and liquidation risks. Smart contract bugs can lead to hacks, while rug pulls occur when developers abandon a project and drain liquidity pools [1]. Borrowers on lending protocols also face liquidation risks if the value of their collateral drops below the required threshold [1]. As such, yield farmers are advised to conduct thorough research and prioritize protocols with strong security audits and transparent governance structures [1].

The DeFi landscape continues to evolve, with over 1,000 protocols offering yield opportunities as of late 2024. However, the sustainability and security of these opportunities remain key concerns. Yield farmers must remain cautious and understand the true source of their returns, as projects offering high yields without clear backing can be unsustainable or fraudulent [1]. Additionally, users should consider lock-up periods and the liquidity of their assets before committing to any yield farming strategy [1].

In conclusion, yield farming remains a dynamic and complex aspect of DeFi. While it offers opportunities for generating returns, it is not without risk. As the sector matures, users are increasingly prioritizing security, sustainability, and transparency when selecting yield farming opportunities [1]. With the lessons from the Terra Luna collapse and the rise of airdrop farming, the future of yield farming appears to be one of caution and innovation [1].

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[1] What Is Yield Farming? (https://www.coingecko.com/learn/what-is-yield-farming)