Yield Aggregator Lego Game: How long can the yields last? What are the advantages and risks?

This article is from Defi之道, the original title is: "Imperial College London Releases DeFi Research Paper 'SoK: Yield Aggregators in DeFi'", author: Captain Hiro.

This article summarizes the paper "SoK: Yield Aggregators in DeFi," which is the result of a joint research effort by the UCL Centre for Blockchain Technologies and Imperial College London.

Since the explosion of decentralized finance (DeFi) in the summer of 2020, Yield Farming has been a very popular activity among cryptocurrency holders.

As of May 2021, asset management protocols in DeFi had locked over $3 billion, and as of the writing of this article, the locked amount has reached nearly $2 billion.

Despite many (scam) projects promising users huge returns in a short time, yield aggregator projects like Idle Finance, Pickle Finance, Harvest Finance, and Yearn Finance are trying to establish a sustainable source of income for the DeFi community. This makes me wonder:

• Where does the yield actually come from?
• How much yield is generated from the money built by the aggregator?
• What is the general mechanism behind all these aggregators (if any)?
• What are the benefits and risks of putting your money into a yield aggregator?

I co-authored a paper on yield aggregators in DeFi with Jiahua Xu from the UCL Centre for Blockchain Technologies and Toshiko Matsui from Imperial College London, which answers all the questions posed above. We proposed a generalized framework for yield aggregators. Now, let’s dive into the most profitable part of DeFi, which is Yield Farming.

Introduction

As you read in my previous article about Automated Market Makers (AMM), DeFi has experienced explosive growth since the summer of 2020. Yield Farming is one of the most talked-about applications in DeFi. The concept was initially introduced by Synthetix, but it gained wider attention with the release and distribution of Compound's governance token COMP.

Since then, participants in Compound have earned newly minted COMP tokens as rewards through lending activities, a process later referred to as "liquidity mining."

To this day, this process is still being replicated by other projects, encouraging developers to find ways to combine rewards from different protocols. Yield Farming emerged in this context. In this context, aggregator protocols built on existing DeFi projects are trying to provide a one-stop solution for those looking to engage in Yield Farming.

Where Does the Yield Come From?

There is no such thing as a free lunch, so where does the yield generated by these aggregators come from? It seems to have three main sources.

Lending Demand

As the demand for crypto asset loans increases, lending rates rise, leading to higher returns for lenders. Especially in a bull market, despite high rates, speculators are willing to borrow money because they expect the assets they leverage to appreciate. The annual yield on stablecoins from Aave and Compound reached 10% in April 2021, when market sentiment was very optimistic.

Liquidity Mining Projects

Early participants often received governance tokens representing ownership of the protocol. This incentivized people to invest funds into the protocol, as the reward tokens typically come with additional governance functions. This function is often considered valuable because token holders will have a say in the project's future strategic direction. Essentially, early users are rewarded for helping the project grow and taking on the risks that may arise in the early stages of smart contracts. Sushiswap and Finance Finance are examples of this.

Revenue Sharing

Some tokens grant users a share of the revenue generated through the protocol. One example is the liquidity provider (LP) tokens in automated market makers (AMM) (you can read more about it here). The more trades that occur, the higher the returns for liquidity providers. Another type of revenue-sharing token is xSUSHI. Holders of Sushi tokens receive xSUSHI as a reward, which allows them to earn 0.05% of the trading revenue from the Sushiswap protocol. The governance token VSP from Vesper Finance can be included in the vVSP pool, which captures about 95% of the fees generated by Vesper.

Mechanism Behind Yield Aggregation Strategies

Now that we know where the aggregator's yield comes from, how do users earn yield through yield aggregators? Let’s use a hypothetical yield aggregator called "SimpleYield" to explain the diagram below.

Mechanism of yield aggregators

In Stage 0, funds are placed in a smart contract. Although newer protocols allow for multi-asset pools, typically a pool contains only one type of asset.

Users deposit assets into a pool and, in return, receive tokens representing their share of the value in the pool. For example: depositing # ETH into the SimpleYield dETH pool and receiving back #syETH tokens, which represent x% of the total locked value in the pool.

In Stage 1, the funds in the pool are used as collateral to borrow another asset through lending platforms like Compound, Aave, or Maker. This stage is not always necessary and can be skipped. The main purpose of this step is to allow the execution of Yield Farming strategies using another asset (rather than the initially pooled asset). For example: the ETH deposited by users in the SimpleYield ETH pool can be placed in Maker to borrow the stablecoin DAI.

Stage 2 involves yield generation strategies, which can vary significantly in complexity across different protocols. The diagram below shows that the inputs for this stage are either non-yielding assets (red coins) or yield-generating assets (green coins). Over time, the green coins generate yield and continue to grow. For example: the SimpleYield ETH pool uses ETH to borrow DAI, which is then used in Compound, where the aggregator earns yield through cDAI tokens and COMP tokens as part of Compound's liquidity mining program.

Execution process of a single strategy. SC stands for smart contract.

In the final stage, Stage 3, the yield generated in Stage 2 is sold on the open market for the original pool's assets and flows back to Stage 0, where it is redeployed in Stages 1 and 2. The pool increases the value of existing shares without issuing new shares. For example: the COMP tokens generated in Stage 2 are sold on Uniswap for ETH, which then flows back to Stage 0. The #syETH tokens originally generated by users now have more value because the pool's value has increased without generating new syETH tokens.

Strategy Showcase

Now that we understand how yield aggregators generally work, the crux of the protocol lies in Stage 2, the actual yield generation stage. Let’s look at some examples of Yield Farming strategies. Note that the examples described here are relatively simple, and these strategies can be much more complex in reality.

The evolution of the pool's value is simulated in a controlled market environment. This article provides simulation results.

Simple Lending

The example used in the previous section is a simple lending strategy. As part of a liquidity mining project, funds are deposited into a Pooled Lending Fund (PLF) protocol to earn interest and governance tokens.

Circular Lending

This strategy aims to maximize the number of governance tokens obtained through circular lending. The aggregator can deposit DAI into the Pooled Lending Fund, borrow more DAI against this deposit, and then provide that DAI back to the Pooled Lending Fund. This cycle can be repeated multiple times, but simulation results based on supply and interest rates indicate that this strategy becomes very risky when circular lending is done too many times.

Liquidity Mining Using Automated Market Maker LP Tokens

Automated Market Maker (AMM) LP tokens generate yield because trading fees are retained in the AMM pool. While the AMM is still running liquidity mining programs, users earn rewards in governance tokens in addition to the yield from trading fees. This strategy is also considered relatively risky because impermanent loss can eat away a significant portion of returns when the prices of the underlying assets start to fluctuate.

Comparison of Battle-Tested Yield Aggregators

Summary of major existing and early yield aggregators - data as of May 1

Idle Finance

Idle Finance is one of the first yield aggregation protocols, launched in August 2019. Idle currently only uses simple lending strategies, allocating funds across Pooled Lending Funds (Compound, Aave, Fulcrum, dYdX, and Maker). The protocol has two strategies: "Best Yield" and "Risk Adjusted." The first seeks the best interest rates across the aforementioned platforms, while the risk-adjusted strategy considers risk factors to further optimize the risk-return score.

Pickle Finance

Pickle was launched in September 2020 and provides yield through two products: Pickle Jars (pJars) and Pickle Farms. Jars are Yield Farming robots that can generate returns from users' funds, while Farms are liquidity mining pools where users can stake different types of assets to earn PICKLE governance tokens. pJars use the "liquidity mining of AMM LP tokens" strategy. Farmers deposit Curve LP tokens or Uniswap/Sushiswap LP tokens, which are used to generate governance tokens through liquidity mining projects.

Harvest Finance

Harvest was launched in August 2020 and offers compound interest through its FARM liquidity mining project. The protocol primarily has two strategies: single asset strategies (including the "simple lending" strategy) and LP token strategies (including the "using AMM LP tokens to mine liquidity" strategy). 30% of the generated yield is used to buy back FARM on the open market and flows to FARM holders, rather than the original pool.

Yearn Finance

In July 2020, the world's largest yield aggregator was finally launched. Yearn offers multiple products, with this article considering Earn and Vaults. The Earn pool employs a "simple lending" strategy to deposit assets into Pooled Lending Funds at the highest interest rates. Vaults allow for the use of more complex strategies.

Total value locked, data from https://defillama.com/home

Advantages and Risks of Yield Aggregators

Advantages

• Farmers do not need to actively devise their own strategies but can leverage workflows invented by other users, transforming their investment strategies from active to passive.
• Since cross-protocol transactions are conducted through smart contracts, fund transfers are automated, eliminating the need for users to manually transfer funds between protocols.
• With funds concentrated in contracts, the number of interactions is reduced, lowering interaction costs, thus diluting gas costs.

Risks

• When Yield Farming strategies use assets as collateral to borrow other assets, lending risk is always present, even when they only provide assets to Pooled Lending Funds. In high utilization scenarios (high borrowing/lending ratios), when many lenders withdraw simultaneously, some may have to wait for certain borrowers to repay their outstanding loans. This is known as "liquidity risk." When borrowing funds, there is a "liquidation risk" if the value of the collateral falls below a predetermined liquidation threshold.
• Since Yield Farming strategies are often built on a series of Lego blocks, there is a combination risk. Technical and economic weaknesses provide tempting opportunities for malicious hackers to exploit.
• The yield of a strategy is often determined by many factors, leading to unstable annual yields for certain strategies. Annual yield fluctuations caused by impermanent loss, low trading activity in automated market makers, or price changes in governance tokens can be unattractive to many potential investors.

Conclusion

In the past year, a large number of yield aggregator protocols have emerged. Although the overall framework behind them is similar, each has its own style. Idle Finance launched the first version of its product in 2019, which deposited funds into PLF to provide the best interest rates over a given time.

Inspired by Compound's liquidity mining project, Yearn Finance expanded this model in July 2020, inventing more complex strategies called Vaults alongside the release of their Earn product. With the emergence of more forms of liquidity mining projects, Harvest Finance and Pickle Finance specifically utilized LP tokens for Yield Farming later that summer.

Yield aggregators have been, and continue to be, an attractive way to collect yields in DeFi. But how long can this yield last? As we have seen, yields primarily come from three sources. While research on the sustainability of yields is worthy of a separate paper, we can assume that yields from local token distribution events are relatively short-lived.

Once the token distribution plan is completed, this yield will be exhausted. Although new protocols can thrive with newly initiated token distribution plans, this source of yield seems unlikely to be sustainable. In this regard, lending demand may be more sustainable, but it is highly dependent on market sentiment, especially for non-stablecoins. Revenue-sharing tokens appear to have the most lasting yields, especially if DeFi can maintain its recent growth rate.