Jump Crypto: Five Fundamental Ways for DeFi Players to Earn Stable High Returns

Original Authors: Nihar Shah, Lucas Baker

Original Title: 《Yield Farming for Serious People》
Translation: Biscuit, Chain Catcher

Abstract

⦁ This article studies yield farming from the perspective of fundamental principles, exploring how crypto assets operate to achieve compound returns. It clarifies the most basic value exchanges throughout the mining process.
⦁ DeFi investors passively provide five forms of value: operating networks, providing loans, supplying liquidity, managing protocols, and promoting protocols.
⦁ The rewards for these activities by DeFi investors are provided collectively by protocol owners, users, and investors.

Introduction

Warren Buffett once advised, "Never invest in a project you don't understand." Therefore, investors may see yield farming as a world filled with "free money" (airdrops) and scams (rug pulls), dominated by self-proclaimed "old gamblers" and "warriors" who make money and then disappear.

However, upon closer examination, yield farming is merely a business activity where DeFi investors provide value by taking on risks. People can easily be misled by the hype surrounding new protocols, erroneous jargon, and the hot money flowing through the market; yield farming is actually a reward for entrepreneurs who put in the effort to build new platforms.

In this article, we explain yield farming through basic economic principles, specifically addressing two questions:
⦁ What core value do DeFi investors create, and what rewards do they receive for it?
⦁ Who pays for these rewards, whether openly or behind the scenes?

For many traditional businesses, the answers are straightforward. For example, our local sandwich shop offers a range of services—sourcing quality ingredients, assembling sandwiches, and cleaning tables—where diners directly pay for these services. Yield farming is not complicated. Stripping away the jargon, most yield farming strategies involve DeFi investors participating in five types of economic activities in a passive and delegated manner:

⦁ Operating networks, such as validating transactions.
⦁ Providing loans to market users.
⦁ Supplying liquidity for token holders.
⦁ Managing and governing protocols.
⦁ Promoting protocols to enhance visibility and marketing effectiveness.

This article examines yield farming through these simple, abstract perspectives to help current and potential investors understand their opportunities and assess their risk profiles. As specific strategies evolve, we will avoid delving into the mechanisms of any particular transaction. Instead, we will explore the underlying fundamental concepts that broadly apply to current and future yield farming.

What is Yield Farming?

The term "yield farming" is often used repeatedly in many contexts. Our first task is to establish a specific and accurate definition. Yield farming is a passive management strategy for earning explicit yield positions in cryptocurrency.[1]

• Passive management strategy: Participating in yield farming is hard work; investors must constantly seek strategies, manage risks, and adjust their positions. However, we consider these strategies passive because once a suitable mining opportunity is found, the invested assets yield returns with minimal ongoing operations. This framework sharply contrasts with active ways of earning rewards, such as running validation nodes or managing algorithmic market-making strategies, which require continuous technical maintenance.
• Clearly defined interest: To make our definition more precise, we focus on strategies with clearly defined interest payment schedules. These schedules can take various forms: fixed and floating, simple and complex. The schedule itself serves to distinguish yield farming from simple buy-and-hold strategies (e.g., purchasing tokens or NFTs with the hope of appreciation), as these do not involve any explicit interest schedule.

Relative to traditional buy-and-hold strategies, yield farming can be further defined as a way to earn additional returns while holding the same position. To help better understand this definition, we can compare it to some examples from traditional finance.

• An investor depositing cash into a bank account does not engage in yield farming, as this is a conventional action and does not involve a management strategy. However, an investor who continually opens new high-yield savings accounts to earn bonuses and enjoy discounts would be engaging in yield farming.
• Similarly, a consumer who uses a credit card normally does not count as yield farming, while a consumer who actively manages a credit card rewards portfolio to maximize miles, bonuses, and other rewards does. In this case, the underlying asset would be the credit limit.
• An investor who merely holds stocks does not engage in yield farming, as this is the default buy-and-hold behavior and does not yield explicit returns. However, an investor who earns interest by lending their stocks to short sellers would be yield farming.
• Those who buy and hold, earning fixed returns, find themselves in an awkward position. If we consider cash as the underlying asset, then an investor lending cash to borrowers is indeed yield farming, as they can passively earn interest from the loan. However, in many cases, we tend to view fixed-income securities (e.g., bonds) as the underlying asset, in which case the investor does not earn any additional returns.

Of course, additional returns come with risks. To obtain these benefits, DeFi investors take on risks and provide a range of value services to protocols. We have identified five value services provided by investors.

1. Network Operation

The most fundamental function in a crypto network is to operate the network correctly and securely. This is accomplished by node operators, commonly referred to as validators, who process transactions in exchange for the network's native tokens. While many networks incentivize operational behavior through computational intensity (proof-of-work networks), many others rely on collateralized validators (proof-of-stake networks). If a validator performs poorly or behaves maliciously, the collateral may be partially or fully forfeited.

Thus, the first major form of yield farming is when investors delegate their tokens to high-quality validators, i.e., reliable and honest validators, in exchange for a portion of the rewards. If investors allocate their tokens to low-quality validators, those validators may face negative consequences, such as collateral forfeiture, which the investors will bear.

There are many examples, but two common ones are easier for people to understand. For instance, traders on Coinbase can choose to stake their ETH on the platform, delegating their ETH to Coinbase as it participates in upgrading the Ethereum network to Ethereum 2.0, in exchange for approximately 5% annual interest (based on the rate at the time of writing). Alternatively, Terra traders can use an application to stake their Luna, delegating their Luna tokens to one of several different validators processing the Terra network in exchange for rewards.

Now consider two questions: What economic value do investors create, and who pays them?

• DeFi investors allocate their assets to high-quality validators, enabling the network to operate more efficiently and securely.
• The rewards are paid by network participants, who pay validators fees in exchange for the right to use the network, and then validators return a portion of those fees to investors.

2. Providing Loans

The summer of 2020 is referred to as "DeFi Summer," as decentralized protocols exploded in growth, significantly altering the landscape of crypto lending. Prior to this, lending primarily relied on large centralized institutions, but since 2020, a new generation of decentralized protocols has allowed individual traders to deeply engage in lending activities.

Thus, the second major form of yield farming is an extension of the first. Investors can not only lend to validators but can also lend cryptocurrency to anyone. Specifically, investors place tokens into liquidity pools, from which borrowers can take loans using collateral.

There are many such protocols, with the most popular being Aave, Compound, and Anchor. These protocols typically accept deposits of underlying assets—an asset that already exists outside the protocol, such as UST in Anchor, which can be lent to borrowers. These protocols track deposits by issuing new synthetic tokens to lenders (e.g., Anchor's "aUST"), which borrowers can use to redeem the original tokens and accrued interest.

Currently, almost all protocols focus on over-collateralized loans. Thus, lending faces the risk of collateral depreciation outpacing liquidation speed. However, some protocols, like TrueFi and Goldfinch, are expanding into unsecured loans by vetting borrowers and understanding some off-chain real-world information about them. Future DeFi investors may choose between lending protocols that accept fully collateralized loans or directly bear the risk of borrower defaults.

As before, we pose the same two questions: What economic value do investors create, and who pays for their actions?

• DeFi investors lend tokens to traders in need, enabling those traders to express their views on asset prices more effectively. In the future, DeFi investors can also provide value by allocating tokens to higher-quality borrowers and projects.
• The returns investors receive come from borrowers continuously paying interest (the protocol itself also takes a portion). While some protocols temporarily guarantee fixed rates, most protocols offer floating rates based on supply and demand.

3. Liquidity

Liquidity provision, like lending, has been democratized and scaled through DeFi protocols. Previously, only centralized exchanges and professional market makers had the capacity (fundraising, technical maintenance, and ongoing operations) to provide liquidity. Today, individual traders can do so as well.

This is the third major form of yield farming. Investors deposit cryptocurrency into liquidity pools (known as "automated market makers" or AMMs). Traders can utilize these liquidity pools to swap tokens—typically paying explicit fees in addition to slippage.

Liquidity providers earn these fees or spreads by facilitating two-way liquidity but also bear the risk of capital loss if the underlying exchange rate changes (market volatility). This sharply contrasts with active liquidity providers, who frequently adjust their positions as exchange rates fluctuate.

Major protocols that enable DeFi investors to operate liquidity pools include Curve, Uniswap, and Sushiswap. These liquidity pools serve as on-chain liquidity hubs, facilitating trades between many different asset pairs.

Again, we ask the same two questions: What value do investors provide? The answer is straightforward. DeFi investors provide liquidity to those in need, enabling them to trade tokens with minimal market impact.

The second question is more complex—who pays for this value? It is important to note that liquidity providers are rewarded in three ways.

First, AMMs distribute direct rewards (i.e., trading fees and spreads) to liquidity providers. The bonuses are paid by users who access liquidity from the pool.

Second, they issue rewards in their native tokens, such as Curve issuing CRV tokens. (Note that Curve was the first protocol to successfully implement this model, which has since become widely imitated.) In addition to direct economic value, these tokens often come with special reward programs (governance rights).

For example, investors on Curve can increase their bonuses in the pool by locking up their CRV tokens, boosting their rewards by 2.5 times. The rewards consist of two parts. First, investors holding small amounts of CRV receive lower fees from liquidity provision, implicitly subsidizing investors holding large amounts of CRV. Second, non-investors holding CRV are diluted due to the inflation of CRV supply, further subsidizing investors.

Third, individual protocols may pay rewards to those providing liquidity for their specific tokens. They achieve this by (directly or indirectly) purchasing governance tokens from large liquidity protocols, redirecting additional rewards to their token pools. This approach will be discussed in more detail in the next section.

Some may appear to provide liquidity for projects but may differ slightly. For example, Olympus DAO is known for offering extremely high yields (currently 900%) for staking its OHM tokens. However, these yields are achieved through significant token dilution, largely as a reward for marketing (which we will discuss more in the final section).[2]

4. Management and Governance

Although "code is law" is often considered the motto of blockchain, most crypto projects still involve additional human intervention to guide funding, upgrade protocols, and address systemic threats. Most such operations are conducted through decentralized voting—stakeholders initiate proposals, review code, vote on proposals, etc. However, in recent years, aggregator protocols have become increasingly popular, especially in guiding capital.

The fourth major form of yield farming is providing power to aggregator systems to manage tokens in a passive and delegated manner. For example, the Convex protocol has been very successful in directing liquidity on the Curve platform to liquidity pools. The Yearn protocol has also achieved similar success by allocating assets across multiple lending and liquidity protocols.

This reminds us that a single yield farming strategy can provide value in multiple ways. For instance, DeFi investors can provide liquidity directly on Curve or through Convex on Curve. In both cases, they earn rewards for providing liquidity, but in the latter case, they achieve additional rewards by providing liquidity more efficiently.

The answers to our two core questions—what value is provided and what rewards are received—are more nuanced than in previous cases. Specifically, there are two ways DeFi investors earn income through managing protocols.

The first is value creation, where high-yield investors create surplus through more efficient management. Using the same examples of Convex and Yearn, these protocols can reallocate liquidity to specific markets faster and cheaper than single-staked traders. (Note that combining incentives with markets is a rapidly changing and evolving debate topic.)

Second, investors receive explicit and implicit rewards:

• First, investors achieve better returns by allocating resources to high-value protocols. They then receive rewards from users, such as borrowers or liquidity utilizers.
• Second, investors save on transaction costs by using such protocols. This can be significant—transaction fees on the Ethereum network can sometimes exceed $100 per transaction, making large transactions more attractive.

(For example, an ATM that charges $100 for a withdrawal. You want to withdraw a lot of money! Thus, the cost per withdrawal is lower.) Gunner pool protocols spread these costs, allowing for more frequent portfolio adjustments. Investors can also save personal workload through automated portfolio management, as protocols automatically identify and shift funds to the current best opportunities.

However, investors can also profit from management through value extraction:

• Investors can earn rewards through aggregators or by utilizing protocols (like Curve) individually, but aggregators utilize reward enhancement mechanisms more effectively. Thus, at the marginal cost, additional rewards are provided by small liquidity providers and token holders who do not continuously provide liquidity. In short, value is being transferred rather than created.
• In some cases, "bribing" investors to allocate tokens to specific mining pools can occur.[3] These bribes often come from new protocols aiming to guide liquidity, incentivize usage, and attract attention. However, this is more costly for independent investors, who see rewards being transferred away from their mining pools, while agricultural token holders bear the inflation.

As builders in the crypto world, we at Jump hope that management and governance can continue to evolve, increasing the ratio of value creation to value optimization over time. For example, DeFi investors could be incentivized to support code upgrades, just as they currently receive rewards for choosing efficient gunner pools. Defensive measures like weighted voting could also help reduce bribery, exploring the feasibility of methods to prevent large holders from accumulating voting power.

5. Increasing Visibility

Finally, a key and practical criterion for yield farming players to measure protocols is: big data equals influence! Specifically, the more TVL (Total Value Locked, i.e., accumulated assets) a protocol has, the more attention it receives, the more trust it garners, and the more likely it is to become a leader in the field. TVL may also impact the valuation of the protocol.

While the concept of "fair value" is still in its infancy in the crypto space, TVL multiples are commonly cited for assessing project valuations, similar to how companies use book value multiples and asset management firms use AUM multiples. In today's explosive growth period for protocols, climbing the rankings may be one of the most effective ways to stand out.

Thus, the final value provided by DeFi investors is increasing the visibility and trust of projects by staking assets. To maintain this value in the ecosystem, protocols often reward investors for "earning" attention, giving them time to grow and refine.

Specifically, protocols require investors to purchase and lock tokens in exchange for token allocations—the longer the lock-up period, the greater the rewards. Of course, locked holders cannot predict market fluctuations, bearing significant price risks compared to liquidity holders.

This mechanism is outlined in more detail in articles about token incentives. For users, token distribution helps unlock additional utility, which takes years to achieve, by transforming part of it into immediately realizable financial utility.

As a reward, locking limits supply (alleviating sell pressure) and aligns DeFi investors' incentives with the protocol's goals. That is to say: initially, you are in it for the rewards; ultimately, you are in it for the utility—such token distribution plans successfully facilitate protocols through their development phases.

Upon revisiting the core questions of fundamental economic value and rewards, we conclude:

• DeFi investors provide higher TVL to protocols, thereby increasing rewards.
• DeFi investors receive rewards from protocols, which typically offer rewards in the form of native tokens. This means that, in the short term, non-investors pay for these rewards by bearing the burden of inflation. However, in the long run, the protocol hopes to successfully create value and attract new users. In this case, later holders pay for early (yield farming) marketing activities.

Conceptually, this channel is the most ambiguous and prone to Ponzi schemes. In fact, protocols must address key issues, such as whether they can retain users after implicit marketing budgets run out. However, there are successful precedents in the startup world for "lightning expansion"—a strategy where venture-backed startups heavily subsidize users to gain market share before raising prices.

This strategy has proven effective. The crypto industry is now replicating this script, generating significant upfront expenditures with the opportunity to realize substantial value over time. By guiding the Lindy effect, protocols hope to increase their market share in the cryptocurrency space in the short term to ensure long-term success.

Reward-driven marketing is like walking a tightrope; we must proceed with caution. Protocols that do not offer any rewards are likely to fail without attracting attention. On the other hand, highly aggressive protocols (e.g., those offering 1000% staking yields) attract only DeFi investors, with few non-investors providing rewards. This leads to short-term spikes in "temporary liquidity" pools, but they can easily collapse in an instant.

Financialization and Scaling Yield Farming

Despite many changes, the core yield farming strategy remains quite simple. Investors passively provide value to protocols in exchange for direct and indirect rewards. However, an ultimate factor has emerged with development: financialization. Crypto has developed a robust ecosystem of financial protocols that allows DeFi investors to freely transfer assets and use leverage. This is how many DeFi investors increase their base single yields to more enticing levels (e.g., from 20% to 100%).

While discussing the use of leverage in yield farming is beyond the scope of this article, we will mention a common example: liquid staking. This is where investors deposit underlying tokens into a protocol and receive synthetic receipt tokens. As long as the receipts are accepted as collateral by other lending protocols, investors can leverage their receipt tokens.

In other words, investors can deposit underlying tokens (e.g., ETH), receive synthetic tokens representing that claim (e.g., sETH), borrow ETH using the synthetic tokens as collateral, deposit that ETH, and receive sETH, and so on. This sequence is not unique, and the functionality of shorting or segmenting adds more complexity to the asset mix.

But it is important to emphasize that while financialization can increase yields, the fundamental theory remains the same. Investors earn rewards for taking on risks and passively providing value, while financialization connects different parts of the ecosystem and amplifies risks and returns.

Conclusion

Essentially, DeFi investors are not much different from traditional investors. Both take on risks (whether price risks or uncontrollable risks), provide value, and earn returns. We hope that as the fog of jargon and insider terminology dissipates, yield farming can evolve into an economic activity that helps the crypto ecosystem operate more efficiently.

However, like traditional farming, yield farming is not easy. Despite the simple concept, practical yield farming requires many capabilities, such as identifying opportunities in value gaps, quickly adjusting positions, and understanding subtle risks in smart contracts. Mature investors should prepare for mistakes and be ready to lose their assets at any time.

As the industry matures, we believe these issues will be alleviated, and more individuals will be able to participate safely. Then, yield farming will fulfill the greater promise of cryptocurrency—financial democratization, allowing anyone, regardless of their complexity or wealth, to participate in providing these core sources of value in the crypto world.

Thanks to the research team at Jump Crypto, especially Sam Haribhakti and Maher Latif for their feedback. This article does not constitute financial advice.

【1】Although "interest" in traditional finance more strictly refers to the value paid by borrowers to expand credit, we will continue to use it in the context of cryptocurrency here.︎

【2】These yields are achieved through frequent token rebasing (three times a day). Rebasing does not create value; it merely redistributes it. For example, a 900% APY requires increasing the token supply by ten times, which in turn means a 90% decrease in the value of each token.︎

【3】This may sound unbelievable, but "bribing" in DeFi is a standard term for rewards given to supporters of a given proposal, not implying improper or illegal inducements.