In DeFi, “yield farming” refers to the process of putting your crypto assets to work and generating the most returns possible on those assets. This strategy gained traction with the introduction of governance tokens. Governance tokens are a type of crypto asset that empowers holders with voting rights on platform decisions, potential revenue sharing opportunities, and the ability to steer a project's direction. They are frequently used as an early bootstraping mechanism to attract more capital. As more capital flows in and the user base grows, the fixed pool of rewards gets distributed among more participants. Consequently, yields in DeFi can be inconsistent and swing significantly based on the governance token's market value. This dynamic has users perpetually hunting for the best yield opportunities.
Enter DeFi yield aggregators (also called “yield optimizers”), the solution to this challenge. They are platforms designed to optimize yield returns for users. At their core, yield aggregators utilize smart contracts to pool users’ crypto assets together under a vault. A “vault” is a set of smart contracts (a self-executing contract with the terms hardcoded into it) with an associated strategy aimed at maximizing returns on a particular asset. These assets are then strategically invested across various yield-generating pools through pre-programmed and automatically executing strategies. You can almost think of yield aggregators like a fund manager that takes care of your investment portfolio based on specific guidelines and mandates.
Yield aggregators enhance earnings by continuously surveying the DeFi landscape. They identify the most lucrative yield strategies for specific assets or risk profiles. For users, this means the aggregator handles all the legwork: from shifting between strategies to reinvesting rewards for compounded growth. It’s important to note that yield generated in DeFi typically are not reinvested automatically. This means users have to manually collect them and reinvest them, which incurs gas fees that eat into your investment returns.
Yield aggregators generate yield from various sources, such as:
- Lending: This is the yield that users earn by lending their crypto assets to others. For example, if a user deposits DAI in Compound, they will receive interest payments.
- Market making: This is the yield that users receive for providing liquidity to enable decentralized trades. For example, if a user swaps tokens on Uniswap, they will pay a fee to the liquidity providers who supply the tokens.
- Staking: This is the yield that users receive for participating in a blockchain’s consensus mechanism. For example, if a user stakes ETH on Ethereum, they will receive rewards in the form of more ETH.
- Token rewards: This is the yield that users receive for performing a specific action or fulfilling a certain condition. For example, if a user deposits DAI in Compound, they will receive incentives in the form of COMP tokens.
Yield aggregators have the same types of risk as other protocols in DeFi. These platforms leverage and are built on top of existing DeFi protocols, which means it exposes users to an extra layer of smart contract risk. If an aggregator employs a strategy involving both Aave and Compound, depositors in that pool face compounded risk from all three platforms. An exploit in any one will impact your investment returns. As a result, the inherent risk depends on each aggregator and its chosen strategies.
Yield aggregators in DeFi can offer several benefits including:
- Maximizing returns: Yield aggregators use smart contracts to automatically harvest token rewards and re-invests them back into the pool. This process might seem minor, but can greatly enhance your returns over time.
- Gas savings: Yield aggregators pool capital from several users under one vault (set of smart contracts). This vault or smart contract then executes transactions on the blockchain. Every transaction on a blockchain requires paying a gas fee. These gas fees can impact your returns over time. A yield aggregator is able to socialize this gas cost across several users so it ends up being cheaper than if you had done it individually.
- Innovative strategies: Yield aggregators receive a performance fee for offering a particular strategy. These strategies are often maintained by a strategist who adjusts and updates their strategies based on market conditions. By depositing into a yield aggregator, you benefit from these novel strategies to earn yield in DeFi.
If you want to start passively earning yield in DeFi, you can check out some of these yield aggregators: