Following the crypto hype-cycle of 2017–18, it’s safe to say that the industry has made some progress. There is now a spectrum of crypto-enabled financial services available; from stable coins, synthetic assets, peer-to-peer insurance, and peer-to-peer borrowing and lending, to name a few.
Crypto-enabled financial applications — coined Decentralised Finance (DeFi) — are challenging the established order of centralised financial services in ways that unlock new income-generating opportunities that are more open and accessible to everyone.
At its core, financial services are multi-sided marketplaces that are typically coordinated by banking intermediaries. ‘Financial assets’ typically make up the supply-side and ‘buyers’ or ‘borrowers’ form the demand side.
In today’s low-interest-rate environment, ordinary people who deposit their money in a bank account no longer can make any money on their savings; especially when you have to also take into consideration the intermediary fees needed to keep the banks afloat as well as inflation.
Through removal of rent-seeking banking intermediaries thanks to crypto-economic game theory, DeFi aims to offer a silver lining.
DeFi is making it incredibly easier for anyone in the world to access the financial services industry in a permissionless way and reap the benefits as either or supply-side and demand-side contributor to its full extent.
Income-generating opportunities for supply-side participants can be more fruitful in comparison to the legacy system since less of the available margin is used to cover the costs of paper-based settlement processes and remunerating profit-seeking intermediaries.
However, the buck doesn’t stop there. More recently, these income-generating opportunities have risen far greater than just a few basis points better than the legacy financial industry.
DeFi service providers — that exist as protocols residing on the Ethereum blockchain — have begun issuing their own digital tokens and gifting them to their existing and new users to entice growth. These “governance tokens”, typically have the nominal purpose of giving owners a say in how the specific DeFi service is run. Since these tokens have real utility (with very similar qualities to holding shares in a company), they can be considered valuable, on a case-by-case basis.
The introduction of these application-specific governance tokens has, therefore, catapulted the income-generating opportunities available in crypto to new all-time highs. Resultantly, this has triggered a hot new trend, termed “yield farming,” which is shorthand for creative strategies where users of these protocols participate in inventive ways to earn as many of these tokens as they possibly can and maximise their dollar-denominated returns.
Upwards of 1000% APR in some cases sounds like spellbinding stuff. But, how many people do you actually know who are taking advantage of yield farming that DeFi have to offer?
According to a study by Cambridge University, less than 1% of the world’s population own cryptocurrency at all. And despite rapid growth, only 0.0024% of global wealth is collateralised in Decentralised Finance (DeFi) services.
So, if DeFi is our financial future, then why still are so few of us taking part?
Where DeFi and Yield Farming Falls Short
To change an individual’s financial habits, it would be prudent to assume that any new proposition should either be more rewarding and/or less risky than the status quo.
When we consider how rewarding some of these new yield farming opportunities are, at first glance, the rates appear rather compelling.
However, when you consider the time investment for an average DeFi novice in education, trial and error as well as the risks involved with moving their wealth into a smart contract that they do not understand how to assess, the reward is simply not big enough.
Even the crypto-veterans are struggling to keep up.
Given that this space is evolving at warp speed, new yield farming opportunities are popping up daily. Crypto-veterans need to be quick to (1) Assess the risks involved; (2) Assess the expected return on investment in comparison to their existing portfolio; and (3) rebalance their portfolio accordingly to ensure risk/reward is optimised for. All of which is complex, time-consuming and prone to human error.
Not mention the rising gas costs necessary to perform a transaction on the Ethereum network. The technical limitations of Ethereum are pricing out a lot of the target market user groups.
The result is a negative feedback loop that deepens the inequalities of wealth and income in DeFi, as the new income-generating yield farming opportunities that DeFi has to offer are inaccessible to those that have smaller sums of money to play with.
This cycle threatens the long-term sustainability of DeFi, potentially impacting the incentive for new consumers and businesses to participate, and dampening the viral potential of crypto-economics.
Yearn Finance — DeFi’s Saving Grace?
Yearn Finance’s meteoritic rise has been a rapid response to these compounding problems in DeFi through its introduction of ‘yVaults’.
yVault menu @ yearn.finance
yVaults work by allowing liquidity providers (LPs) to deposit their crypto-assets in a specific pool directly. The robo-advisor designated to the yVault would then invest the capital from the pool across the best yield farming opportunities available to the specific crypto-asset.
yVaults essentially introduce automated investment strategies, serving to abstract away a lot of the complexities that made yield farming difficult to optimise for.
Consequently, Yearn Finance has become the largest yield farming enterprise in crypto, managing to help more individuals take part in the sorts of investment activities that were once available only to the more sophisticated and affluent users.
Finding Product-Market Fit
Yearn Finance has certainly lowered the barrier for yield farming across a variety of crypto-assets. yVaults have given birth to a powerful new tool that allows users to take full advantage of when trying to maximise the return on the crypto-assets in their possession without the headache of constantly rebalancing their positions.
So, has Yearn Finance’s yield farming optimiser found product-market-fit?
For crypto-veterans with a pre-established understanding of cryptocurrency and the DeFi landscape, it most certainly seems so.
However, if we were to zoom out, it is fair to say that Yearn is far from truly taking yield farming “mainstream”.
We believe, as wonderful as solution Yearn is, it is not built to serve two specific target customer groups that arguably form the lion share of the total addressable market:
(1) DeFi and cryptocurrency novices; and
(2) Non-DeFi-focused institutional investors.
To understand why, let’s break the problems down individually:
The user experience is still too complex — If a DeFi novice goes to the Yearn site and see all these options on the front page: Vaults, Earn, Zap, APR and Cover they’d have no clue where to start. In addition to bombarding the users with an array of different DeFi products to choose from, each of them needs a specific crypto-asset, e.g. ETH, USDT, USDC, Curve, etc. For a crypto novice, choosing what to deposit and why is part of the challenge. It demands users having a bullish or bearish thesis on the underlying crypto-assets themselves.
Gas fees still price people out — While Yearn makes it easy and cost-effective to invest in an array of protocols and reap the rewards of yield farming by investing in a yVault, the process of getting the specifics crypto-assets necessary is itself a challenge that demands users to make several transactions that can still cost significant amounts. Additionally, the fragmentation of liquidity across all of the different yVault pools prevents reaping the full benefits of diversifying gas fees among the providers of pooled capital.
Allocation still demands due diligence — Yearn may abstract away some of the complexities involved in rebalancing yield farming investment strategies; however, it does not provide transparency over the risks of investing in a particular strategy. Investors are expected to audit the financial and technical risks for themselves. For crypto-novices as well as more sophisticated institutional investors, this is time-consuming and demands a trained eye to conduct.
Investments are not optimised for risk — Since strategies and the corresponding protocols that they interact with are not vetted or scored in a standardised fashion, it is unclear whether the investment strategies offered by Yearn itself offer the best return for a given level of risk. As an institutional investor, balancing risk and reward is of paramount importance. Should a given strategy employed by a yVault fail to satisfy the risk/reward assessments, investors will be unable to allocate a meaningful amount of their capital to the strategy to reap the full benefits of automated yield farming.
Additional rebalancing is necessary — Yearn Finance does a fine job at rebalancing a portfolio for a given strategy with a specific input asset. However, what it fails to do is add a layer of rebalancing abstraction to ensure that the risk-adjusted yield is optimised for across all the available strategies. Today, users of Yearn Finance are expected to manage this for themselves manually.
The Market Needs a ‘WealthFront’ for Yield Farming
While Yearn Finance has gained a lot of traction relatively quickly, its ability to break yield farming into the mainstream remains uncertain, given the complex-set of features it offers that are catered to the more advanced users.
However, for DeFi and yield farming to truly penetrate the crypto-novice and passive institutional investor target demographics, additional layers of abstraction are necessary.
In the legacy financial world, automated investment service providers have made it incredibly easier for ordinary individuals to invest in a wide variety of investment strategies based solely on their risk tolerance profile. Companies such as WealthFront, Betterment and Acorns have been proven to be successful in attracting idle capital from the average joe.
Since ‘yield farming’ has only really emerged in the past few months, there are very few players out there today that aim to simplify the experience in a way that is comparable to the likes of a WealthFront.
Should a product of this sort emerge for the yield farming phenomenon, it could have the power lower barriers to entry even further, satisfying the needs of mass-market users.
APY Finance — a viable contender?
Aiming to fulfil the role of “WealthFront for DeFi” is a new kid on the block — APY Finance — a project that is set to launch in October. Founded by a talented group of developers at ETH HackMoney earlier this year, APY Finance proposes to offer investors a way to automate yield farming similar to the likes of Yearn, however, with some additional layers of abstraction.
It achieves this through:
1. Accepting only stable coin deposits — instead of users having to purchase an array of different crypto-currencies to invest in one or several vaults, they can simply make a single investment in APY Finance’s liquidity pool. In turn, the APY robo-advisor takes control and autonomously diversifies the capital collected in the pool across an assortment of strategies that may require alternative cryptocurrencies as input assets, e.g. ETH, renBTC, USDT, etc.
2. Scoring and analysing yield farming risks on behalf of the LPs — APY Finance uses a risk assessment framework inspired by ConsenSys to assess each of the investment strategies it employs in the back-end to score smart contract risk, financial risk and centralisation risk. By doing so, APY Finance’s robo-advisor gains a degree of consciousness with regards to risk, allowing it to make more calculated decisions on behalf of the LPs.
3. Rebalancing the portfolio of strategies autonomously — Yearn Finance only allows users to invest in cryptocurrency-specific vaults; it does not offer the ability to move the capital from one vault to another in an automated way. APY Finance aims to abstract away this complexity through automatic rebalancing of all the strategies employed concurrently.
4. Interoperating with Yearn Finance and other strategy-specific robo-advisors — One of the many beauties of DeFi is its composability. Since Yearn Finance offers a variety of yield-optimising investment strategies, APY Finance can incorporate each of them into its own robo-advisor. Diversifying capital to one or several Yearn yVaults could theoretically be made possible, should the system believe it offers the best risk-adjusted return for the pool of capital.
An Overview of How APY Finance Works — Yield Farming’s Upcoming Money Lego Piece
While becoming the subject of a fair share of speculation, crypto veterans believe yield farming and DeFi are part of a large and permanent expansion of their industry as it has the power to draw in financial capital in search for yield.
With the explosion of liquidity mining campaigns offered by a variety of new and existing DeFi protocols, Yearn Finance offers an easier way for users to automate several aspects of their yield farming endeavours.
However, given the need to jump through several hurdles to utilise Yearn efficiently and safely, the products offered are in reality serving only the savvier DeFi users. Until a new product emerges that caters to the novice or more risk-averse investors among us, I believe strategy-specific yield optimisers offered by the likes of Yearn will struggle to attract and retain mass-market users.
My view is that those that will capture the lion share of the total addressable market will be those that offer an experience similar to the likes of WealthFront. APY Finance looks like a promising contender; I’ll be watching.
Full disclosure: I am an investor in Yearn Finance (YFI) and APY Finance (APY).