In less than three months, Yearn Finance has evolved from a relatively little-known credit aggregator to one of the main drivers of the DeFi market with a capitalization of $670 million (and over a billion USD at peak) and is at the heart of today’s hottest industry trend — Yield Farming. Yearn dominated Yield Farming so convincingly that some introduced its token, YFI, as the Yield Farming Index. But with such a sudden rise, it’s worth thinking about the potential complex value issues, influence, risks, and opportunities for Yearn. It’s time to dive into one of the most complex DeFi protocols on the market.
The birth and high days of YFI
Until July 16, Yearn was a simple DeFi credit aggregator designed to optimize user profitability. It had $8 million in assets under management, and since its launch in January, it has earned a combined 10.58% profit per annum for its liquidity providers. But most importantly, it did not have a token.
Everything changed the next day, on July 17, when yearn.finance founder, Andre Cronje, published a notorious blog post called “YFI”. In an effort to transfer control over the yearn.finance protocol to the users, Cronje developed a plan for users to manage YFI by providing liquidity to Curve and Balancer pools. This may have been the first truly honest launch in years when Cronje did not allocate YFI tokens to himself, abandoning the funding rounds, tokens for project advisers, pre-mines, and the like. All YFI tokens were distributed to the yearn.finance protocol users.
A couple of months later, a supposedly “completely useless token” is worth $670 million and drives an “industrial-scale agricultural machine” of $770 million (and over a billion USD at peak) and provides token holders with about 20 million dollars of profit a year.
Industrialization of Yield Farming
A while ago (about three months back), Compound launched its liquidity mining program and started a speculative trend, which many dubbed The Agricultural Revolution of DeFi. Simply put, liquidity mining refers to the process of distributing tokens to users for taking part in the protocol. The purpose of liquidity mining is to distribute control over the protocol and stimulate its implementation. The community introduced the “Yield Farming” because of the analogy of users who invest their capital in the protocol’s work to obtain tokens, with farmers, collecting harvest from the fields.
A few weeks into the launch of Compound Mining, Yield Farming was quite simple. You invest your capital in one of several protocols that offer incentives in exchange for liquidity and start earning tokens. This first stage of Yield Farming was similar to farmers who manually process their fields. Users had to define and understand each strategy before they could manually enter the capital. But as more and more protocols were running liquidity mining programs, Yield Farming was getting more and more complex; this process started consuming more and more time for the participants. In addition, as Gas prices rose sharply due to the congestion of the Ethereum network, many small “farmers” ceased to be engaged in Yield Farming. Everything changed when yearn.finance launched the second version of its protocol — v2, which introduced yVaults.
The most effective way to think about yVaults is to imagine a two-way market where capital providers are on one side, and strategy developers take the other. The authors of the strategy distribute the users’ capital, and the capital providers choose which strategies they want to use. The strategies automate Yield Farming for users. With the launch of yVaults, potential farmers can now simply deposit their funds in yVault, and their capital will be automatically allocated to the best strategies available. Warehouses not only reduce the risk faced by users trying to understand the different capabilities of Yield Farming but also alleviate their Gas fee concerns by sharing it with other providers of pooled capital. As a result, yearn.finance has become the largest Yield Farming enterprise in the industry, doing what used to be a case where only sophisticated users could participate. It took mankind more than ten thousand years to move from the agrarian to the industrial age. It took DeFi a couple of weeks to succeed in a similar revolution.
Cash Flow Machine
YFI is not a simple project. It has two major products Earn (credit optimization) and Vaults (optimization of Yield Farming), as well as many different products in its road map, aimed at insurance, stock trading, leverage, venture capital, and liquidation. In addition, this tokenomic model is still under development, with Delphi Digital and Gauntlet consulting firms being involved. However, it is important to understand how YFI currently earns money on its two main products, Earn and Vaults, as they can help draw an idea of its future (from an economic point of view).
The economy is simple. YFI charges a Gas subsidy (productivity) fee of 5% of the capital it manages and a withdrawal fee of 0.5%, if users withdraw their capital. Withdrawal fees apply to both Earn and Vaults products, while performance fees apply only to Vaults products. Specifically, with Vaults, performance fees are charged each time “harvesting” takes place (selling the processed asset back for the underlying asset). After the acceptance of improvement protocol “YIP-36”, which determined that Yearn would use a portion of the system rewards (fees) as operating capital, 100% of the system rewards were sent to its multisig Treasury. The YIP states that the Treasury must maintain a buffer of the equivalent of $500,000, with all surplus rewards allocated to YFI placed in the management pool.
Within a week after implementation, the Treasury has already accumulated over $463,000 in revenue, which would translate into just over $21 million per year. With a market capitalization of $390 million at the time, this implies a price to profits ratio of about 20x, which for all intents and purposes, can also be seen as a price to earnings ratio, given that the protocol has no expenses beyond what it receives from its Treasury.
The low price to sales ratio of YFI means that if all YFI holders had staked, they would have received ~ 5% of annual return (only YFI holders participating in the corporate governance pool receive cash flow). Since currently, about 12% of YFI is placed in the governance pool (a large percentage of YFI is placed in other pools), YFI participants get ~ 40% of annual return, which implies a PE ratio of 2.4 times. It is best to understand these ratios as a range. Currently, YFI holders participating in the management pool receive ~ 40% of annual returns, but if everyone stakes, they will receive ~ 5% of annual returns. The 5% can be considered as a limitation based on the current price and profit per token.
Yearn’s Yield Farming strategies were so successful that they began to drive the markets significantly. It is important to understand that Yearn’s Vaults not only automate users’ strategies but also harmonize them. Thus, instead of some users selling tokens after processing them, and others holding them because they simply prefer to do so or do not want to pay Gas, all yVault users do the same thing. And when this one thing is the systematic sale of fermented tokens, it can have a significant impact. The most recent example is CREAM, a decentralized credit protocol based on Compound, which recently launched liquidity mapping. Since the launch of the YFI warehouse, the warehouse has systematically grown CREAM and sold profits for additional YFI. Essentially, the strategy benefits from the CREAM speculators, who auction newly received CREAM tokens and redirect them to YFI.
The yCRV repository below shows what this process looks like under the hood. There are a few differences, but the general logic is the same. Replace yCRV with YFI and YFII with CREAM, and the figure will be very similar.
As the implementation of yVaults grows, the Yearn system will collect an increasing percentage of the total profits from all the most profitable “agricultural opportunities” as long as the trend continues. The question then arises as to whether this is sustainable.
The main reason why Yearn can generate such high cash flow right now is that the yield is very high. That is possible because the protocols are supported by a speculative enthusiasm for liquidity mining programs. The reason why “farmers” can get 1000%+ “yield”, is that more and more speculators continue to buy new tokens. Simply put, new speculators pay for the “yields” that “farmers” get.
It is not clear how long the passion for Yield Farming will last. It may well continue beyond next year or may end overnight. However, as soon as interest diminishes, token holders will need to find more sources of money. This may be due to either an increase in AUM to compensate for lower “yields” or additional products to provide alternative income sources for the Yearn system. The current rate of use of Yearn is equally important for YFI token holders. A performance fee of 5% of Yearn means the highest utilization rate among all DeFi protocols. The fee may well be justified given the value that Yearn provides to capital providers, but it is not a guarantee. Even Cronje himself believes that YFI token holders will not simply be able to get rent from capital providers.
Moreover, under the current system, Yearn does not pay the authors of the strategies. It is as if an asset management company did not pay its portfolio managers. To the extent that Yearn acts as a decentralized asset management platform (which some compare to an untargeted / arbitrage-oriented automated management platform), it will eventually have to compensate strategy developers, resulting in cost increase.
There may not be a single project that is more suitable for reflecting Yield Farming growth than YFI. YFI’s short term total available market is the common market for Yield Farming, which currently provides $7.3 million in daily liquidity rewards. This implies an annual rate of $2.6 billion and the strongest tailwind for YFI.
However, although YFI is currently the leader in Yield Farming, it is not the only one fighting for the “yield pie”. Apart from several (often questionable) forks of YFI, a couple of new Yield Farming aggregators such as APY.Finance and asset management platforms such as Set V2, appeared on the market, which will increase competition. In addition, as mentioned earlier, the current returns from Yield Farming will not last forever. Speculators will eventually stop buying this many new tokens, which will lead to lower returns. However, the successful launch of Yearn’s planned insurance, exchange, leverage, and liquidation products may diversify YFI revenue streams and provide additional value for YFI holders.
At present, YFI remains one of the most exciting experiments in decentralized management. The honest launch of YFI has created a large, diverse, and enthusiastic community of people who are extremely interested in the success of the protocol. Thanks to Cronje’s professionalism and leadership, the pace of Yearn’s new product launches is impressive. There are very few protocols that launch new products as fast as Yearn. However, although Yearn looks relatively smooth at the moment, applicants are entering the market, and Yearn is going to release many new products, the risk is still there. The coming months will show whether this nascent community can continue its magic and benefit all stakeholders.