The Mechanics of Yield Farming and Yield Aggregators
Yield Farming is a popular topic nowadays, not many understand the mechanism behind it. The VSO token is present in some automated yield farming protocols, so we are going to dive deeper into how these protocols work.
Let’s take a look at the inner mechanics of yield farming protocols, since it is a complex subject with an increasing level of users, volume, usage, TVL, etc.
What are Yield farming aggregators?
Yield farming aggregators essentially automate the process of staking and collecting the generated rewards on behalf of users, to optimize gas fee spending via different strategies [sometimes complex]. These strategies involve moving tokens around different platforms and maximizing yields via auto compounding.
Why do yield aggregators exist?
Part of the tokens involved in yield farming is governance tokens issued by protocols. These tokens incentivize activity on the protocol and allow holders to propose and vote on changes to it. More usage on a platform means more fees generated that results in higher yields on deposited tokens.
One way of generating auto compounding returns is by collecting rewards from staking a certain token (could be a LP token or not) and swapping them for the underlying token, which in turn generates more rewards (compounding earned interest), and so on.
Another way of generating returns for users is a protocol that rewards an interest-bearing token for stakers. The interest comes from fees generated by people using yield farming strategies on the platform. These fees are utilized to buy the interest-bearing token on the market, creating buying pressure on it. These tokens may also be auto compounded.
When analyzing farming opportunities, aggregators look into tokenomics: project TVL and profitability, whether or not the reward and underlying tokens are deflationary (whereby the protocol utilizes part of generated fees on its own platform to purchase its own tokens and burn them) and what fees are generated by them. Aggregators fight for the best returns for their users in a space where most issuance of tokens that are farmed is limited.
Some examples of yield aggregators are: Trader Joe (Avalanche), DeFi Yield Protocol (Avalanche), Eleven.Finance (Cross-chain), Yearn Finance (Ethereum), Harvest Finance (Ethereum), Badger (Ethereum).
What strategies are used by successful yield farmers?
The most successful yield farmers maximize their returns by deploying more complicated investment strategies. These strategies usually involve staking tokens in a chain of protocols to generate maximum yield.
A common feature of yield aggregators has boosted farms. By staking the native token of the aggregator protocol, the tokens accrue value via redistribution of collected vault fees and sharing of harvested vault rewards. That is, fees that are collected from other vaults and rewards that are also collected from other vaults are redirected to vaults that the managers of the protocol want to incentivize users to deposit in (usually new vaults that they want to promote).
The main indicators of how much one earn by depositing tokens in a vault are APY and APR. Although one might think you can use them interchangeably, they have differences.
Annual Percentage Yield (APY) takes into account the compounding interest of the asset, while Annual Percentage Return (APR) does not. Vaults that auto compound automatically harvest rewards, which are then invested back into the pool, so the yield is calculated over the new total amount. APR would be a better metric for vaults that require manual harvesting of rewards.
APY and APR figures are not precise indicators of return, since they depend on many factors like the amount of fees generated by a liquidity pool (which is based on traded volume/volume of swaps) as well as the Total Value Locked (TVL) in a certain vault. These factors are dynamic, so a vault may show an absurd APY as soon as it-s launched, but since high returns attract depositors quickly, TVL increases and APY decreases quickly as well. The more people that deposit tokens into a vault, the lower the APY because the issuance of the awarded tokens will be more distributed.