This photograph taken on July 25, 2020 shows an aerial view of a farmer driving his combine … [+]
There is a running joke going around these days that, like any good source of mirth, has a dagger of truth in it. The joke is that like the clock striking midnight for Cinderella, at age thirty every coastal millennial begins growing their own vegetables in a crowded planter off the side of their cramped downtown apartment while incessantly chattering about leaving the city to become a hobby farmer. There is a new craze sweeping the crypto community, however, that may alleviate any yearning for the musty soil of one’s forefathers in favor of working digital pastures closer to home.
The hot new craze is known as yield farming, the significance and legitimacy of which is up for debate. That hasn’t stopped enterprising young farmers from rushing in, with one measure of industry assets managed in these strategies known as Total Value Locked having just eclipsed $3.5 billion.
[Ed note: Investing in cryptocoins or tokens is highly speculative and the market is largely unregulated. Anyone considering it should be prepared to lose their entire investment.]
Yield farming is the act of using stablecoins (cryptocurrency tied to the value of the US dollar) to participate in a new crop of protocol projects that have been created specifically for the purpose of matching lenders and borrowers in a permissionless and decentralized way. Each protocol has its own peculiar wrinkles, but the general mechanism is that an investor looking to lend out capital must agree to lock their cryptocurrency up for some amount of time, and in return receive back interest paid on the capital as well as tokens that are native to that particular protocol.
The consumers and providers of these loans, as can be expected, are generally of the swashbuckling type found on the fringes of any good (or at least interesting) subculture. Borrowers tend to use the loans to either finance leveraged trades on decentralized exchanges, or to fund their own, even riskier lending practices. With a model like that, really, what could go wrong?
The potential risks, rewards, or valuation of any one token or protocol however are outside the purview of this article. Before one can hope to live exuberantly off the fat of the land, one must understand the crop life cycle, and before that, more fundamentally, how ammonium is turned into nitrogen to feed the plant itself. In that vein, let us examine from first principles the two different types of returns an asset can generate, and the three ways to generate those two types of returns.
Returns on an asset can be decomposed into two different fundamental types, namely cash flows generated by the asset and capital appreciation of the asset itself due to changes in underlying value. There are three ways to generate those returns. Returns can be generated by creating or improving an asset, correcting mispricing between assets, or seignorage via the Cantillon effect. This taxonomy is universal, and can be understood in the context of farming whether it be digital or terrestrial.
For simplicity’s sake, let’s take the fictional economy of Yieldistan. In one far corner of this little fiefdom lives a productive farmer named Alice. Alice has grown a generous harvest of apples this year, so many in fact that she has an excess beyond her capacity to store and consume. While not a farmer, her neighbor Bob is an informed citizen who follows the news trickling in from disparate and distant parts of the commonwealth. Bob knows that while apples will sell locally for the price of one banana per apple, across the empire far far away he can get a more favorable exchange rate. Bob proposes to Alice a deal. He will borrow five apples up front, travel across the fields of yonder, and sell the apples. When he returns with his banana bounty, he will sell them locally, netting more apples than they had to begin with. This transaction will result in seven total apples, six of which he returns to Alice, and one which he will keep for his troubles. This corresponds with the second way of generating a return on an asset, by correcting mispricing.
In a second scenario, Alice again is a local farmer, Bob her neighbor, while Christina is another local farmer. The apples produced by Alice and Christina are substitutes in that they can both be consumed for similar purposes, but aren’t fungible. Christina can’t sneak onto Alice’s farm at night, take some of her delicious apples, and leave inferior apples in return, as they are clearly marked.
Alice, the entrepreneur that she is, senses an opportunity. Alice offers to let Bob build a co-op farmstand next to her farm and take upon himself the responsibility of making some improvements to the equipment around the orchard. She will lend him some apples in order to finance these improvements. Due to these improvements, as well as the reputation Bob carries with him about town, the farmstand is overrun with clientele. Additionally, Alice now has a banner harvest year following the improvements on her land and expects to have an increased harvest for years to come. The value of both her orchard and her apples has increased, and Bob is now able to generate some apples of his own. This corresponds with the first way to make a return on an asset, through creation or improvement.
Lastly, we have a scenario where local town farms collectively produce 100 apples a month. The ruler of Yieldistan, Queen Preenta, lives far away and over a mountain. In her cellars there are, for all intents and purposes, an unlimited number of apples. In order to best manage her queendom, she will release some apples from time to time, while at other times she will demand some back as fealty. One day, out of nowhere, Preenta releases 100 additional apples on the townspeople.
In a vacuum, and according to classic economic theory, one would expect the going rate to immediately adjust from one apple to a banana to two apples for one banana. However, this assumes the equal and immediate distribution of the new bounty of apples in the local economy, a frictionless market structure, and other dynamics that are unlikely to be present.
To tie this from the terrestrial to the digital farming realms, let us expand the thought exercise just a bit further. The reason Queen Preenta injected these apples into this local, closed economy in a faraway corner of her empire was not out of pure gracious benevolence. Nay, according to Preenta’s industrial policy advisors, the orchards of this land were being massively underutilized. By injecting part of her stores in, she is putting apples in the hands of apple experts, who she expects to plant them and grow, well, even more apples which as we know are in high demand elsewhere. By signaling more apples will be airdropped in and given to those who are growing apples, she is incentivizing otherwise unoccupied apple experts living in other parts of her empire to make the pilgrimage and tend to the land here as well. She expects a prudent, reasonable, staid response and apples to flow smoothly like milk and honey.
Yieldistan, however, is made up of people. And people have always, throughout the history of humanity, done people things, and will seemingly continue to do people things until either Neuralink or the aliens takes over. So the time old tale is told again. Pilgrims rush in, selling their bananas and buying apples. Some of them are apple experts, sure, but many of them couldn’t even tell the difference between the Bismarck and the Baldwin cultivar! More and more people come to this small corner, desperately selling their bananas and buying apples hand over fist. This confuses the local classically trained economists (who aren’t very bright), as they expected a higher amount of apples circulating to depress the price. Instead, the exchange rate moves further in favor of apples, as they hope to benefit from the favored policies of Queen Preenta.
To be clear, there could be some legitimate reasons for the increased demand for apples. The attention raining down could have widened the awareness of apples to those who had never really considered apples before, or even known they existed. There could be a real perception in the market that the investment in this land could raise the total underlying value of all apples. But, for the most part at this stage, the immediate value captured by the present holders of apples is due to apples experiencing capital appreciation from higher demand and the expectation that holding that apple means they will be gifted more apples. Those that held apples initially, the apple magnates of our little land, will have benefited disproportionately from this uneven early distribution, and capture more of the total upside that Preenta had intended for equal distribution to her people. This is, in essence, seignorage and the Cantillon effect.
A cynic might pause here. Like Vizzini from The Princess Bride, the theory that rational actors could participate in this kind of nonsense, or that the nonsense could sustain itself is “inconceivable!” As noted previously, however, economic theory works very well in theory and very rarely in practice.
Despite some legitimate criticisms, economic models can actually be useful as approximations of the world, and should be used with the caveat that they are understood for what they are. There is a famous economic model called the Solow-Swan model under what is known as Neoclassical Growth Theory. The theory is, essentially, that the economic output of a closed society is given by three factors, namely capital, labor, and technology. Capital and labor are inherently scarce resources, and while they can be developed, grown, or borrowed, they have bounded quantities with linear effects on production. Technology, however, can be exponential (they use the term ‘boundless’). While at first this can seem wonky, upon further inspection it makes sense, at least in reality if not necessarily in theory. It’s a bit hand-wavy, sure, but it’s a useful hack with explanatory power.
This is essentially the rational economic bet that yield farmers are making. While requiring the presence of all three factors, the exponential bet on achieving value accrual is not on the capital, or the labor, but instead on the technology factor that the accumulation of that capital and labor can potentially unlock.
It is likely you have heard this concept many times in different forms. The last forty minus five-ish years of economic theory has generally referred to it as “productivity gains”, whereas the last five to ten years of technology development have called them network effects. Either way, it functions much like dark matter does in physics: it’s the squiggly greek symbol that we can’t measure, not a single person really understands, but absolutely must be there in order to explain how all the other parts that we can see and feel and touch come together.
Critics of the yield farming craze will point to the ponzi-like nature of the schemes. And they are! The incredible part is that in this case, the users themselves are leaning into it. The model behind an absolutely inscrutable new protocol token offering called YFI has been popularly referred to as “ponzinomics”, however this time it’s by the fans and users themselves.
Lest we miss the forest for the trees, this doesn’t mean it’s not an understandable if somewhat head-scratching bet on the surface. The users in these small closed economies are making a gamble that they can bootstrap liquidity onto the platform, drawing capital and labor, which will eventually allow them to create value via the channel of a boundless technology factor. The yields reaped from lending to others doing, well, mostly the same types of engineering and the capital appreciation of the assets from increased demand can finance the growth phase. It’s the same theory behind Queen Preenta incentivizing her serfs to move to the faraway enclave to till the soil, improve the land, and plant more apple trees.
Whether it works or not very much remains to be seen. It is certainly wise to be deeply and heavily skeptical. Either way, it is going to be a wild ride. Despite the call for skepticism, the projects and the community that has flourished around them are a cheeky, whimsical part of the greater crypto empire. As has been seen many times before, it is often these innocuous, seemingly useless areas of technological development that eventually lead to real progress. Contrary to popular belief, it is usually bubbles that precede, rather than follow, sustainable development in a new space, with the excess and supposedly misallocated capital sowing the seeds for the development of legitimate technology.
That being said, for any enterprising young pilgrims, it is wise to ask yourself what type of returns you expect to generate and via what method before setting off for foreign lands. Will the returns be generated from growing an asset organically, like an apple tree? Will they be earned, by performing tasks that collapse a mispricing, resulting in more total apples even if they’re taken from somewhere else? Will they be shared as part of a mutually beneficial incentive package that helps grow the entire orchard? Or will it be airdropped, in order to bootstrap the development of a prosperous new community?
The reality is that despite the screaming masses and their strong opinions, none of these possibilities are inherently wrong in and of themselves. The real mistakes are in taking a risk that you don’t understand, or that you shouldn’t have because you fell prey to the psychology of the market. Despite the abundance of vaporware projects, an enterprising young pilgrim who can think for themselves, do their own research, and discern differences may stand to profit. Or not. The most likely outcome is that most if not all of these projects either fade into obscurity or collapse with the same spectacular fervor they came into existence with. These are foreign, uncharted lands after all, and they offer no guarantees.
In the end, it’s all going to come down to just how much the market likes dem apples.
Disclaimer: Rory is an active trader and investor holding positions in several cryptocurrencies as well as equities and other private investments at any point.