Yield Farming: Should Average Investors Prepare for Harvest?
“DeFi” is short-form for decentralized finance, a method of executing financial transactions without the middlemen—brokerages, exchanges, banks, and other intermediaries. (Devine, US News). An understanding of yield farming cannot be achieved without first understanding the term DeFi. In the purest sense of the term, DeFi “must have no centralized control but run autonomously on a blockchain through the use of smart contracts.” Id. These smart contracts are “bits of code that perform actions once certain conditions have been met,” self-executing when specific outcomes occur. Id. Generally, DeFi has come to be known as the term for “any application or business that uses blockchain technology or cryptocurrency to create alternative financial products.” Id. One practice catching the attention of the SEC is yield farming, a method of lending crypto currency to which the SEC believes federal securities regulations apply. (Kharif, Bloomberg Law).
As part of the DeFi movement, yield farming specifically is the practice of lending cryptocurrency in return for interest and fees, sometimes—and arguably most importantly—in the form of units of a new cryptocurrency. (Kharif, Bloomberg Law). The practice of yield farming is part of an expansion away from Bitcoin and into the alt-coin universe, and transactions are executed through decentralized apps (“dApps”)—many of which operate on the Ethereum blockchain. (Rapoza, Forbes). While people have been able to earn interest on their cryptocurrency for several years, the practice of yield farming and lending in exchange for other cryptocurrency began in June of 2020, when the Ethereum-based credit market “Compound” began distributing its own token to users in exchange for cryptocurrency. (Kharif, Washington Post; Dale, CoinDesk).
Essentially, yield farming is similar to depositing money into a bank account earning the depositor one percent interest while the bank turns around and lends that money earning five percent. Id. The difference between depositing money into a bank and yield farming comes into play where instead of depositing money, an investor is “depositing” or lending cryptocurrency. (Kharif, Bloomberg Law). The cryptocurrency is “deposited” through a dApp. Id. The dApp then lends the cryptocurrency to borrowers who often use the coins for speculation. Id. Different coins have different interest rates that vary based on demand for the particular coin. Id. Instead of a bank, the decentralized protocol as part of the dApp contains a smart contract that reduces cost and increases efficiency. (Rapoza, Forbes). Instead of interest payments in the form of cash, lenders receive new units of cryptocurrency. (Kharif, Bloomberg Law). Because the value of these alt-coins or tokens is driven by demand and user base, yield farming as a practice involves a high risk, high reward investment that could be likened to C rated junk bonds. (Rapoza, Forbes).
As part of the trend toward alt-coins and the practices that come with DeFi, Coinbase Global Inc. has been pushing to open its Lend product to investors, allowing those investors to earn 4% annually by lending out virtual tokens. Id. However, Coinbase has seen pushback from the SEC through an assertion that many virtual tokens and coins are considered investment contracts. Id.
The battle over investment contracts begins with the question of whether digital assets can be considered a security under U.S. federal securities laws. (FinHub Staff, SEC). The term “security” includes an “investment contract,” which “exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.” SEC v. W.J. Howey Co., 328 U.S. 293 (1946). Despite the SEC’s assertion that many of the tokens and coins used in yield farming are securities, the industry has pushed back with the notion that the SEC’s definition of “investment contract” is too vague for virtual assets—specifically for smart contracts. (Kharif, Bloomberg Law). While smart contracts are written by a programmer, it is difficult to say that the operation of smart contracts are the “efforts of others” as an investment contract requires. (Levine, Bloomberg). Smart contracts are deterministic an open source, and any investor is trusting in the smart contract’s code rather than the programmer that wrote it. Id. On the other hand, if the smart contract itself can be likened to a person or company, its status as an investment contract becomes clearer. Id.
If smart contracts allocating these virtual tokens and coins for yield farming are, in fact, investment contracts, federal securities regulations would apply. Id. In addition to investor risk stemming from unregulated securities, other regulatory concerns include theft by hackers and market manipulation through artificial demand. (Kharif, Bloomberg Law).
While many of the early investors in digital assets did not include big-name institutional investors, inflation and market volatility have driven more and more of these type of investors toward DeFi and yield farming for steady returns. (Quinn, Nasdaq). A survey of 100 hedge fund CFO’s revealed an overwhelming majority of CFO’s who anticipate that portfolios will maintain at least a 7.2% holding in cryptocurrency and other digital assets by 2026. Id.
For the average American investor, the practice of yield farming would seem a bit complex and bit risky—a notion supported by the SEC’s concern. Early investors participating in yield farming often hold large portions of reward tokens received as interest, and as a result the moves made by these investors could have a large impact on token prices. (Kharif, Bloomberg Law). Without an in depth understanding of cryptocurrencies, the reasons for their value, and the related risks, the average American investor may not have the tolerance (or the stomach) for the volatility these coins can be subject to.