Yield optimization is the process of using optimization techniques and data analysis to maximize revenue and value. In crypto, yield optimization typically refers to an entity passively maximizing return on their funds by using an automated service that actively manages their funds to optimize yield.
People have sought yield, or a return on an investment over a period of time expressed as a percentage for centuries. One of the biggest reasons people continually seek yield is due to inflation, or the increase in general level of prices of goods and services over time. Inflation refers to a measure of the rate at which the value of a currency is declining, or in direct terms the decline in purchasing power of a currency over time. The United States had a median household income of $67,521 USD in 2020. If the average price for a loaf of bread increased 20% from $5.00 USD in 2020 to $6.00 USD in 2021 and the median household income stayed the same, the 20% inflation harms consumers in the United States because the purchasing power of their dollar for bread has declined.
There are many causes of inflation, such as expansionary monetary policy, expansionary fiscal policy, demand-pull inflation, and cost-push inflation. Collectively, there has been steady inflation in most stable growing economies for centuries. To counter inflation, people seek a yield that is higher than the inflation of their domestic currency to maintain or increase the purchasing power of their savings.
Cryptocurrencies such as ADA and Bitcoin are popular because of their limited supply, which serves as a hedge against inflation. However, blockchains with smart contract capability like Cardano and Ethereum enable participants to obtain yield in cryptocurrencies. Decentralized Finance (DeFi) applications such as decentralized exchanges (DEXs), lending protocols, and other dApps allow liquidity providers (LPs), or those who allow their funds to be used by a dApp for its functionality, to gain additional tokens through a process called yield farming.
Yield farming is when holders of coins like ADA provide their ADA, or liquidity, to a protocol to gain more tokens. Staking, which is delegating or depositing your coins or token to a platform to receive yield via coins or tokens, is another method of obtaining yield. Yield farming and staking is required for many dApps or blockchains to work. Yield farming in crypto was popularized by the introduction of DEXs like Uniswap and lending platforms like AAVE on Ethereum. In traditional finance, the liquidity needed to trade on stock exchanges or provide loans is provided by banks or other centralized financial institutions. In DeFi, individual liquidity providers, no matter if they have $100 worth of crypto or $10,000 worth of crypto, can provide their crypto as liquidity, giving a DEX liquidity or a lending protocol funding for loans in return for fees charged to users of the platforms.
DApps that provide yield farming opportunities are commonplace today, such as the Genius DEX, which is a concentrated liquidity order-book DEX built on Cardano. In addition to DEXs and lending platforms, there are other dApps like Insurance and derivatives that provide yield. If the yield of one platform is very high, users will add assets to that liquidity pool, which ultimately lowers the yield if the use of the liquidity pool or dApp stays the same. Next, users will move on to another opportunity where the yields are higher. This process continues to repeat itself. However, most users don’t have the time or skill to constantly reallocate their funds to the highest yield farming opportunity. Yield aggregators do the work for LPs, reallocating their funds for them. At the end of 2021 there were over $8 billion USD in total value locked (TVL) in yield aggregators.
Yield refers to income generated over a period of time. Many platforms express yield as Annual Percentage Yield (APY), which is the annual return that includes the impact of compounding or reinvesting returns, or Annual Percentage Return (APR), which does not include the impact of compounding. LPs can earn yield by depositing their crypto assets into dApps or protocols that provide return.
- Yield Farming—Providing liquidity to a platform in return for a portion of the fees generated by its use. LPs can provide their funds to a liquidity pool on a DEX or a lending platform, receiving a portion of the trading or lending fees generated. Each LP typically receives transaction fees generated by the liquidity pool proportional to the liquidity they provided to the pool for dApps using aggregated pools. In addition, yield farming can be obtained by providing liquidity for loans on lending platforms.
- Liquidity Mining—A method similar to yield farming is liquidity mining, which is when the LP’s rewards consist of the project’s native token plus the fees generated by the liquidity pool. For lending platforms or DEXs, liquidity mining is used to incentivize LPs to provide liquidity to the protocol, which is necessary for its functionality.
- Staking — Staking refers to participants delegating or locking up their crypto assets in a Proof of Stake (PoS) protocol like Cardano or dApp-related staking such as Genius Yield’s staking program. In exchange for users delegating or locking up their coins in the protocol, which helps secure decentralized PoS protocols, participants receive rewards in the form of the protocol’s coin. Rewards are usually directly proportional to the amount of the participant’s stake.
The yield of each of these yield opportunities are constantly affected by the market factors such as supply and demand and the utilization of the platform. That means that LPs have to constantly monitor and review all available yield opportunities in order to make sure they are maximizing the return on their assets.
Yield optimizers, or yield aggregators, are dApps that liquidity providers can deposit their funds into that uses a combination of data analysis and algorithms to constantly move the LP’s funds to optimize yield. For example, the Genius Yield Optimizer will use AI-powered algorithmic strategies to maximize yield for LPs, strategically placing and rebalancing their liquidity at the optimal price and risk level. While some strategies just reallocate to the highest yield, more complex yield optimizers look at the impact of rebalancing or offer features such as auto-compounding for LPs.
In return for these services, many yield optimization strategies charge users a fee, which may be a management fee and a percentage of any profit.
Yield optimization strategies are used across most large blockchains like Cardano and Ethereum with the goal of giving users the maximum yield. There are also customized yield optimization strategies that vary based on potential return and risk and the type of strategy, such as Dollar Cost Averaging.
Yield optimization is just not limited to dApps as many centralized finance (CeFi) companies offer opportunities to gain yield from staking specific coins or tokens. Below are various categories where LPs can seek yield:
- DEXs - LP’s liquidity, or crypto assets, are used to make trades between digital assets on a decentralized exchange, with a portion of the trade fees being given to the LP as compensation. An example is the Genius DEX.
- Lending - Protocols that allow users to borrow and lend assets. LP’s funds are loaned out, with the LP earning part of the interest on the loan as yield.
- Staking - LPs are paid by the protocol for staking on their platform.
- Insurance - Protocols that charge fees for providing insurance against monetary losses. LP’s liquidity is used to potentially cover catastrophic losses while the LP collects fees charged for the insurance coverage.
- Yield Aggregators - Protocols that actively manage the LP’s funds to optimize yield. Examples are the Smart Liquidity Vaults created through the Genius Yield Optimizer.
Many protocols such as DeFi or Proof of Stake (PoS) may be considered securities by some regulatory entities. In addition, DEXs, which usually has the highest TVL out of all the DeFi categories, may be considered exchanges that should be registered and regulated.
Many of the technologies that allow yield optimization could run afoul of regulations if they allow the trading of unregistered securities or the ability to ease money laundering. Uniswap delisted around 100 tokens in 2021 from its front-end web portal due to regulators believing that some of the securities were illegal or not properly registered as securities.
Ethically, creating dApps that seek to optimize yield adds utility for potential users. Yield optimization is important because many LPs don’t have the time or skill to optimize their return. Yield optimization, combined with blockchain technology, gives people who don’t have access to certain investment opportunities reserved for people of a certain financial status the chance to get similar returns. In addition, yield optimization helps the market stay efficient, similar to how hedge funds and active investors help create efficient stock market prices. Multiple yield optimization strategies push many opportunities based on their price and yield, to a market price that reflects their intrinsic value. Yield optimization faces the same moral dilemmas as other blockchain based applications as many believe making decentralized applications that can be monitored by authorities is illegal.