At the height of the 2020 DeFi boom, total value locked in protocols skyrocketed to unprecedented heights, primarily due to the emergence of yield products such as liquidity mining and yield farming. At the time, yield farmers were aggressive by nature, constantly chasing liquidity pools with the highest APY rate and consistently maximising rewards.

The popularity and high-intensity activities of yield farmers led to the development of yield farming aggregators. These are protocols that allow users to participate in the best yield farming opportunities from a single platform. Notable among yield farming aggregators is Yearn Finance.

This article covers yield finance, its operations, and the potential risks involved in interacting with yield farming aggregators, providing you with a holistic understanding of the protocol. Take a deep breath, and let’s dive in.

What is Yearn Finance?

Yearn Finance is a decentralised suite of DeFi products on the Ethereum blockchain that provide yield farmers with an aggregate of the market’s highest yields. DeFi yield products aggregated by Yearn Finance range from lending and borrowing protocols to DEX liquidity pools and, recently, LSDs (liquid staking derivatives).

With Yearn Finance, farmers are able to optimise their passive investing strategies and make optimum use of their crypto assets as they are constantly exposed to the most profitable yield opportunities.

In addition to its service as a yield aggregator, Yearn Finance helps farmers automate the process of moving capital from one protocol to another in search of competitive yield, a process known as profit switching. Interest rates on lending protocols such as AAVE, Compound, and other yield-bearing protocols are typically floating rates and therefore subject to intermittent change; hence, capital automatically shifts among these protocols as interest rates change.

How Yearn Finance Works

Yearn Finance operates using four core products:

• Earn: This is the first product from Yearn Finance. It simply aggregates and identifies lending protocols with the highest rates and moves capital as required, ensuring farmers are exposed to the best APY rates at all times. At this time, only dYdX, AAVE, and Compound are available.

• Vault: Yearn Finance debuted the Vault feature after its token launch. It aggregates staking pools based on yield opportunities present in the market and automatically switches capital as required. Also, it allows farmers to pool their funds together, effectively helping them reduce gas costs, as well as automate the yield generation and rebalancing process, which can save users time and effort.

• Zap: Yearn Finance collaborated with Curve Finance to expand its services with Zap, which bundles transactions and allows users to swap in and out of liquidity pools. This functionality uses five stablecoins (BUSD, DAI, USDC, USDT, and TUSD) and helps farmers save on labour and gas costs.

• Cover: This is an insurance product that users can purchase for their deposits in vaults and liquidity pools in the event of financial loss, hacks, exploits, or other unforeseen events. The insurance premiums are paid in YFI tokens, which are the native tokens of Yearn Finance. If a loss occurs, the insurance will reimburse users for their losses up to the amount of their coverage.

Meet YFI

YFI is the native token of the Yearn Finance protocol, launched to further decentralise the development, control, and decision-making processes of the protocol. With YFI, holders can participate in the development of the protocol by voting for the execution of community-proposed decisions.

Some notable decisions made by the community thus far include the hiring of a team of marketers and developers, nuanced vault strategies, and community access to a portion of protocol fees, which made YFI a dividend-yielding asset.

In addition to playing the role of a governance token, YFI tokens can also be farmed through a number of methods, including providing liquidity for decentralised exchanges and depositing capital into Yearn Finance’s products.

Risks Involved in Interacting With Yield Aggregators

Yield aggregators like Yearn Finance have revolutionised the DeFi landscape by simplifying yield farming and making it possible for farmers to deploy improved strategies. These platforms have made it so that users don't need to have a deep understanding of the underlying protocols, thus allowing timely execution with less effort.

However, yield aggregators are not without their risks. Some of them include:

• Impermanent Loss: 

This is an unrealized loss that occurs due to market volatility. It is a situation in which assets deposited in the liquidity pool become worth less than their present value in the market. This means that the profit you gain from staking a token in a liquidity pool is worth less than what you would have earned just holding the same asset.

However, the loss is not truly yours until you withdraw your asset from the liquidity pool.

• Smart contract risks: 

Smart contracts are simply computer programmes that govern the operations of a protocol. These programmes are susceptible to hacks, attacks, and theft and oftentimes contain loopholes that might be exploited.

Yearn Finance is no different as it fell victim to a number of vulnerabilities, leading to attackers syphoning off $11 million from the DAI vault in February 2021. More recently, on April 13, 2023, another attack resulted in a loss of $11.54 million. These examples underscore the inherent dangers associated with smart contracts.

• Liquidation risks: 

Yield farming overexposes farmers to market volatility as farmers essentially leverage their capital as collateral, which can be liquidated if the value of the underlying asset falls below a certain threshold. This occurs when the market price of the assets you deposited into a liquidity pool falls below the price you deposited them at.

Wrapping Up:

Despite the risks, yield aggregators can be a powerful tool for generating passive income in DeFi. However, it's important to do your research and understand the risks associated before using them.

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This article is intended for educational purposes and is not financial advice.