Finding Alpha Amidst the Farming Madness

Everything in DeFi is intertwined. Protocols and their native assets don’t exist in their own siloes. In order to understand how any of it works you need to have a solid grasp on all of the interrelated systems. Like a financial Rube Goldberg machine, when one protocol starts liquidity mining it has a series of cascading effects impacting trading in one market which then alters interest rates in another and so on. If you can follow the breadcrumbs you can glean insights into the market, forecast what may occur in the future, and hopefully, gain an edge in a market ripe with opportunities.

Nowhere is this Rube Goldberg-like effect more evident than the Dai markets which are deeply entrenched across the whole DeFi ecosystem. It is the most popular asset in DeFi lending and borrowing markets and serves as a common pair in automated market makers. As these various protocols have sought to incentivize liquidity, Dai has undergone dramatic growth. At the end of June, there was $175 million Dai outstanding. Today there is over $400 million. By looking at where the Dai has been flowing to, you can identify the key growth drivers and assess its impact.

On June 15, Compound began its token distribution which kicked off the flight to yield. Initially, rewards were based on interest paid out which led to an inflow of capital to the BAT pool as it had a more aggressive interest rate model. On July 2, governance voted to replace that parameter with the USD value of borrow demand. This led to the first Dai shock as yield farmers began acquiring it to deposit on Compound and recycling it numerous times such that the Dai supplied on Compound was actually greater than the total outstanding (and still is). As a result, both the price and interest rates on secondary lending markets for Dai noticeably jumped.

The next shock came in the much-hyped YFI token distribution which increased the total value locked (TVL) in yearn.finance from $8 million to around $350 million in a couple of days. We begin seeing an exodus of Dai from Compound as it enters Balancer to seed the YFI pool. Once again the race to acquire Dai pushed it further from its peg and increased rates.

As quickly as it came, the second YFI distribution stopped, capital immediately reversed course, and $120 million left Balancer with $90 million of it going to farm on Compound over the course of the next two days. These two protocols have been the most popular destinations for mercenary capital looking to maximize yields so it’s no surprise that when one introduces or removes incentives, the money will freely flow to the other.

We see a similar dynamic play out with the YFI clone, YFII, where Dai flows into Balancer to earn tokens only to exit the second it ends. As more DeFi projects get creative in building liquidity for their token, Dai will continue to act as a vehicle for yield generation.