This, I think, is one of the best innovations in DeFi. Imagine if TradFi companies could pay higher dividend yields to their most loyal shareholders. I’m sure that would be a popular tool for CEOs — and potentially even a solution to the short-termism that corporate America is always accused of.
“We shall not grow wiser before we learn that much that we have done was very foolish.”
— Friedrich Hayek
In Defense of Farming
On a podcast this week, Sam Bankman-Fried was asked to explain yield farming.
He responded, “Let me give you sort of, like, a really toy model of it,” before sketching out the basics with an easy-to-understand analogy involving a box with some crypto in it.
Unfortunately, the hosts reacted to this 101 explainer as if it were a graduate-level discourse on the highest evolution of everything that crypto is now and could ever hope to be.
Others had a similar reaction: A Financial Times columnist incredulously reprinted a transcript of the exchange, implying that the high priest of crypto trading had pulled back the curtain and revealed there’s nothing there to see.
The column opened with the lede, “Honk honk! Here comes the crypto clown car,” and, amusingly, closed by linking to the FT’s “Crypto and Digital Assets Summit.”
(Weird way to plug your crypto conference, but OK.)
It’s easy to dunk on crypto like this. A lot of very foolish stuff has been done in the name of digital assets and DeFi.
But, as per Hayek, we own up to our mistakes and get wiser in the process.
Lots of those mistakes were made in yield farming, but yield farming is hardly central to crypto anymore.
Some people got wildly rich farming in the summer of 2020, but those days are long gone (sadly).
And, anyway, we’ve gotten a lot wiser since.
There are now a number of legitimate use cases for the staking yields that crypto farmers collect.
And some of them are notably more sophisticated than what’s on offer in TradFi.
What’s at stake?
People have different definitions of “yield farming,” which can mean any or all of staking, liquidity providing, lending or borrowing.
The question put to SBF seemed to refer to liquidity providing, but his answer was a description of staking: Put crypto in a box in return for an IOU, and receive more IOUs as a “yield.”
This is the process that most often attracts Ponzi accusations, and that was indeed the hosts’ reaction to SBF’s box analogy.
Staking crypto is not, however, a Ponzi: You are not being paid with other people’s crypto to give the mistaken impression that an empty box is earning a yield.
You are being paid with either actual earnings or newly created crypto.
Either way, it’s not a Ponzi!
You may think the latter case is a distinction without a difference. (Other people’s crypto? New crypto? Who cares?)
But no crypto project is pretending to earn a yield when it’s not. If you’ve gotten that impression, it just means you’re too lazy to read the docs.
(Full disclosure: I’m usually too lazy to read the docs.)
If you were to read the docs for SBF’s box example, it wouldn’t seem to have much purpose.
The host pounced on this as if it was a big gotcha moment: “At no point did any of this require any sort of, like, economic case.”
SBF didn’t make the economic case because they didn’t ask him to!
They only asked for “an intuitive understanding” of farming.
So let’s make the case for staking here.
Playing the Long Game
There are two types of yield in crypto: Rewards and fees.
If a protocol that is not earning fees is paying out tokens, those tokens are rewards.
Why would a protocol not generating profits pay anything out to holders?
For starters, it may just be aspirational: The rewards yield is like a promise from the protocol to token holders that it will make a certain level of returns in the future.
Before scoffing, consider that this happens in TradFi, too!
When oil prices are depressed, for example, oil companies will often borrow money to pay out in dividends.
That has no economic utility other than the messaging from management to shareholders: We will make enough profit in the future to justify the dividends we’re paying now.
So, our rewards-paying crypto box is not any worse than what goes on in TradFi.
But we can do better than that: Crypto rewards often have more utility than cash dividends.
The primary difference is that rewards are paid only to stakers, rather than all token holders.
Typically, it’s only the free-floating supply of tokens that are eligible for staking: Founders, VCs and core devs will generally not be able to stake their still-restricted tokens.
Which means that staking can dilute insiders to the benefit of outsiders. (Not something you see in TradFi.)
The rewards process can also decentralize control of a protocol: Most protocols aspire to full decentralization, but, early on, they need decision-making to remain centralized. Staking allows a protocol to gradually decentralize.
In the case of a crypto box that is earning fees, staking doesn’t need much of an explainer — it’s just crypto’s method for distributing those fees.
Why not just pay the fees out to all holders, like with dividends?
For one thing, staking may be a regulatory arbitrage — a protocol that earns fees and pays them out like a dividend risks being declared an unregistered security by the SEC.
But it’s also a way to incentivize longer-term thinking: Staking allows protocols to pay more of their earnings out to long-term holders. Many protocols pay higher yields to stakers who agree to lock up their tokens for an extended period of time.
This, I think, is one of the best innovations in DeFi. Imagine if TradFi companies could pay higher dividend yields to their most loyal shareholders. I’m sure that would be a popular tool for CEOs — and potentially even a solution to the short-termism that corporate America is always accused of.
The Utility of Foolish Things
So that’s the case for staking. All of which I’m sure SBF would have explained on the podcast if he’d been asked.
Does that mean everything that goes on in crypto is economically sensible?
No! Plenty of foolish things are happening.
But even the very foolish things can have some utility: If nothing else, each foolish fail makes us all a bit wiser.
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