Yield farming: Turbo charging your crypto assets
It can’t be denied that yield farming is on the lips of most crypto holders. This innovative, yet risky way of leveraging crypto assets has seen investors score double to triple-digit returns in the past four years.
But what is yield farming? What platforms support the practice? And why are investors willing to put so much on the line? The answers to these questions and more on today’s episode.
Remember: All investing involves risk. The content of the podcast is for informational purposes only and is not investment advice. Please always use caution and diversify.
Hello and welcome to the 17th episode of Alternative Investing. I’m Trevor Kraus, Communications Manager at MyConstant.
In the world of decentralized finance there are constantly new innovations and ways to invest your money. And if you’re someone who just skims the headlines, you’ll hear about these innovations but you might not do the deepdive of investigative work.
So in this episode I’m going to discuss yield farming. Yield farming is sometimes called liquidity mining. And if you’ve read the headlines you’ll likely read that incredible returns can be made.
So what is yield farming? How did it begin? What are some examples of yield farming? And most importantly, what are the risks?
So let’s get a good definition first. Yield farming, in essence, is a way of trying to maximize a rate of return on capital by leveraging different DeFi protocols. Yield farmers try to chase the highest yield by switching between multiple different strategies, the most profitable strategies usually involve a few defi protocols like compound, curve, uniswap.
If the strategy doesn’t work anymore, or a better one becomes available, they move the funds around. They may for example move the funds between different protocols or swamp their coins to other ones that are currently generating more yield. This is called crop rotation.
Yields on decentralized platforms are mostly projected from recent market trends and could drop quickly. Some investors who call themselves yield farmers are constantly moving their money trying to generate income, but crypto transaction costs called “gas” fees can eat up profits.
Moreover, the cryptocurrencies these yields get paid in can fluctuate wildly in value. When Bitcoin slid as much as 10% on one recent day, popular DeFi coins such as Uniswap’s fell almost 20%.
If you compare this to traditional finance, it’s like someone looking for a savings account with the highest APY. APY standing for annual percentage yield. And it’s a common way to compare rates of return across different products. It’s also a common way of expressing the returns of different yield farming strategies.
Speaking of APY, it’s common to see traditional savings accounts hovering around 0.1% APY. Anything over 3% is almost unheard of nowadays — that is, unless you have your money in MyConstant’s instant access where it earns 4% APY. But I digress.
When it comes to Yield farming the returns that have been reported are up to 100% APY — which sounds wild. So, what’s the catch? How is this possible?
Well, there are three major elements that we need to look at: liquidity mining, leverage and risk.
Liquidity mining is a process of distributing tokens to the users of a protocol. On the first DeFi projects that introduced liquidity mining was synthetic. That started rewarding users that helped with adding liquidity with the SETH and ETH pool on Uniswap wis SNX tokens.
Liquidity mining creates additional incentives for yield farmers as the token rewards are added on top of the yield that is already generated by using a certain protocol.
Depending on the protocol, these incentives might be so strong that farmers might be willing to lose on their initial capital. Just to get more rewards in the distributed tokens which makes their overall strategy highly profitable.
A good example of this is the liquidity mining of comp tokens introduced by Compound that was initially giving higher rewards to the users who were borrowing assets with the highest APY. This incentivizes farmers to start borrowing this asset as the value of minted comp tokens was compensating them for the high borrow rates they had to pay. This got so popular it was the catalyst for a wider spread of yield farming.
Besides liquidity mining, leverage is another element that makes super high returns possible. Leverage is a strategy of using borrowed money to increase the potential return of an investment. Farmers can deposit their coins as collateral to one of lending protocols and borrow other coins.
Now they can use the borrowed coins as further collateral and borrow even more coins. By repeating the whole procedure, farmers can leverage their initial capital many times over and generate greater returns on their initial capital.
The last missing element of double or triple digit APYs are the high risk farmers are willing to take.
Mark Cuban, the billionaire owner of the Dallas Mavericks and an active crypto yield farmer, stated recently, “Yield farming is not much different than buying high-dividend paying stocks or high-yield unsecured debt or bonds,” “There is a reason they have to pay more than other companies. They are at greater risk.”
And he’s correct. When I just spoke about leverage, all the loans that farmers are taking are overcollateralized and supplied collateral is susceptible to liquidation if it drops below a certain threshold — that’s risky.
If this sounds familiar, we do the same thing on MyConstant. When you borrow money we take up to 200% in crypto-collateral. If the collateral falls below 100%, it’s liquidated to repay investors.
Beyond leverage, yield farmers face other pretty standard smart contracts risks such as smart contract bugs, platform changes, Admin keys and systemic risk. This could be Ether sharply losing it’s value.
Lastly, other than the smart contract risks, you have DeFi risks. This could be hackers, hacking their way into the liquidity pools and stealing the funds.
So all of these risks combined paint a picture of a high risk / high reward scenario.
Yield farming strategies are sets of steps that aim at generating high yield on capital. These steps usually include lending and borrowing, supplying capital to liquidity pools or staking LP (liquidity providers).
A simple strategy to get APY on your capital is done by putting up stablecoins like DAI or USDT on any lending platform and start getting a return on the capital.
This is actually a common strategy on MyConstant where customers can lend their coins from 4% APY up to 7% APR and can withdraw the principal and interest anytime.
Liquidity mining and leverage can supercharge this particular strategy. For example, farmers can get rewards with extra COMP tokens for lending and borrowing on Compound. They can also borrow funds with collateral to buy more coins. But remember, this comes with risk of liquidations.
Another strategy is supplying liquidity to liquidity pools. Yield farmers can supply coins to Uniswap, Balancer or Curve and get rewarded with fees that are charged for swapping different tokens. Balancer is a good example of a protocol that rewards LP suppliers with extra BAL tokens increasing their APY.
Staking LP tokens. Some protocols encourage users further by allowing them to stake their LP tokens that represent their participation in an LP pool. For example, Synthetix, ren and curve got into a partnership where users can provide WBTC, SBTC and RENBTC into the CURVE-BTC liquidity pool and receive curve LP tokens as a reward. These tokens can be staked on synthetix MINTR where farmers can be rewarded in REN, SNX and CRV tokens.
So one—at this point—if you’re not a crypto person you might be a little confused. So I’m not going to continue with the yield farming strategies, and Two, the other reason I won’t continue is that these strategies can become obsolete rather quickly.
For example, protocols or incentives can change. A strategy that is highly profitable today, might not be profitable next week.
But I think by now I’ve given you a clear picture of what yield farming is. So now, let’s take a look at some popular DeFi platforms that yield farms are heading to with their crypto.
If you type in yield farming or DeFi into your search engine, Yearn Finance will invariably show up.
Yearn Finance is an aggregator service that uses automation to allow them to maximize profits from yield farming. Yearn can also be seen as a decentralized group of aggregators that utilize lending services such as Fulcrum, DYDX and Compound.
As a group of protocols, Yearn Finance runs on the Ethereum blockchain and allows users to optimize their earnings on crypto assets through lending and trading services.
The main idea behind the Yearn Finance is to simplify decentralized finance investments such as yield farming. Instead of opting for a decentralized lending application where you deposit into a liquidity pool, Yearn Finance receives deposits and uses customized tools to act as an aggregator for DeFi protocols and brings huge yields to cryptocurrency traders and investors.
The value you gain from yield farming is one of the key factors you need to look at when investing in a DeFi platform. As of last month, the total value locked on Yearn.Finance has surpassed 5 billion USD.
Yield farmers are drawn to Yearn Finance because it’s easily accessible.
Accessibility is as important as the core features of a crypto project. When a crypto project is easily accessible, it draws in liquidity, which plays into its demand and supply dynamics.
Like everything else about this project, Yearn Finance is doing very well in terms of accessibility. One can buy Yearn Finance on pretty much all the significant exchanges ranging from Binance to Kraken.
Yearn is also pretty easy to store. You can store it in any of the major hardware wallets, or online hot wallets.
Yearn Finance tokens also give holders a voice in governance. The great thing of holding a governance token is that you always have a say in the direction of the project you’re invested in. In Yearn Finance, the token is not just an asset for speculation but is also a governance token.
The more tokens you have, the more say you have in the direction of the project. At any given time, if you are among the 33% of token holders that vote for a given proposal, you can be sure that it will go through.
Now let’s look at some of the downsides of Yearn Finance.
Unlike other DeFi coins that have more of its tokens left to mine, YFI has a current circulating supply of 36,635.44 which is the same as the total and maximum supply. This means that the laws of supply and demand cannot take hold of the cryptocurrency in the short or long term.
This means that it would take increased interest from other investors who would purchase YFI tokens from other holders at relatively higher prices to move its price to new milestones. In the long term, this does not bode well for the governance token that powers the Yearn Finance protocol.
Another popular DeFi platform is Uniswap. Uniswap is a trading protocol that leverages liquidity pools to facilitate the creation of unique markets for any pair of assets and employs an automated liquidity protocol as its trading model. Uniswap can also be referred to as a decentralized exchange known for playing the role of a facilitator in automated trading or decentralized finance tokens.
One of uniswaps benefits is its large capital assets. An asset’s market capitalization is highly important in determining its stability. A large-cap asset investment is defined as the value of a cryptocurrency that has a market capitalization of $10 billion or more.
This helps growth and value investors since the digital asset is less likely to come across a business or economic circumstance which can render it extinct or force the whole project out of operations completely.
Uniswaps coin, UNI, can be found on some of the top 10 cryptocurrency exchanges worldwide. This is important since these exchanges are trusted by millions of users who buy, sell, and hold digital assets for the long term.
One downside of Uniswap is that it is considered slow by many users.
Uniswap is a ERC20 token and this means it’s one of the applications running on the Ethereum network.
By default, it falls prey to all the features of the first-mover of smart contracts. Ethereum’s network 1.0 has a major problem and is related to the use of the proof-of-work (POW) algorithm. POW protects the blockchain from hackers but fails to make transactions move faster.
Compound Finance is a DeFi lending protocol. In more technical terms, it’s an algorithmic money market protocol. You could think of it as an open marketplace for money. It lets users deposit cryptocurrencies and earn interest, or borrow other crypto assets against them. It uses smart contracts that automate the storage and management of the capital being added to the platform.
Any user can connect to Compound and earn interest using a Web 3.0 wallet, such as Metamask. This is why Compound is a permissionless protocol. It means that anyone with a crypto wallet and an Internet connection can freely interact with it.
Why is Compound useful? Well, suppliers and borrowers don’t have to negotiate the terms as they would in a more traditional setting. Both sides interact directly with the protocol, which handles the collateral and interest rates. No counterparties hold funds, as the assets are held in smart contracts called liquidity pools.
The interest rates for supplying and borrowing on Compound are adjusted algorithmically. This means that the Compound protocol automatically adjusts them based on supply and demand. In addition, COMP token holders also have the power to make adjustments to interest rates.
What are the pros and cons of compound finance? Well, earning interest is a simple use case, and Compound’s user experience is quite beginner-friendly. But Compound can also be a good way for more advanced traders to increase leverage on a position.
For example, let’s say a trader is long ETH, and they supply that ETH to the Compound protocol. Then, they borrow USDT against the ETH they provided and buy more ETH with it. If the price of ETH goes up and the profits earned are more than the interest paid for borrowing, they make a profit.
However, this also increases the risks. If the ETH price goes down, they’ll still have to pay back the borrowed amount with interest, and the ETH they put up as collateral might get liquidated.
What are some of the other risks? Compound has been audited by firms such as Trail of Bits and OpenZeppelin. While these are generally considered reputable auditing firms, bugs and vulnerabilities can bring unexpected problems, and they are part of any software.
You should carefully consider all the risks before sending funds to a smart contract. But regardless of the type of financial product, you should never risk more funds than you can afford to lose.
So Uniswap, Yearn Finance and Compound Finance are all high risk / high return DeFi platforms. This is where MyConstant enters the picture.
On MyConstant we have a feature called Crypto Lend where you can lend your stablecoins out and while they’re on loan you earn 4% APY. Or if you lend our native token, PVR, you can earn 7% APR for however long it’s on loan.
When you submit your coins to Crypto Lend we’ll automatically distribute them among our DEX partners. All interest earned on transactions is sent directly to your balance and updated every second.
There’s no lock-up periods or extra fees (besides network costs for sending your crypto to us). And you can withdraw your crypto anytime.
Also, if you have cryptocurrency that you want to hold onto but you want to unlock it’s value in terms of receiving a loan in USD, you can borrow and use your cryopo as collateral. When you do this we store a portion of your crypto across various cold and hot wallets, keeping your crypto as safe as possible.
You might not make the double or triple digit returns on MyConstant’s but I would definitely say we’re a lower risk alternative to improving the value of your crypto.
So I think I can wrap things up by repeating that yield farming is the practice of staking or lending crypto assets in order to generate high returns or rewards in the form of additional cryptocurrency.
In short, yield farming protocols incentivize liquidity providers (LP) to stake or lock up their crypto assets in a smart contract-based liquidity pool. These incentives can be a percentage of transaction fees, interest from lenders or a governance token (see liquidity mining below).
These returns are expressed as an annual percentage yield (APY). As more investors add funds to the related liquidity pool, the value of the issued returns rise in value.
At first, most yield farmers staked well-known stablecoins USDT, DAI and USDC. However, the most popular DeFi protocols now operate on the Ethereum network and offer governance tokens for so-called liquidity mining.
While incredible returns can be made with yield farming, there are also significant risks.
Yield farming can be incredibly complex and carries significant financial risk for both borrowers and lenders. It is usually subject to high Ethereum gas fees, and only worthwhile if thousands of dollars are provided as capital. Users also run further risks of impermanent loss and price slippage when markets are volatile.
Most notably though, yield farming is susceptible to hacks and fraud due to possible vulnerabilities in the protocols’ smart contracts. These coding bugs can happen due to the fierce competition between protocols, where time is of the essence and new contracts and features are often unaudited or even copied from predecessors or competitors.
For example there was the Yam protocol which raised over $400m in days before a critical bug was exposed. And Harvest.Finance, which in October 2020 lost over $20 million in a liquidity hack.
So please be sure if you’re going to invest your crypto in yield farming, you don’t invest more than you can lose and you’re well aware of the risks at hand.
So I hope this episode sheds some light on yield farming and how it can work to your benefit. I know many people who hold onto their crypto and just don’t know what to do with it. Yield farming is a great way to make extra money that would otherwise collect dust in your digital wallet.
Thank you for listening today. If you have any question or topic suggestions that you would like to hear, definitely send me an email at [email protected].
You’ll hear from me again in another two weeks. Thank you for listening.
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