A Primer on Yield Farming

Yield Farming is a Risky Investment Strategy that Chases Yield Across Decentralized Finance (DeFi) Protocols

Yield farming is an investment strategy that cryptocurrency holders employ in which they use their crypto to make more crypto by earning interest, or being rewarded another type of token. The process involves lending or borrowing of crypto token on decentralized finance (DeFi) protocols and earn a return for their contributions. DeFi protocols are automated codes that provide peer-to-peer financial capabilities. Decentralized finance protocol are created enable financial transactions without a centralized authority such as a bank, exchange, or insurance company. For example, a decentralized finance lending protocol uses code written on a blockchain to enable cryptocurrency users to connect their cryptocurrency wallets and borrow/lend cryptocurrencies via a smart contract.

A simple way to understand how yield farming works is by taking an example of two decentralized exchanges (DEX) liquidity pools A and B. Let’s assume DEX A is offering 10% interest on ETH deposits and a 20% interest on BTC deposits, whereas DEX B is offering 20% on ETH deposits and 10% interest BTC deposits. An investor who holds BTC and ETH has the option to deposit in either of the two DEX, but they will deposit their BTC in DEX A and their ETH in DEX B. Over time, the yields could change and the investors might want to move their holdings from one DEX to another. Deposits into the DEX are done in cryptocurrency pairs, thus another cryptocurrency will have to be deposited along with BTC and ETH to make a cryptocurrency pair.

The yields being offered is a function of liquidity on the DeFi protocol. These DEXs have liquidity pools (LPs) that are used to support the protocol’s functionality for users (ability to exchange tokens on the DEX). Liquidity pools can be thought of as a large pile of crypto tokens in which many people contribute and their function is similar to those of market makers. One way to measure the liquidity of a protocol is the Total Value Locked, or TVL, which gives an idea of how much money have investors contributed to LPs. The higher it is, the more liquidity is available. At its peak, DeFi protocols had cumulative TVL of $107.5B on November 9th 2021, versus the present TVL of $41B. The yields being offered are ways to attract investors to contribute to the DeFi liquidity pool. Highly liquid pools will have lower yields, while low liquidity pools will offer higher yields. However, high returns also come with the high risk that the DeFi protocols are new projects that may fail to achieve their intended goals.

The lending and borrowing of tokens is handled by pieces of code called smart contracts that automate the financial agreement between two or more parties. As direct lending and borrowing poses a counterparty credit risk, decentralized platforms are involved in the process. Liquidity pools (LPs) in particular, help in the settlement process by providing liquidity for the tokens.

Yield Farmers Generate Returns by Providing Liquidity, Lending, Borrowing and Staking

The general principle of yield farming is to use the existing crypto tokens to make more crypto tokens. One such way is by providing liquidity to liquidity pools. An investor can deposit two different cryptocurrencies in a 1:1 ratio by value into an LP. In one common example, users will get liquidity pool tokens (LPTs) to confirm that they have contributed to the LP. The amount is locked for a pre-defined window in some DeFi protocols, while it is available for instant withdrawals in others. The investor can redeem the LPTs for their originally deposited tokens, plus a portion of the fees that the LP charged from the borrowers of the deposited tokens in the pool. For example, if an investor wants to put $10,000 in a LP hosted on Aave, a popular decentralized lending platform, they can take two tokens like BTC and USDT, worth $5,000 each and deposit them to the LP. Aave would then issue LPTs called aTokens (a stands for Aave), which in this case would be aBTC and aUSDT. After the lock-in period is over, which can be anywhere between a few days to a few months, the investor may choose to let his/her BTC and USDT remain in the LP, or redeem them in exchange for the aTokens and also get some extra BTC and USDT in proportion of the fees earned. Some DeFi protocols also give their native tokens as rewards which could become valuable if they are widely adopted in the future.

While LPs are the most common way of yield farming, lending and borrowing is another way in which investors can borrow low yielding cryptocurrencies and lend the borrowed currency at a different protocol at a higher rate. LPs can also be used for such borrowing and lending, though most crypto borrowings have to be overcollateralized. Some DeFi platforms that allow borrowing and lending are Compound and Aave.

Lastly, staking is another way to generate returns. In staking, an investor can commit their crypto tokens to a Proof-of-Stake blockchain network and participate in verification of transaction on the network. Investors earn interest on the crypto that they pledge to the network. One such example is the Ethereum blockchain on which investors can commit their ETH2 to earn extra ETH2.

Some Risks Associated with Yield Farming Includes Hacking, Impermanent Loss and Regulatory Risk

Yield farming comes with many risks as well. One key risk is the risk of a hack of DeFi protocol as a result of vulnerabilities in the computer code. Since DeFi protocols are essentially pieces of code, they are vulnerable to hacks. Once hacked, not only cryptocurrencies can be siphoned off from the platform, but the loss of confidence in the project could lead to DeFi participants to take out their crypto from it and the project could eventually shut down. Volatility of cryptocurrency is another cause of concern for those who have locked in their tokens in DeFi ecosystems, as investors may be unable to exit their positions to make a large profit or avoid a large loss. This can lead to an impermanent loss, which is the unrealized loss in the crypto position because of the asset being locked, as compared to the asset being available for trading. Regulations around digital assets is constantly evolving, thus there is uncertainty as to how DeFi ecosystems could be affected moving forward, in light of the recent crypto downturn.

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chainalpha

Fundamental analysis on cryptocurrencies, digital assets and blockchain enabled financial products