If this were a college Viva, I would have said that farming for more yield is called yield farming. Lucky for you, this isn’t one. So I am going to break down every piece of this seemingly complicated topic, in such a way, that you can become smarter version of yourself when you finish reading this. In this blogpost we talk about what is yield farming by comparing it with centralized finance, ways to yield farm and risks associated with it. Buckle up and let’s get started.
What is Yield and APY?
Breaking it down, yield is nothing but the return you get over a period by investing your assets. Often this is measured in APY or annual percentage yield. APY is the rate of return gained over the course of a year on a specific investment. Compounding interest, which is computed on a regular basis and applied to the amount, is factored into the APY.
What is Yield Farming? The CeFi Parlance:
Let’s take it from the top. It’s first day of the month and you get that sweet message of a salary credit in your account. Post that you take care of your rent, EMIs and basic living stuff. And if you are concerned about your future, you plan your investments with whatever is left.
At this point, you have multiple options to consider from. You carefully pick and chose whatever suits your risk profile and goals the best. Here’s what I am talking about:
- You could leave your money in the bank account to get a petty 3% return.
- Or, you could look for an FD that barely beats inflation.
- Alternatively, you could diversify amongst stocks, mutual funds, debt, equity, gold and all those fancy words.
In essence, what you just did was a smart allocation. You allocated your asset (money) into multiple avenues to pick and chose the one that works best for you.
Yield farming is no different. Just that instead of fiat money, your crypto is the asset here. Now instead of your crypto lying in your wallet, you could put that to work to earn some interest. The art of finding such avenues (more on it shortly) and deploying your cryptocurrency in it is called yield farming.
Yield is your interest measured in APY and farming is nothing the opportunity to grow that cryptocurrency.
With that being said, some of the yield farms are giving you an APY of up to 300%. Sounds like a scam right? Let’s explore more.
Methods of Yield Farming:
Just like in CeFi you have a bunch of ways to earn money using your money, same is the case with cryptocurrency. You can deploy your coins at best spots to earn more coins on the top of it. Let’s explore some methods.
A. Liquidity Providers:
All decentralized exchanges work on automated market maker model. This involves people locking in their funds with the exchange in something called liquidity pool and these people are called liquidity providers. Soon enough, traders come and exchange their cryptocurrency from that pool. When these traders come along, they have to pay a fees for exchanging their crypto. This fee is distributed amongst the liquidity providers.
We recently covered this topic in detail with mathematics so that you can understand how liquidity pools work. If you wish to dive in deeper, you can read that article here.
But this isn’t as easy money as one may think. Liquidity providers are exposed to something called impermanent loss. Which is nothing but the temporary loss you incurred by you by providing the liquidity (due to fluctuations in the price of the assets involved) as compared to simply holding that token. Once again, this is covered in detail here at pandatechie. Please use this link to delve deeper into impermanent loss.
B. Borrowing and Lending:
Borrowing and lending are the backbone of every strong economy. In traditional finance, this lending activity is primarily carried out by the banks by using the money deposited by people like you and me. They charge a certain % interest for this from the borrower and give it back to us by keeping a sizeable chunk for themselves.
B.1 Lending:
Imagine this in a DeFi ecosystem. You could now directly deposit your cash at a fixed APY and generate a passive source of income. This APY is listed on platforms like AAVE and Compound. Basis the crypto, it can be anything between 1% to 30%. Because our savings account could fetch us ~3.5% and stock markets could do ~12%, anything more than that becomes extremely juicy.
B.2 Borrowing:
Imagine that you have a heck of an investment opportunity at hand but you need capital to make it big. In a Centralized banking system, you can do this by borrowing money from the bank. For that you need a collateral and you decide to put your house on mortgage. You could use the value of your house while the house in itself is appreciating (hopefully).
Similarly, in the crypto ecosystem, if you are bullish on the prospects of a crypto and still want some capital for some other purpose, you could use that crypto as collateral and borrow. Later, you could pay the principal and interest and get back your (hopefully) appreciated crypto.
B.3 Leveraged Lending:
This is basically putting your lending ventures on steroids. So hear me out in this one. Imagine you have $100 worth of BAT. You can deposit it on a platform like AAVE or Compound and borrow $60 worth of a stablecoin like DAI against it.
Here comes the fun part. You now go to a third party exchange like CoinDCX and use this stable coin to buy $60 worth of BAT. And you put that BAT into the platform yet again. After doing this activity thrice, you end up with $200 worth of BAT which is yielding an APY of 30%. Please note that you only had $100 to start with.
While this sounds extremely lucrative but it can backfire if the price of BAT starts going down. This means the platform will automatically liquidate you if your collateral loses value.
C. Staking:
Oversimplified definition coming up: Staking is locking your coins into a protocol to become an active validator of transactions in order to get free coins for each successful validation. Staking requires some sort of technical knowhow and hardware in order to become a validating node.
However, platforms like Binance can do it on your behalf if you lock funds with them. I personally have staked my ETH for upcoming ETH2.0 launch next year. As you must be aware, Ethereum is moving from a proof of work to a proof of stake algorithm. Currently, there’s a 24% APY for staking your ETH.
If you are confused what a PoW and PoS consensus mechanisms are, here’s something that will clear your doubts.
Staking LP Tokens:
Some platforms incentivize the liquidity providers with their native tokens like UNI (Uniswap) or CAKE (Pancakeswap) for providing the liquidity. These tokens can be staked on their platforms to earn an additional APY on their investment. It is primarily done to discourage liquidity providers from taking out their money from the pool. Please note that these tokens like UNI or CAKE are inflationary and can be minted as per the discretion of the protocol. It is a double edged sword indeed.
D. Coins with Redistribution Fees:
I recently came across a token called the salvation coin. The tokenomics was rather interesting. They charge a flat 10% fee to transact the coin. This 10% is then redistributed as follows:
- 20% of it is donated to a NGO
- 50% of it is distributed amongst the token holders
- 30% of it is distributed amongst the hodlers.
There are more famous coins that work on a similar model. Ex. Safemoon is another cryptocurrency where 10% transaction fee is distributed amongst hodlers (5%) and burnt (5%). Needless to say that holding such tokens would yield additional crypto. However, that doesn’t mean the crypto you are getting in return cannot go to dogs. It is very much possible that your earned and principal crypto may lose its entire value.
Conclusion:
Transitioning from CeFi to DeFi has been an overwhelming experience for me. Although I have tried covered most of it, scouting for such opportunities is an endless endeavor. It is quite likely that I might have missed on to something.
What do you think? Do you have any such opportunities in mind?
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Until next time..
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