Examples in Traditional Finance

To compare yield farming to traditional finance, we can consider rates on traditional products like savings accounts or credit cards. Savvy users will often try to find the best savings account by considering the highest annualized percentage yield (APY) and the lowest fees. Similarly, a user may try and find the best credit card by looking for the highest rewards at the lowest cost. It would not be unusual for someone to open a new bank account or switch credit card providers if they can get better value elsewhere.

These simple comparisons demonstrate a common way of comparing financial products. These same considerations are the most common drivers of different yield farming strategies. 

With traditional savings accounts, you will typically encounter an APY less than 2% and at many banks less than 1%. However, yield farming offers determined users opportunities to increase return, and some strategies can even return greater than 100% APY.

Is 100% APY really possible? 

There are three factors that drive high returns available for yield farmers: liquidity mining, leverage, and risk. 

Liquidity mining issues new tokens to participating users.

Liquidity mining is a process of distributing tokens to the users of a protocol to incentivise participation. One of the first defi projects to introduce liquidity mining was Synthetix. Synthetix started rewarding users who added liquidity to the SETH/ETH pool on Uniswap with SNX tokens. Liquidity mining earns additional token rewards for yield farmers. These token rewards are generally earned in addition to interest from participating in a protocol. Depending on the protocol, the additional token incentives may be so significant that yield farmers are willing to forgo positive interest rates and accept losses on their deposits to get more rewards from distributed tokens. While complex, this strategy can be highly profitable.  

An example of liquidity mining is COMP tokens in the Compound protocol. Compound initially rewarded users who were borrowing assets with increased APY. This incentivized farmers to borrow assets because the value of minted COMP tokens compensated users for borrowing costs. As a result, COMP liquidity mining became popular and helped spark widespread interest in yield farming. 

Leveraging increases exposure for return on capital.

Leverage is another tool that makes high returns possible. Leveraging is a strategy that uses borrowed money to increase the potential return of an investment. In yield farming, farmers can deposit their cryptocurrencies as collateral to one of the lending protocols and borrow against them. Farmers can use the borrowed coins as further collateral and borrow even more coins. By repeating this procedure, farmers can increase their holding to be several times greater than their initial capital. By increasing the number of tokens at their disposal, farmers can increase their returns.

Risk is the cost of super high APY.

The third element that drives high APY for yield farmers is a risk. Yield farmers are often willing to take on risks that passive investors will not in order to maximize their potential for earnings. The first risk to consider is coming from leverage. While leverage increases exposure for profits, it also increases exposure for losses. Yield farmers often use overcollateralized loans meaning that collateral can be liquidated during market dips when the collateral value depreciates below a certain threshold. In addition to liquidation, yield farmers are also exposed to increased risk from smart contract bugs. By constantly moving their assets between protocols and smart contracts, yield farmers interact with more smart contracts than normal users and are statistically more likely to encounter bugs. Yield farmers are also more susceptible to platform changes, admin keys, and systemic risks. All of these risks create the potential for significant losses. However, those willing to take risks can reap lucrative rewards. It’s high risk and high-reward game.

Elements of a Yield Farming Strategy

A yield farming strategy is a set of steps to generate the maximum yield on capital. These steps include at least one of the following elements but more often a combination. Lending, borrowing, supplying capital to liquidity pools or staking LP tokens.

Lending protocols offer a simple way to generate a return.

Lending and Borrowing is a simple way of increasing APY on your capital. Farmers can lend their cryptocurrencies through one of many lending and borrowing platforms. When someone borrows the same assets from the protocol, borrowing fees will generate a return for the yield farmer. While this may sound simple, liquidity mining and leverage can supercharge returns from lending. First, farmers can use liquidity mining in their strategy by looking for lending protocols that offer rewards for lending out high-demand tokens. Next, farmers can use the rewards as collateral to borrow even more funds to lend out, allowing them to leverage their position and compound their earnings. Finally, yield farmers can repeat these three steps over and over, increasing their return each step.

By participating in liquidity pools, users can earn transaction costs.

Yield farmers can provide cryptocurrencies to liquidity pools in protocols like Uniswap balancer or curve. By depositing capital to these protocols, yield farmers provide the working capital for these projects to function. In exchange for capital, participants in liquidity pools are rewarded with fees generated by the protocol. Again, liquidity mining and leveraging can increase rewards for farmers. By supplying coins to high-demand liquidity pools, farmers may be rewarded with extra tokens. Balancer is an excellent example of a protocol that rewards liquidity pooled suppliers with additional Bal tokens, increasing APY.

Staking rewards users for participating in blockchain consensus.

In addition to the rewards mentioned above, some protocols incentivize users by issuing liquidity provider or “LP” tokens. LP tokens represent assets deposited in a protocol like a coat check ticket representing a coat deposited at a coat check. LP tokens can normally be staked to participate in the protocol governance and earn additional rewards. For example, Syntheticx, Ren, and Curve entered into a partnership where users who provide WBTC SBTC and Ren BTC to the curve BTC liquidity pool receive curve LP tokens as a reward. In addition, these tokens can be staked on Synthia Mintr, where farmers can earn CRV, BAL, SNX, and Ren tokens as rewards.  

Successful yield farmers mix all available strategies to maximize returns.

Many of these strategies can be combined to maximize yield farming returns. Because a successful yield farming strategy may become obsolete very quickly, farmers will actively mix and match depending on market conditions. A strategy that is super profitable right now may not be profitable tomorrow. If you want to be successful as a yield farmer, it is essential to keep an eye on your strategies and be ready to switch when necessary. 

Conclusion

Yield farming is a new and exciting way to generate returns, but it is far from efficient. Nevertheless, this creates an opportunity to obtain significantly higher returns on capital than the small returns promised by traditional finance or even centralized crypto finance. But, of course, this potential for gain is fraught with risks, many of which are likely still unknown.

High yield farming returns may help drive user adoption for blockchain by attracting more people to use defi protocols. However, it can also make life hard for casual users who are not interested in yield farming.

We want to extend credit to finematics. His Defi series offers a great introduction to Defi concepts and has inspired much of our own defi basics posts.