DeFi Yield Farming, Dug Deep
Can DeFi disrupt traditional finance? We don’t know that yet. But it’s a rapidly evolving financial system with new opportunities for crypto wealth generation.
No wonder many have cashed in with the hopes of striking it rich. At the time of writing this article, 1.8+ million users (unique addresses) are using DeFi. The total dollar value of all DeFi contracts was at an estimated 57+ billion. These are great numbers for something with negligible users four years ago!
With so much money rushing in, it’s not surprising to see strategies like yield farming gain a lot of buzz. However, many users treat it like betting on horses and risk losing everything. So it’s good to understand yield farming in detail.
But before we dig into yield farming, let’s take a quick look at a fundamental process called providing liquidity.
Most wealth in DeFi markets is created by providing liquidity, i.e., taking out cryptocurrencies you are holding in the wallet—to lend or deposit—making them available for financial transactions.
Lending cryptocurrency provides liquidity for transactions on DeFi Applications (dApps). For example, by lending some ETH, you can provide liquidity to facilitate transactions like DAI-ETH cryptocurrency swaps.
Decentralized Applications (dApps) are blockchain software that use smart contracts for transactions. A dApp that facilitates cryptocurrency exchanges is called Decentralized Exchange (DEX).
Since dApps use smart contracts for transactions, there’s scope to add complex rules. The relevant example here is liquidity pools.
A simple liquidity pool is a pair of tokens like USDC-ETH, DAI-USDC, or WBTC-ETH. Here you must provide liquidity for both cryptocurrencies of a token pair. Providing such liquidity is the basis of DeFi yield farming.
What is DeFi Yield Farming?
DeFi yield farming is a liquidity provisioning strategy with the intent to maximize earnings.
Liquidity pools, lending, and staking are a part of liquidity provision. While lending and staking have low risks and low rewards, liquidity pools have high risks and high rewards. So if you lend or stake, you are a liquidity provider but not necessarily a yield farmer.
With ou can farm many liquidity pools with high yield potential. And harvest the token pairs before their yields plummet. Thus, maximizing your earnings.
Yield
Yield means earnings generated over a period of time. But we like to think that yield in yield farming refers to growth.
Your earnings are not realized until you harvest. You can only estimate your farm’s present worth.
To get an idea of yield, you can look at the returns, pool share percent, swap trends, trade (swapping) fees, liquidity in the pool, the volume traded, incentives, and so on. Let’s look at a few of them.
Returns
Past returns of the liquidity pool, denoted as APR, APY, or RoI, indicates interest earnings for the specified time period on the dApp.
A DEX can mention APR for the past 24hours, 30 days, or a year. Or some aggregate metric like RoI which might give an impression that a pool is great for investment.
All DEXs have a different way of showing returns. While a few show annual return based on the past 24 hour data, others might show a fixed estimated returns based. There's no standard metric.
Because crypto markets are quite volatile, you can never fully trust past APR/APY to predict the future performance.
Pool Share
By providing liquidity to a pool, you get a pool share proportional to your contribution.
Whenever users swap tokens on the DEX, they pay a Liquidity Provider (LP) fee. The LP fee is distributed among the providers according to the pool share.
Say, your pool share for the ETH-DAI pool on Uniswap is 0.05%. Whenever users trade ETH for DAI on Uniswap, they pay 0.3% of the ETHs traded as LP's fee. You get 0.05% of that 0.3% LP fee.
So your pool share is a big factor for earnings. A large pool share might give you better yields. The pool's liquidity and token swap trends are also key metrics.
Incentive Tokens
Liquidity pools, especially those with new tokens, can offer incentives to LPs. Historically, incentive tokens haven't gained enough compared to popular tokens.
Yield Farming Risks
All crypto tokens have been super volatile in the short term. Albeit many tokens have soared in the past year. So you have the option to either gain just by holding tokens in your wallet (Hodl) or take the risk losing them in yield farming.
We’ll discuss a few yield farming risks to keep in mind:
Impermanent Loss
Impermanent loss is simply the difference of gain between investing in a liquidity pool and hodling in the wallet.
Let’s assume you provide 1 ETH and 2999 DAI to a pool with ETH valued at $3000 at the time. But the market price of ETH rises to $4000 the next day (and DAI is stagnant).
Real-world prices of tokens are different than those on a DEX. Due to constant price fluctuations, your DEX will correct the ETH price to match the market price on its exchange. And maintain the pool with equal dollar value of both tokens. In our case DAI and ETH. So the DEX will utilize your provided ETHs, decreasing the number of ETHs in your pool share and increasing the number of DAIs.
A liquidity pool will always maintain a balance of token value in the specified ratio; generally 50:50). So, for 50:50 liquidity pool of DAI-ETH, the value of all DAIs and all ETHs always maintain 50:50 ratio. But the number of DAI and ETH tokens in the pool can change.
Because of this, you now have 0.8 ETH. The value of your ETH in the pool is $3200, but it would have been $4000 if you held it in your wallet. You did gain $200 but lost the opportunity to gain $800 further. So, the more price rises, the larger the impermanent loss gets.
Impermanent loss is temporary if you don't remove the liquidity and the dollar price of ETH returns to $3000.
Impermanent loss doesn't account your earnings from APR/APY and LP fees.
Note that every DEX has its own formula to on how to utilize your provided tokens. So the impermanent loss varies on every DEX.
Fake Tokens
Anyone can create and name a token on Ethereum, including creating fake versions of existing tokens. Fake tokens might also claim to represent projects that do not have a token. You can use Etherscan to check a token’s integrity.
Smart Contract Bugs
Smart contract is a piece of software. And no software can escape bugs (or issues, glitches, crashes, etc). So, there's always a chance of bugs eating-up your farm.
Hacks and Heists
In 2020, about half of crypto hacks and heists were on DeFi. DeFi is a nascent tech with little to no customer verification requirements, unclear regulatory compliances, and unexplored weaknesses.
Sum-up
- Yield farming is a high-risk high-reward investment.
- You need to look at several metrics including ARP, liquidity, volume, and pool share.
- Due to the volatile nature of crypto markets, historical data cannot be fully relied upon.
- A massive token price increase will decrease your profit.
- DeFi, like every new tech, has technical risks.
- Beginners can first learn from investing in stablecoin pairs.
Two Cents
Yield farming shouldn’t reduce down to pump-and-dump schemes. If users abuse DeFi’s capabilities and create another bubble, the world might lose trust. A lot of belief is at stake!
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