By Teodors Muzis & Raimonds Gorenko
Yield farming is the process of staking cryptocurrency to generate returns or rewards in the form of additional cryptocurrency. It is one of the applications of decentralized finance (DeFi), which will be the focus of this article.
One of the most exciting prospects is that DeFi platforms offer much higher interest rates through yield farming in comparison to traditional banks. Because yield farming is closely tied to liquidity pools, we must first explore them and answer – what exactly is a liquidity pool?
DeFi is fundamentally about removing intermediaries in financial transactions and enabling trading without needing a central exchange that provides liquidity. In traditional finance, a central body, for instance, a bank would receive deposits that would provide liquidity for the market. DeFi is governed by the smart contract, which connects system users and accomplishes this task with no middleman – a stark contrast to traditional financial system.
Liquidity pools consist of tokens locked in a smart contract. The role of locked tokens is to provide the liquidity of the market to ensure trading can take place. Liquidity is important as it dictates the price changes of a token. If it is low, a token is extremely volatile with even a single small trade having a significant price impact of 10% or more. Liquidity pools are a contrast to traditional financial markets, with pricing algorithms (Automated Market Makers – AMMs) replacing order books. And with no identification or deposits needed, decentralised exchanges offer a very convenient way of swapping tokens. The industry has experienced rapid growth since its inception in 2019, and the total market cap of DeFi now exceeds $80 billion according to CoinMarketCap. Analytics site DeFi Pulse has gathered data about top 10 protocols with highest Total Value Locked (TVL) – value of tokens locked in all the liquidity pools of a specific decentralized finance protocol. The two biggest – Aave and Maker – both have more than $9 billion locked in liquidity pools (see the table below), giving a good idea about the popularity of the pool.
More risky options even exceed APY’s of 1000%. You might be wondering what the drawbacks of yield farming are and how an APY of over 1000% is sustainable. This is, in fact, not meant to be sustainable and is a temporary opportunity. When an APY is extremely high (occasionally APY of even 10 000% or nearly 30% a day can be seen), it means there is a serious incentive to distribute the tokens, likely to launch the specific project. For example, some projects state in their roadmap that 10% of total token supply is to be distributed to liquidity providers in the first month. After this period ends, the APY rapidly drops as there is no strong incentive to continue the rewards.It’s very important to incentivize users to deposit their tokens in the liquidity pool. One way is by offering different benefits to these liquidity providers. Most often that includes distributing tokens. Let’s take an example. If the trading fee in a decentralized exchange would be set at 0.2% and you provided 0.1% of all the liquidity, you would collect 0.1% of the 0.2% trading fee for every trade. In a popular pool with active trading, APY’s of more than 20-30% can be achieved this way. Or, in popular crypto vocabulary, a yield of 20-30% farmed. Additional liquidity mining rewards can be offered, to further incentivize users to provide liquidity. For instance, Uniswap used to offer Uniswap tokens in addition to fees earned. These tokens could be sold or further staked for additional rewards on other platforms. This is compound interest at work. On an average savings account hardly any interest is earned but with lucrative returns on Defi platforms, this effect is strongly felt.
Yield farming is not risk free and one needs to take on significant risks to obtain the higher yields available. Some of the risks involved in yield farming are:
- Impermanent loss
- Price drops
- Liquidity pool hacks
- Issues with smart contract
- Liquidation (if tokens are borrowed against a volatile collateral)
- Stable coins losing their pegs
We will briefly look at the first three mentioned in the list as these are the most common risks associated with yield farming.
Impermanent loss is a loss occurred due to large differences in the price of the tokens in a trading pair due to high price volatility. For example, if the value of one asset in the pair goes up by 500%, a 25% impermanent loss would be experienced. Similarly, a drop in value for one of the tokens will lead to a sharp impermanent loss (see the chart below). Impermanent loss is the difference in your token value in the liquidity pool and what they would be worth if you simply held the tokens in your wallet, hence the share of trading pool fees and/or tokens must be offered to incentivize provision of liquidity.
Often rewards are paid in extremely volatile tokens that may lose as much as 90% of value in a day due to sharp increase of the supply and as a result you may see a lucrative return turn into dust in a matter of hours as many users are selling the farmed tokens. Let’s use GatorSwap as an example. The token price sharply increased from a few dollars after initial announcement of the project and issuance of limited supply of the tokens to over $700 as buyers were incentivized to capture huge APY’s, ranging as much as 80% a day. After the yield farming started, farmers were quick to sell their farmed GatorSwap tokens, which made the value of the coin plummet in a matter of hours to under $1 and it now stands at around $0.02. Despite the yields being outrageously high, the price drop made profiting almost impossible and impermanent loss devastated the initial investment.
Possibly the best way to mitigate risk of impermanent loss is the use of stable coins or single pool tokens. By definition, as long as stable coins maintain the peg, the price doesn’t change. The downside is APY being significantly lower, although still magnitudes higher than on a savings account. And still some very lucrative APY’s staking stable coins can still be found. For example, at the time of writing his article, on the rapidly growing Polygon network Polycat Finance protocol offers to stake two stable coins (Tether and USD Coin) for a yearly APR of 120.27% and 111.51% respectively, which turns into APY of 232.27% and 204.47% if daily compounding is included. Though a deposit fee of 4% must be considered for short
term farmers, meaning it would take around 2 weeks to cover it before receiving profit.
Lastly, rug pull is an outright scam when liquidity pool creators maintain an access to the pool and steal user’s money by withdrawing liquidity or dumping tokens – project owner premines tokens cheaply for himself and then dumps them on the liquidity providers. This is a result of lack of audits and how easy it is to create new tokens with open-source protocols like Ethereum. This is one of the reasons reputable pools often have a lockup period during which funds can’t be withdrawn.
As discussed, yield farming is a high risk-high reward trade. DeFi allows users to greatly benefit from compounding interest to earn from tokens that would otherwise sit in your wallet. But significant price fluctuations in a pair of tokens can wipe out your initial investment and instability of APY’s means a very short-term view. It’s important to consider how popular the liquidity pool is as more trades taking place results in higher earnings from fees. More risk averse individuals should make sure the platform is audited, possibly stake just stable coins and consider only providing tokens if they are confident in price stability and the project.
This article is not an investment advice and should only be used for educational purposes. Always do your own research, consider the risks and only invest what you can afford to lose.
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Charts and graphs:
Defi Pulse (2021, June). DeFi protocols by TLV. [Data renewed every day] Retrieved June 1, 2021, from https://defipulse.com/
Finematics (2020, Aug 21). Losses to liquidity providers due to price variation. Retrieved May 19, 2021, from https://finematics.com/impermanent-loss-explained/
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PolycatFinance (2021, June). USDT and USDC Pools. [Data renewed once every few minutes] Retrieved June 2, 2021, from https://polycat.finance/pools
PooCoin Charts (2021, Jun 1). GatorSwap token chart Retrieved June 1, 2021, from https://poocoin.app/tokens/0x88371dec00bc3543231e01089c3dc6d94289d4af
OOBIT (2020, Aug 12). What Is Yield Farming, The Hottest New Thing In DeFi? Retrieved May 23, 2021, from https://www.oobit.com/blog/what-is-yield-farming-the-hottest-new-thing-in-defi/
 Stable coin is meant to hold the same value as the United states dollar