The Crypto market is in a bearish cycle. There are now no two ways about it.
$BTC is down more than 60% & most of your favorite altcoins have had a 90% drawdown from peak levels.
However, that doesn’t mean that you as an investor should lose hope, pack up and go home. Bear markets are great to accumulate & prepare for the next bull cycle.
One such strategy is yield farming, and I decided to write a beginner’s guide to educate all of you on how you can profit from this.
1. What is Yield Farming?
Yield farming is a collection of strategies used in decentralized finance (DeFi) that create more cryptocurrency from your existing holdings.
This is a return maximization strategy that aims to enhance yield.
2. What are the Various Yield Farming Strategies?
There are primarily three yield farming strategies:
- Liquidity Providers
- Lending
- Borrowing
2.1. Liquidity Providers
Every time you interact with a decentralized exchange (DEX) you are assured that the coin you want to swap into shall have a ready counterparty on the other side willing to sell.
This is ensured by the DEX through the use of liquidity pools, where holders of various cryptocurrencies lock their holdings and earn passive income in return.
So, for example, a $DOT liquidity pool would have holders contributing their holdings of $DOT & a counter asset, say $USDT, to the pool to facilitate trading on a DEX. In return, the liquidity provider shall earn a percentage of the trading fee, which may be paid in a third cryptocurrency or new LP Tokens.
2.2 Lending
This is fairly simple. As a holder of a cryptocurrency, say $ATOM, you lend your holdings to borrowers through a smart contract and earn interest. The interest may be paid in $ATOM or a third cryptocurrency.
2.3. Borrowing
This is also a fairly simple strategy. As a holder of a cryptocurrency, say $LINK, you deposit your holdings with a platform through a smart contract. You then borrow another cryptocurrency, say $ETH, using your $LINK holdings as collateral.
The subsequent increase in the price of $LINK will continue to benefit you whereas you may farm the borrowed $ETH for additional yield by providing liquidity or lending to earn interest.
3. Yield Farming in Action
A typical yield farming strategy may involve one or more of the aforesaid strategies used in conjunction. Let’s try and work through an example below:
To recap, Mario has borrowed $USDT against his $ETH holdings at 7% and used the borrowed cryptocurrency to earn additional LP tokens by locking them up in a liquidity pool at 15%. HE trades these LP tokens for $USDT which he uses to buy more $ETH. However, is the strategy profitable?
Let’s run a few scenarios assuming a year has passed. Also, we assume that LP tokens are issued and interest is due at the end of one year. Mind you, this is a simplistic assumption as this is done on a daily basis.
3.1. $ETH Price Falls to $1,500:
- The initial investment is now worth USD 1,500.
- The $USDT borrowed has an interest due of $USDT 140.
- However, the LP Tokens for $USDT has generated an additional return of $USDT 300.
- After accounting for the interest, the $USDT 160 worth of LP Tokens are used to buy $ETH at an average price of USD 1,500 = 0.11 $ETH
- The net result is that Mario’s $ETH holding has now increased to 1.11 ETH at an average price of USD 1800.
- Effectively, despite the bear market, without spending a single dime, Mario has averaged down on his cost basis.
- Important! – with the cost of the $USDT loan unchanged, it is highly likely that we will never get to the one-year anniversary as the protocol may liquidate the position leaving Mario with $USDT holdings only.
3.2. $ETH Price Increases to $2,500:
- The initial investment is now worth USD 2,500.
- The $USDT borrowed has an interest due of $USDT 140.
- However, the LP Tokens for $USDT have generated an additional return of $USDT 300.
- After accounting for the interest, the $USDT 160 worth of LP Tokens are used to buy $ETH at a price of USD 2,500 = 0.064 $ETH
- The net result is that Mario’s $ETH holding has now increased to 1.064 ETH at an average price of USD 1,879.
- Effectively, he has lowered his cost basis and earned an extra USD 121.
4. Risks of Yield Farming
Our simplistic examples highlight how in each scenario our protagonist, Mario, is able to reduce cost or increase his overall profitability on the $ETH trade. That being said, yield farming has its share of risks.
- Regulatory Risk: In most jurisdictions where Crypto has been allowed as an asset class, there still exists a lot of uncertainty on the status of DeFi. Effectively, while decentralized and technically immune to Government action, these platforms are acting as financial intermediaries between borrowers and lenders. Such intermediation is generally regulated and any untoward Government action may negatively impact DeFi protocols at least temporarily.
- Cyber Attacks – Given the large volume of holdings locked up on DeFi protocols, they are a prime target for hackers. Numerous cases in the past 2 years are evidence of this. If the protocol is unable to recover the stolen funds, you may be at risk of having lost your locked funds.
- Rug Pulls – This is a situation where a DeFi protocol attracts users to lock up their holdings on their platform. This attraction is created often with the promise of higher than average returns with the protocol owner then proceeds to run away. Given the decentralized and unregulated nature of the DeFi sector, this is a huge risk.
5. Concluding Note
Yield farming is an interesting proposition to utilize your idle crypto assets to generate additional returns. In a down-trending market, it could also help you average down without spending more capital.
However, the DeFi sector is prone to certain risks that a prospective yield farmer should be cognizant of.
The volatility in Crypto markets means that our simplistic examples may not always hold & rates of return, which are a function of demand and supply, may change adversely.