May 31, 2022
So you have $100. What can you invest in? Part III: Yield Farming
7 min read
Traditional investments are passive. If you have stocks in a 401(k), you have an investment but you really can’t do much with the assets you’re holding and someone else often manages the contents. The only returns you gain are the increases in value of the asset when the asset is sold. Yield farming is much more dynamic. With yield farming, one earns a return on an asset without selling it. The classic example is a rental house. If you own a house worth $250,000 and rent it out for $500 a month, you are earning a return on your house without selling the house. If after five years the house has increased in value by 20%, then you have gained $50,000 in asset value. At the same time, you have earned $30,000 in rental income for a total return of 32%. And you can use the $30,000 for other purposes without needing to sell the house. Further, if home prices stayed steady, you would still have earned $30,000 (assuming rent prices didn’t change). In this way, yield not only increases returns, but it also acts as a hedge against potential losses. In traditional finance, wealthy clients had the opportunity to use their assets in precisely this way. Now, Fintech has delivered this possibility to all investors.
Lending is simply the process of letting someone use your assets, in this case cryptocurrencies, for a period of time in exchange for a fee. This is one of the main ways that banks make money: savers deposit their money in order to keep it safe and interact with the electronic banking system, and the banks lend it out to borrowers for interest. One used to earn a meaningful amount of interest on their deposits in banks, but those days are long gone now.
In the crypto markets, there are both centralized and decentralized lending programs. Programs like Blockfi, Celsius and Nexo are centralized programs that take deposits and then lend them out. You receive a set amount of return on your investment, but you take the risk that the lending institution isn’t worthy of their credit and ends up rehypothecating your deposit. The decentralized platforms like Aave, Maker and Compound are less centralized and generally do not require going through identity verification procedures. In each case, though, if you were going to own a cryptocurrency anyway, then lending it out may provide some extra return (sometimes quite considerable) at the cost of adding some counterparty or idiosyncratic risk to your portfolio. Defi-Rate lists the current percentage one can expect to receive across multiple platforms. For instance, USDT earns between 2.89% on Aave to 10% on Compound.
Staking is a simple yet profoundly important opportunity in the world of DeFi. While making money is still part of the goal, staking adds a new dimension of both owning and governing new projects. You are being invited to help build Web 3.0. There are a wide variety of staking mechanisms but generally speaking it is like lending in that one receives a return from the staked cryptocurrencies. However, in this case you are locking up your coins to act as a “validator”. You are making a significant contribution to different projects that help them operate. Often, though not invariably, your stakes are locked up for a period of time — the longer the lock up the higher the returns. This increases the risk because if your currency were to suddenly drop in value, you would not be able to sell that coin as it would be locked in the staking protocol. Your returns are generally paid in the staked coin but also often include a governance token as a reward for supporting a protocol — you earn a double return on your investment. How much that return will end up being valued is anybody’s guess. For instance, MakerDao is one of the most sophisticated communities that invites participation through staking and governance. In this way, you are not simply earning a return on your investment but actively participating in building Web 3.0 with the ability to make real decisions about how the projects operate. This is a huge difference from allowing a third party to manage your retirement account, which would generally invest in public companies over which you have no influence.
True Yield Farming
Now it gets really interesting as more complex investments have been created that introduce new mechanisms of generating a return by providing liquidity in AMMs (automated market makers), allow lending on margin, and more. Yield farming is somewhat complex and has a variety of risks. Where staking invites investors to participate in building new projects, these innovations reward investors who are able to navigate the multivariate sources of risk in order to provide liquidity to the rest of the ecosystem. Dapps like Curve allow you to earn returns by staking pairs of coins into liquidity pools. Being a liquidity provider in such a dApp will earn you some of the trading fees that the pool charges its customers. The amount of the fees you receive is proportional to the percentage of assets that you have contributed to the pool. Additionally in some cases, liquidity providers earn an extra return in the dApp’s native token. How much that native token will eventually be worth, of course, is anybody’s guess. Nonetheless, whereas simple lending might earn rates of 3–10%, yield farming one can earn easily in excess of 20%.
There is another type of risk that is important to understand in yield farming, known in the industry as “impermanent loss”, which is a terrible name because it very much could be permanent, and in most cases usually is. A better name for it would be what finance has been calling it for centuries: “unrealized loss”. In any case, the risk is in losing the value gained in one asset while you have it locked in the liquidity pool. If you have provided $50 of Ether and $50 of USDC to a liquidity pool and Ether increases in price, you generally do not gain the value of the increase in Ether; you are only entitled to the same $50-worth of Ether, which is going to be less Ether since it has gained in value. Not great. Additionally, however, you would receive the dApp’s native token that is paid as a reward for providing liquidity into the pool. Providing liquidity in these dApps is akin to selling a covered straddle and earning your premium partly in the assets traded in the pool and partly in some in the dApp’s platform token that may or may not ever be worth anything. In such a scenario, a liquidity provider is hoping that the relative value of the two assets they stake in the pool does not change very much while the speculative asset they are earning as an extra incentive increases in value as much as possible. How likely that is to happen, however, only you can judge.
Other dApps are also creating a myriad of possibilities to extend potential returns; increasing the risk, the complexity and the opportunity. Apricot finance allows users to borrow against their staked coins and thus create leverage — up to 3x. So, instead of farming $100 worth of tokens earning a 20% return, a user could leverage the same tokens and turn that into nearly 60% returns. Of course, the risks are quite high as a change in the value of one of the pool’s assets that you are staking may create a big problem for you since those tokens you are losing are not yours completely; you are borrowing some. This introduces the risk of possibly losing everything you have staked in the pool if your position becomes subject to liquidation due to market prices changing sufficiently. Nonetheless, whereas staking invites you to participate in creating and governing new projects, yield farming rewards those who can navigate a diverse set of tricky market risks. It’s all quite different from passively holding assets in a retirement account that is managed by someone else.
For once, technology seems to be delivering on the hype. Small investors now have the opportunity to participate in almost every traditional market. Investment is truly being democratized. Most importantly, where traditional investing has been largely passive and exclusive, you are now invited to help create, own and manage parts of this new world in an environment that encourages education and participation. A revolution indeed.