Yield Farming 101: +100% APY on DeFi?

Over the last year, yield farming has become an unstoppable force in DeFi. Early investors generated a +100% APY (Annual Percentage Yield).

Not from crazy trading tactics, but idle crypto.

That’s like opening a savings account and it doubles every year.

Something you can’t find on any bank, and something you’ll only see in DeFi. 

Too good to be true?

In 2020 alone, the DeFi sector increased its market cap to $10 billion. $9.5 billion came from yield farming. You know investors are making big bucks when the market grows by 20x in one year.

So what’s yield farming, and why is it suddenly everywhere?

What’s Yield Farming?

Even when it’s popular, not many know what it actually means. Because yield farming is any strategy that allows you to profit from idle currency. Any tactic that generates passive crypto can fit in this definition.

Specifically, the yield is what you get from your investment. It could be interest, protocol rewards, or transaction fees. 

Farming suggests the exponential growth you can achieve by leveraging liquidity.

So how does it make you money?

Imagine that for every $100 you lend of ETH you get an annual $30 of interest (30%). A yield farming platform may allow you to leverage another $200 ($300 total). 30% of $300 is $100 interest per year earned from your $100 loan.

Of course, there’s risk involved. If it were that easy, everyone would do it (and banks would close). The risks include price variation, impermanent loss, and liquidation risk (more on that later).

Without risk, it wouldn’t be profitable.

How profitable is yield farming?

You earn APY for providing liquidity to decentralized platforms. Your APY decreases as new investors add more liquidity, regardless of your strategy. Adding $1,000 to a $10,000 pool isn’t worth the same as investing in a $10-million pool.

Profitable strategies lose efficiency as more people practice them. 

Even with few investors, profiting from yield farms is risky. And while it sounds like passive income, it can take hours of research to manage risk. Just like crypto trading.

You may wonder: which one is better, trading or yield farming?

Trading (aka arbitrage) makes you money on price differences. Because yield farming involves lending for liquidity, you profit the most when prices stay the same

Rule of thumb:

  • If tokens prices go up/down = trading
  • If token prices go sideways = yield farming

While you won’t earn as much as in the early days, you can still get close to 100% APY with the right strategy.

How Yield Farming Works

Unlike centralized exchanges, DEXs require liquidity pools to exchange tokens, borrow, and lend. When you lend crypto to these platforms, you become a yield farmer. You can earn money via liquidity mining, leveraged lending, and staking.

Note (About Crypto Taxation):

  • Taxation (CGT) applies mostly to capital gains/losses. Every time you trade a coin, you record the transaction (even if you didn’t sell for USDT). The capital gain is calculated based on the USDT value of the tokens at the time of the transaction. 
  • Similar discounts apply as with other securities (0% capital gains for long-term investments). 
  • All the exchanges where you passed KYC are taxable. And while DEXs don’t require this step, the governments could potentially track them too. 
  • Cryptocurrencies may become tax-exempt when used on personal spending (goods & services) rather than investing.
  • Yield farming rewards may be taxable when you sell for USDT or when send them to a KYC-verified exchange

Liquidity Mining

Liquidity pools allow investors to trade tokens at any price (for a cost), even if there isn’t a buyer. To achieve this, most pools require a 50/50 token split. If you want to invest $1000 in an ETH – USDT pair, you must add $500 worth each.

As traders use the pool’s liquidity, yield farmers earn APY, transaction fees, and token rewards. 

Suppose you invest $1000 in a DEX pool with $9000 (10% of total). Today, the trading volume was $100,000, and the platform charged 1% in transaction fees ($1000). Because you contributed 10%, you earn $100 in fees.

For extra incentive, you mint free liquidity pool (LP) tokens when adding funds to the pool. Because LP tokens represent your contribution, you would generate 10% of the token supply. You can trade them for other cryptos, or you can keep them to earn transaction fees. 

Aka Liquidity Mining

Liquidity Mining Platforms:  Any decentralized exchange like Uniswap, Balancer, or Yiern Finance

Leveraged Lending

Decentralized lenders allow you to take over collateralized loans. So if you want to borrow $60 of token B, you must first lend $100 of token A. This relation protects lenders and makes higher APY possible.

Leveraged lending happens when you reinvest what you borrow into the lent token. It multiplies your APY at the risk of increasing your debt. But as long as prices don’t change, it’s effective:

Imagine you lend $100 ETH and can borrow up to $60 USDT. What if you borrow, convert USDT to ETH, and lend it? You lent $160 ETH and can now borrow $96 ($60+60%). 

If you keep doing it, you get around 3x leverage (1 ETH and 2 ETH worth of USDT). You can now yield 3X APY. And as long as prices stay the same, you profit.

What happens if ETH prices double? You then have 1 ETH and 1 ETH worth of USDT (2 total). And because you still owe 2 ETH, the smart contract may liquidate your debt and leave you at zero.

What happens if ETH prices halve? You still owe 2 ETH. But when you withdraw, you lose money on depreciation.

Liquidity Mining Platforms:  Decentralized lending platforms like Aave, Compound, MakerDAO

Staking

Staking allows you to earn cryptocurrency by locking it for X months. The amount you provide will help secure the network, and the longer you freeze it, the more you can stake (average 10% APY). And while you sometimes find rates like 20% per month, remember that these change every day.

The annual interest reduces when more people start staking. Like liquidity pools. The bonus is, you can stake LP tokens earned from the pools. Free tokens generate interest with a chance to rise in price.

When compared to the others, staking becomes the safest yield farming strategy.

Liquidity Mining Platforms:  Any regulated exchange like Binance, Coinbase, or Kraken

Yield Farming Risks

While yield farming sounds brilliant, it doesn’t mean much if you can’t manage the risks. Trading might be all about price. But yield farming introduces new risks that make it both unpredictable and unsustainable:

Rug Pulls

Just because yield farming makes crazy money, that doesn’t mean that *every project will profit. When everybody is making 100% API, it feels like you can profit from anything. And that’s how scammers hide in plain sight:

a. The founders exit the company once they gather enough investors

b. The founders leveraged investors’ money for free

c. The founders mint infinite tokens and sell them

Because of these exit strategies, the program will lure you to hold for as long as possible. As soon as you start withdrawing, you run into delays, failed transactions, and website shutdowns.

How To Avoid: Document about projects

Good financial decisions come from market research. You can’t manage risk if you don’t find enough data about a project:

  • Platforms with no history
  • Tokens with market caps below $5 million
  • Projects without active teams/communities

Since yield farming is already risky, you can’t afford to miss these red flags.

Smart Contract Exploits

The same smart contracts that make farming possible can lose all your money. Because anything coded by humans will likely have errors or unexpected functions. Almost every year, DeFi hackers appear on the news with yet another “infinite money glitch.”

Because all they need to break in is a bit of luck and motivation (your money). When they do, you’ll be unable to withdraw money from your exchange. And if you have a hot wallet (e.g., Metamask) linked to a DEX, you may find a zero balance.

How To Avoid: Protect your wallets

It’s too much of a risk when trading large amounts. If hackers have attacked your platform in the past, you might want to choose one with better history. If you find a new exchange with better returns, you are exposed to the same risk.

If you don’t want to lose money on a contract exploit, you can get insurance. Platforms like Nexus Mutual can cover large amounts for a fee (e.g., 0.0259 ETH for 1 ETH protected 1 year).

What about the money you keep outside farming platforms? If you connected your Web3 wallet to the site, hackers can still access your funds. To prevent this, switch from hot Web3 wallets to hardware wallets.

You can connect a Ledger wallet to Metamask and trade as usual. Once you disconnect the device, nobody can access those funds. 

Automatic Liquidation

In leveraged yield farming, you can only borrow up to a certain proportion of what you lend (usually 60 to 80%). Once your position value falls below this limit, smart contracts will automatically sell your position. Even if it’s a price spike that lasted a few hours, that will trigger liquidation.

Knowing how volatile crypto is, this happens more often than you think. And the more you leverage, the worse it gets.

Example:

  • 1 ETH costs 100 USDT
  • A collateral factor of 70%: borrow $70 for every $100 lent
  • Liquidation limit of 70%: if borrow $100 and later it’s worth <$70, it immediately deducts $100 from your collateral

Suppose you lend 10 ETH, which allows you to borrow 7 ETH worth of another token (e.g., USDT). With the leveraged yield farming strategy, you can leverage up to ~215% (2X for simplicity) with this collateral factor. You have 30 ETH priced at 100 USDT each: 10 from your collateral and 20 from leveraged debt.

Suppose the ETH price doubles.

The USDT you borrowed can now buy 10 ETH, not 20. Your position goes from 30 to 20 ETH. And because that’s below the 70% liquidation limit (21 ETH), you liquidate 20 ETH and end with 0 ETH.

You risk liquidating your position when:

a. Your collateral token appreciates

b. Your borrowed token depreciates

How To Avoid: Find correlated tokens

While stablecoins suggest stability, that’s not the case when yield farming. One-stablecoin pairs (ETH – USDT) are riskier than altcoin pairs (e.g., ETH – TRX). And two-stablecoin pairs (USDT – DAI) don’t offer enough APY.

Correlated tokens, however, can change prices with minimal liquidation risk. For example, Litecoin has always cost around 0.06 Ethereum because ETH and LTC are 95% correlated. The only time these proportions change is whenever one of both changes the fundamentals (e.g., the launch of ETH 2.0.).

It’s easier to watch two projects closely than understanding the entire market.

Impermanent Loss

We call impermanent loss to the difference you would earn holding your cryptos compared to liquidity mining. The greater the price change, the greater the loss. But when prices bounce back to normal, the loss doesn’t realize (hence why it’s “Impermanent”).

Imagine you own $500 of token A ($1) and $500 of token B ($1). If token A appreciates 400% ($4), your $1000 turns into $2500 just from holding them. But that’s not the case with liquidity mining.

Suppose you join a 50-50 pool, offering the same 500 tokens at $1 each. When token A goes from $1 to $4, traders will buy your $1 tokens to sell them higher for $4 exchanges. As they keep buying, each token costs more until pool tokens cost the same as exchange tokens.

When that happens, the pool’s proportion may go from 500($1) – 500($1) to 250($4) – 1000($1).

250 tokens at $4 plus 1000 at $1 make $2000. Compared to the $2500 from holding, you face a $500 impermanent loss.

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Suppose token A goes back to $1. Traders would start selling them to your pool until they’re worth $1 too. The pool goes back to 500 – 500, and you cancel your impermanent loss. 

How To Avoid: Join “irregular” liquidity pools

As in the example, most pools are 50/50. But if you know the first token will go up in price, why not allocate 80/20 or 95/5? Imagine getting 1000 ($4) – 250 ($1) instead of 250 ($4) – 1000 ($1).

If you believe token A will appreciate, use irregular pools to add more weight. You can find these on platforms like Balancer.

Is Yield Farming For You?

You make the most money when investing in what you know. Yield farming can generate passive income. But the farming strategy has more to do with risk management than maximizing profits.

If you’re looking for low risk, staking is the place to start. If you don’t mind taking more risks, consider leveraged lending. You can also choose liquidity mining for a higher yield variety (interest, fees, tokens). 

Depending on the market trend, some strategies work better than others. So the more you test the more chances you have to profit from yield farming.

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