Yield Farming and Passive Income Strategies

Intro

Simply put, yield farming is the process of maximising your return on capital by using different DeFi protocols. The term “farming” is used to explain the possible growth you can achieve by finding the most optimised space, and “yield” is a financial term meaning what you’re giving for the investment. Let’s start with learning about DeFi Protocols.

DeFi Protocols

In traditional banking, APYs are usually around 0.1%, meaning you’ll get $1 for every $1000 invested. However, yield farming with DeFi protocols can increase as much as 100% APY. Some yield farming opportunities offer 3x of the amount you initially invested. For example, for every $1000 you invest, you’ll get $3000 annually. People try to find the best savings account with the highest APY. There are many different ways to get started in yield farming that will be elaborated on in the following.

Liquidity Mining

One of the earliest projects that introduced liquidity mining was Synthetix. Users can use SNX tokens to add liquidity to ETH/ SETH on Uniswap. Liquidity mining creates additional incentives for yield farmers, and the token rewards are also added to the yield that is already generated. In this strategy, investors supply coins and tokens to a decentralised exchange. In return, the exchange takes a minimal fee of the trades and allocates them to the liquidity providers.

What If There Are Many Trades?

If there are many trades and the investor is one of the very few investors, these fees add up and become a very high ROI (return on investment). For example, you want to invest $10’000 in ETH/ DAI in a pool in Uniswap. Since pools need to keep the 50:50 ratio of their assets, you supply $5000 worth of ETH and $5000 worth of DAI. Uniswap fees are usually around 0.3%, but they can range anywhere between 0.05% and 1% depending on the pair. Approximately $100’000 gets traded back and forth using the pool you’ve liquified, and each time a trade happens, Uniswap takes that 0.3% fee from the traders. It means $300 of fees were collected, and you earned $300 in one day with your investment. This page includes information on how much ROI you can get by providing liquidity in Uniswap. You can also provide liquidity for other DEXs like PancakeSwap (based on Binance Smart Chain) and QuickSwap (based on Polygon).

Leverage

You can perform this strategy using platforms like AAVE and Compound. In fact, Compound offered higher rewards to the users who borrowed assets with the highest APY. What you do with the strategy is that you basically borrow and reinvest your borrowings. For example, you put $100 worth of ETH and borrow $60 worth of DAI. Imagine the platform offers you 30% APR (stands for Annual Percentage Rate) for providing the Ethers, and you’re already earning something from them. But again, you take that $60 worth of DAI and convert it back to ETH using a DEX. Then you reinvest the ETH to the platform, making a total of $160 worth of ETH.

By repeating this process a few more times, you’ll have $200 worth of ETH locked in the platform with a 30% APR. Instead of the original $100, you’ll earn a 30% interest on $200. However, this strategy has its own risks. If the price of ETH falls, the platform might automatically sell your positions. It is called being liquidated, and it is to make sure the funder’s funds are covered.

Lending and Borrowing

Many lending and borrowing services offer rewards to lenders. The reward can go to 30% APR for specific coins, which is much higher than banks’ 0.5% APR.

It is also possible to earn interest by borrowing assets. Keep in mind that loans in crypto are always over-collateralised, meaning you need to put more than the amount you’re willing to borrow. It is to make sure the loan taker will not steal the assets they borrowed.

For example, you have $20,000 worth of Ethereum, you want to take out a loan but also don’t want to cash your assets out. In this case, you can borrow DAI, which is a stablecoin, and lock your Ethereum as collateral. You can borrow $10’000 worth of DAI on AAVE, and whenever you want to get back your Ethers, you pay back your $10’000 worth of DAI. By doing so, you won’t have to cash out your precious Ethers, but you still can use the value of your assets.

Staking

Staking is also a yield farming strategy. For example, Tezos offers around 6% APR, but you need the hardware to set up your own staking node. Other platforms like CoinBase offer staking options but keep in mind that they take a cut-off of that 6% fee.

Ethereum 2.0

A major change in Ethereum 2.0 is that Ethereum will use Proof-of-Stake instead of Proof-of-Work consensus mechanism. Miners do not have to push blocks forward; instead, they need to set up a staking node to keep participating in the network. Keep in mind that setting up a staking node is not easy for beginners.

Staking LP Tokens

When you provide liquidity, you receive LP tokens (Liquidity Provider tokens) from the DEX. By providing liquidity for Uniswap’s ETH/ DAI pool, you’ll receive assets named ETH/ DAI tokens, which are redeemable and also stakable on some platforms. Many platforms allow LPs to stake their LP tokens to incentivise them not to pull out the tokens they’ve provided for the pool. Also, some DEXs give LPs their native tokens like UNI, CAKE, etc., as their reward for staking LP tokens. However, these tokens’ prices tend to decrease since the DEX keeps making more of them.

Holding Assets With Redistribution Fees: The Example of SafeMoon

SafeMoon is a unique token; it is the first asset with redistribution fees. SAFEMOON has a 10% transaction fee, and half of that 10% is burned forever, while the other half is distributed evenly among all SAFEMOON holders. The burning should increase the price in theory, similar to what the process of Bitcoin halving is trying to achieve. However, it is somewhat of a risky investment, as it is the first player in this field, and no other coin with a transaction fee like this was created before. 

The Risks

Each strategy has its own gains and risks, some of which are as follows:

• Over-collateralisation: a risk of leverage is that all the loans the farmer is taking are over-collateralised, meaning they have to put in more assets than they're willing to borrow. The supplied collateral is susceptible to liquidation if the collateralisation ratio drops below a certain amount.
• Bugs and Changes: another risk involved in yield farming is smart contract bugs and platform changes. Since smart contracts are immutable, they cannot be changed once they are created. It means if there’s a bug in the initial code, the bug remains there and cannot be fixed.
• Attacks on liquidity pools: Such attacks are also considered a threat. A common way these attacks are performed is by making a vampire attack. The concept is pretty simple; you create the same protocol but with a more attractive and profitable mechanism. What it does is incentivising investors to take their assets off of a pool and bring it to the other, more profitable one. SushiSwap actually performed this on Uniswap.

Rug Pulls and Impermanent Loss: These two are other significant and well-known threats to your investments. A rug pull is when a developer runs away with the investors' money and ditches the project, and an impermanent loss happens when you provide liquidity to a liquidity pool, and the price of your deposited assets are decreased compared to when you haven’t invested your assets in a pool and just held them.

Outro

With high rewards come high risks, and as much as the rewards seem tempting, one should also consider the various risks involved before making any investment decisions. You should always consider your own financial situation and never invest more than you're willing to lose. We are no financial advisors, but at Cryptologi.st we educate you about different projects and strategies so you can weigh your options and remove emotions from your decisions.

To quickly compare available options and make the best investment decision, check out our website.