Yield Farming
Note: Data in this section last updated March 13th, 2022
Tokens don’t offer dividends and few banks will let you put them in your savings account. So what’s an investor seeking passive returns to do?
As usual, the DeFi community has created their own unique ways of earning interest, and they call these strategies “yield farming”.
Four of the most popular strategies include:
Staking
Lending
Liquidity Mining
Incentive Programs
Airdrop Farming
What is Staking?
Many modern blockchains use a system known as “Proof of Stake” to maintain security. In this system, “validators” (who are effectively auditors) verify transactions, review data and confirm what needs to be added to the ledger. Validators receive rewards for doing this, but they must also put up collateral that may be seized if they are malicious or negligent. The act of putting up collateral is known as “staking”, and if a Validator is competent and honest, it’s a relatively risk-free way to earn interest on crypto
While running a validator node is generally way too complicated for the average user, there are many services such as Coinbase, Binance and Lido that allow users to lend their crypto to Validators for a piece of the fees.
Staking is generally considered the safest method of Yield Farming and rates generally range from 5% to 20% for established projects (and can exceed 50% for riskier projects).
How is Lending Used in Yield Farming?
Despite having different mechanics, the results of lending crypto are similar in both the CeFi and DeFi worlds - you lend someone money and they pay you back with interest.
What is dramatically different is the rates. While a traditional savings account offers <1%, you can easily get 5% to 10% today for lending one of the top three stablecoins.
These numbers were even more favorable earlier in the year, when we saw rates frequently spike to 20% and above!
Lending Rates Exceeded 40% During Early 2021!
What is Liquidity Mining?
Liquidity mining is yield farming’s “high risk - high return” strategy.
Remember those liquidity pools we discussed earlier? In an AMM-based decentralized exchange, “liquidity providers” (also known as LPs or liquidity miners) deposit coins into a liquidity pool so that traders can trade them. As compensation for their deposit, LPs split the trading fees equally.
For example, let’s say that 100 LPs deposit $1M of USDT and ETH into a liquidity pool on Uniswap. If there are $30M in trades over the next month, then the pool will generate $90K in profit at a 0.30% take rate. If an LP wants to exit at that time, she’ll receive a 9% return in a month (>100% APR).
Return rates on liquidity mining vary wildly – stable pools on stable exchanges can have APRs ranging from 0% to 50%, while risky pools on risky exchanges can have short-term APRs exceeding 1,000%. Rates can also change dramatically from day to day. Finally, impermanent loss can eat into these returns, sometimes even resulting in a loss.
In the best cases though, the returns are extraordinary. In this analysis from APY Vision, we see that the top 10 pools produced an average net return of nearly 200%
Net APY (after impermanent loss) of the Top 10 Liquidity Pools in Early 2021
What are Incentive Programs?
Incentive programs can be seen as a form of marketing. New exchanges, or those that want to increase growth, often offer their native tokens as a bonus to liquidity providers. Most major DEXs, such as Uniswap, Sushiswap and Curve have all paid incentives at one time or another.
Incentives aren’t limited to exchanges though. Let’s say you’re a new project that just listed your token on Uniswap. How do you get people to provide liquidity and trade your token? Simple, you bribe them!
When you compound these two sources, you can start to see extremely high yields.
For instance, let’s say Synthetix is offering a reward program by giving free SNX tokens to anyone providing liquidity on their pool in Sushiswap, and Sushiswap is offering SUSHI tokens for anyone that provides liquidity to any of its pools. If you became a liquidity provider to the SNX-USD pool on Sushiswap then you’d earn:
Interest from being an LP
Free SNX tokens from Synthetix for supporting the project
Free SUSHI tokens from Sushiswap for supporting the exchange
In effect, you’re triple dipping!
When you hear about projects offering >100% to >1,000% APYs in DeFi, you can bet you’re dealing with an incentive program like this.
Unfortunately, these funds are almost always limited, so these deals rarely last, and token prices often crash when the music stops.
What is Airdrop Farming?
It’s debatable whether this last category actually qualifies as yield farming, but it’s an interesting topic nonetheless.
Airdrops are a hybrid IPO / marketing strategy where coins are dropped into the wallets of existing users. One of the most recent and famous examples of an airdrop was conducted by Ethereum Name Services.
Basically, anyone who had bought an ENS domain prior to the airdrop got free tokens. While most domains cost <$200 to purchase, these value of tokens shot up to almost $20,000, a 100x return. Some people that bought multiple domains made hundreds of thousands of dollars.
This strategy is unheard of in the traditional world. Imagine if Nike were a private company, but instead of IPOing they decided that they were just going to give shares to everyone that bought a pair of shoes!
As a result of ENS and other high profile airdrops, many crypto fans are using services with the hope of benefitting from the next one. Some likely contenders are Metamask, OpenSea, Arbitrum and Optimism.
What’s the Advantage of Yield Farming?
Interest is serious business when it comes to DeFi. Yield farmers can easily earn double to triple-digit interest rates, and even the safest options can offer yields that substantially exceed traditional finance.
For example, being a liquidity provider to a stablecoin pair is one of the safest plays in crypto. Because you’re holding two stablecoins, there’s no risk of loss of principal (they’re both tied to the dollar), and there’s no risk of impermanent loss (because the assets move in tandem). Outside of the threat of an exchange being hacked – which is, to be fair, a real consideration – this should have the same risk as holding dollars in a savings account. But looking at the rates below, we can see there’s no comparison in the return!
Traditional Savings Account vs. DeFi Savings Accounts
How is this all possible though? How can DeFi afford to pay out so much?
Well, there are several possible reasons, including: 1) unstated risks such as smart contract risk, impermanent loss, etc… 2) temporary arbitrage opportunities due to the immaturity of the market and 3) unsustainable, short-term incentive payments for marketing purposes.
As Vitalik pointed out:
Still, it’s difficult to believe that at least some of this alpha isn’t permanent. After all, the average bank is very bloated — “non-interest” costs such as corporate overhead, legal services, occupancy costs, regulatory fees and intermediary compensation average around 60% of revenue today. By eliminating the middleman and automating transactions, it’s likely that DeFi can purge many, if not most, of these costs. This should free up more profits for the consumer which, in turn, should translate to higher rates.
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