One Thing to Understand about Yield Farming
If you understand arbitrage, you’ve got the right foundation for yield farming.
Yield Farming.
As DeFi continues to explode in popularity, it continues to be the money-making machine for enterprising, technically-minded traders. If, on the other hand, you’re an average crypto enthusiast, reading through yield farming explainers can leave you scratching your head in dismay, with questions like:
How can people who aren’t deeply versed in all things DeFi ever hope to understand yield farming?
Truthfully, it all comes down to putting the right pieces together, just like DeFi projects can be conceptualized as legos that form greater and greater financial structures when connected.
Start with arbitrage
Understanding yield farming means being familiar with the basics of arbitrage trading. If you’re not, then the prevailing opinion is that you’re already working with a disadvantage.
In a cryptocurrency context, arbitrage trading is the act of buying a cryptocurrency on one exchange(market) and selling it for a higher price on another. This is made possible by the fact that historically, cryptocurrencies tend to have different values on different cryptocurrency exchanges.
Though it’s difficult to pin down exactly why this is the case, in general, crypto arbitrage opportunities are made possible by differences in supply and demand as well as trading behavior.
To put it even more simply, as Cointelegraph points out, “Such inefficiencies normally arise in regions where crypto is in high demand.” That means that, for example, Bitcoin could have a much higher price in Venezuela where fiat inflation is extremely higher than in the USA, where things are more stable in this respect.
Arbitrage traders take advantage of these inefficiencies, typically in high volumes, to buy low and sell as high as possible, from one market to another.
How does DeFi relate to arbitrage? (Yield Farming)
With the birth of DeFi, a new form of arbitrage has emerged, which is popularly termed “yield farming.”
On a basic level, to “farm yield,” you stake a token on a platform like Compound or Aave, which has the highest posted APY for lenders(stakers).
For example, right now, Compound’s markets page lists the DAI supply APY at 3.48%, with its other supported assets falling far behind. With Aave, on the other hand, the Synthetix platform’s SNX token is currently offering a 10.21% APY. Basically, if you were a yield farmer, you’d use these values as well as those across all other DeFi lending platforms like MakerDAO and beyond, then deposit an ideally large number of tokens into the platform and asset offering the highest yield (APY).
To truly be a yield farmer, you’d need to change your staking location as the yield drops and move to one with a high yield once again (including to a new platform).
All in all, you’re the lender and you’re always looking for the highest possible yield on your deposited capital at any given time.
Thus, yield farming can be called “lending platform arbitrage.”
Yes, the process gets more complicated the deeper you dive into it, but for now, let’s stick with the basics.
What are the risks of yield farming?
Regardless of what the developers of a particular DeFi project tell you, for the most part, the interest rates involved in yield farming can change at any time. That means that while it may not look like it at first, yield farming is essentially a form of high-frequency trading. Consequently, being a yield farmer means being “always on.”
In other words, you won’t get many breaks from trading if you want to stay on top of things, which is why many yield farmers likely try to automate the process as much as possible with trading bots. Though I plan to dig deeper into that point in a future piece, suffice it to say for now that this refers to setting up automated buys and sells as interest rates change.
In the end, I hope that this intro to arbitrage and yield farming serves you well on your DeFi journey. As always, if you enjoyed this post, let me know below and on Twitter. In my next post, I’ll continue to dig into the risks and rewards of DeFi (and of course DeFi lending). Until then, here’s to all of you, because anyone reading this is still a crypto early adopter!
Finally, most of my free time is now being taken up with my newsletter, which is completely free and focused on how the rise of the Metaverse improves things for everyone. Sub here.
Disclaimer: None of this is meant to be financial advice. I’ve researched and worked in crypto since 2016 and I aim to merely educate people on the upsides and downsides of all sorts of projects and the market itself. Additionally, I’m a student just as all of us are. Therefore, my thoughts on projects evolve naturally over time as I learn more about them. Last but not least, none of these posts represent the thoughts of NBX unless otherwise stated and this includes all posts that preceded this one.
