How to Gain a Substantially Higher Return on Your Crypto
Yield Farming: Make Your Coins Work for You
What is Yield Farming?
Yield farming is technique investors use to maximize their return on investment by utilizing several different decentralized finance protocols.
I know that sounds scary… let my try and break it down for you. Investors move money between different protocols hunting for the best yield (return) on their investment. They may also choose to swap the assets as necessary also known as “crop rotation”.
Think of yield farming as finding a bank that accepts your deposit and offers the highest annualized percentage yield. The main difference is in how much the bank and DEFI protocol pay you. Banks traditionally only offer 3 percent or less on their high yield savings account. Compare that to some of the newer DEFI protocols and bank returns start to look like nothing
Its not uncommon for certain DEFI protocols to offer upwards of 1000 percent APY!
How is it Done?
It is done by utilizing and managing these three elements.
1. Leveraging
Leveraging is the process of using borrowed funds in hopes of increasing the possible profit potential.
First, investors offer up some amount of cryptocurrency as collateral on a loan. They may then borrow a certain percentage of their collateral to be used for whatever the investor pleases. The percentage amount that an investor can borrow from their collateral will depend on the DEFI protocol they are using and what is known as the loan to value ratio (LTV).
Platform like Celsius, BlockFi, and Nexo all offer their users the ability to take up to a 60 percent LTV collateral loan with an extremely low interest rate. I personally have an existing 3 year loan with Celsius where I pay only 1 percent interest.
Savy investors who are confident they can earn a higher yield than what they pay in interest will use the borrowed funds to put back into a DEFI protocol where they can earn a high APY and start the process over again.
Its essential that one has a plan to pay back the loans otherwise their collateral will be sold or liquidated to pay the loan off.
2. Liquidity Mining
Liquidity mining is the process of distributing tokens to the protocol.
DEFI exchanges ask investors to put their assets in a liquidity pool (LP) that helps to add liquidity to the trading pairs they offer on their platform. In return these users earn an additional ROI that is generally earned in that platforms native token on top of the return they earn on the token they used as collateral.
The issuance of the native token to the users who stake their capital helps to incentivize investors to keep their money in these pools to provide liquidity to the platform. For example investors can add USDC to a pool and earn Uniswap token and USDC as a reward. The native token can then be traded at an exchange for a profit or used for its utility on the platform.
Many of these DEFI swap tokens help to save fees on their platform when swaping between different currencies and have seen a massive price hikes in early 2021.
Some liquidity pools offer variable returns on investments and others offer a fixed rate. Generally variable returns start off a lot higher but eventually sink lower than the fixed returns promised by the other protocols.
3. Risk
With high risk comes high reward!
Yield farming is inherently risky and requires an active management style to mitigate risk. I will identify the top 3 risks of yield farming.
- Over Leveraging
Over leveraging is a state when an investor has borrowed to much coins against their collateral. This can happen on a collateral loan if there is a margin call. A margin call is the right for the lender to recover funds to bring the loan back to a certain LTV.
For instance if I took out a` 50 percent LTV loan on 100k worth of a Bitcoin collateralized loan, I could borrow 50K worth of bitcoin against it. Lets say the price of bitcoin cuts in half. My original collateral value of 100k would now be worth only 50k. Since I only borrowed 50k my LTV would now be 100 percent.
This is considered to be too risky for the lender and he must either collect more funds to be added to the collateral, thereby decreasing my LTV or liquidate a portion of the initial collateral to recover his losses.
Similarly the value of the staked coins in a liquidity pool can be sold off if the underlying asset drops significantly in price to maintain a certain threshold. Sometimes investors choose to keep their money in the pools even after this happens because the rewards earned in the protocols native token may more than offset the value lost in the pool.
2. Smart Contract Risk
Smart contract risk is the risk associated with using smart contracts in a blockchain. This risk is not exclusive to yield farming but rather any blockchain that uses smart contracts.
Blockchains that use smart contracts are vulnerable to bugs in the code, platform changes and other systemic risks.
3. DEFI Risks
This risk comes from the vulnerabilities in the DEFI protocol. There have been cyber attacks in the past whose main focus was to drain these liquidity pools.
Increased regulation may mean that you will also have to pay capital gains taxes on the insane APY that you make from yield farming. Consult with a local tax professional on how to best report earning made from yield farming.
I hope this provided a simple enough overview on yield farming and how it works.
As always thank you for reading and come join the conversation!
If you are interested in taking out a low interest loan with Celsius please use my referral. It goes a long way in helping the channel and community.
- Josef S Loffler
