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Guide to Yield Farming & Staking Crypto Assets

Source: cointelegraph, not affiliated

I am writing this, because I have found myself in need to be able to point to something that briefly summarizes the main aspects of yield farming and explains it in a way that the “basics” are covered and I haven’t really found a go-to resource. Put it together quickly, so I might edit this from time to time and there could be typos.

What is yield farming?

With the advent of decentralized exchanges like Uniswap, Pancakeswap, Quickswap or Serum (DEXes), a key ingredient to making them work is for people to provide liquidity for others to trade against. That simply means that for every token pair (like ETH-UNI) that is supposed to be tradeable on a DEX there needs to be somebody to lock up both tokens (in this case ETH and UNI) so that other people can “go to the DEX” (call the smart contract) and exchange one asset for the other. Providing this liquidity is risky, because you are in essence allowing other people to dump on you if one of the two assets has an issue.

As this liquidity is vital for a new token / project, so that people can trade it and also vital for DEXes so they remain relevant, liquidity providers are being rewarded with (1) a share of the fees generated by the respective token pair trading and (2) frequently a pool/farm where you can stake your liquidity provider tokens (LP tokens) and be rewarded with some new token (reward token), which you can sell or again convert into liquidity for which you receive LP token and which you can then stake again to get more rewards. This is called “yield farming”. It means getting a reward for providing liquidity.

I note that this process not only applies to providing liquidity to DEXes, but also to lending out your crypto assets to others on lending protocols or offering them as collateral for insurances, etc.

What is staking?

Staking is the action of sending a certain token (which could be an LP token, but can also be a stablecoin or just any other token) into a smart contract. It is then locked in this contract until you redeem/withdraw it. For this action, you typically get rewarded by the owner of the smart contract.

Why does yield farming or staking exist?

As explained above, the main reason is to attract liquidity to the token pairs on DEXes, which benefits both the DEX and also the project. However, there are further reasons. For example many projects offer “single asset staking”, which means you do not need to provide liquidity anywhere, you can just lock up an asset like ETH, USDC or the project token and receive token as a reward. This might appear non-sensical, but it also serves a purpose: often, the assets are locked for a bit (like a day or so), there is a deposit or withdrawal fee or it simply increases the project’s TVL. All of these can either be used to buy back the project’s token, reduce circulating supply (as it is locked in a smart contract) making the token seem cheaper or help the project gain attention in TVL rankings etc.

What is TVL?

TVL stands for “Total Value Locked” and represents a number in USD that shows how much value is currently held in the smart contracts of a given project. It is often used in the DeFi world to estimate a project’s success or likelihood it survives, etc.

What is the difference between APY & APR?

Your return (yield) for staking or farming is typically expressed in APR or APY. Both are percentage return figures that assume the price of the reward token you receive for staking, as well as the current value of the assets you are staking (in USD) remain constant, while it then simply calculates what your return is based on the amount of reward token you are scheduled to receive over one year.

APR does not take into account compounding, while APY does. Usually, APY is stated using daily compounding, but that can vary. Compounding is the action of withdrawing the reward token (“harvesting”) and re-investing them into the same pool again.

What is a reward token? What is an LP token?

When I say “reward token”, I mean the token that you receive for farming/staking. It is typically the project’s or DEX’s own token. Often it has unlimited supply but not always. If it is not unlimited in supply, the rewards will end at some point.

LP token are “liquidity provider token” and they are used by DEXes as a “proof” you own a share of the pool liquidity. When you contribute assets to a pool, these assets are “securitized” into this token and you are sent the token to your wallet so you can later redeem it for your share of the two token for which you provided liquidity.

How are prices formed on DEXes?

It is useful to understand that prices on a DEX usually form via the liqudity currently provided. The price at which you can buy a token is simply the ratio of assets provided in a pool. So if there is 1 ETH and 5 UNI in a pool, then the price of 1 UNI is 0.2 ETH. When somebody trades and exchanges ETH for UNI, there will be a different ratio locked up in the contract and therefore the price changes.

This means that you can make a price that is extremely high with just very little liquidity (thereby signalling your token is valuable), but once a lot of people trade it will likely fall. Also it means that if liquidity is low at the start of a project, then price rises strongly and only THEN is a lot of liquidity added (by the project owners for example), you can “artificially” lock in the higher price (as it now needs much more money to move it down again) and the great run in the past that will have people salivating.

If the price impact of a trade is too high, DEXes will typically not allow you to trade as much, so the price will never directly go to zero or to infinity. It will always have steps in between.

I note that Serum Dex does not work this way.

What are the most common risks to yield farming?

Yield farming is a risky business. The most common risks are:

  • Smart Contract Risk: As you are sending your assets into a smart contract, if that smart contract has a bug, an attacker might be able to steal your assets. This is why many large protocols have external parties do regular code audits, but even with 100 audits you can never be sure your money is truly safe. You can insure against smart contract risk at platforms like Nexus Mutual, but they generally provide insurance only for large, well-audited platforms.
  • Impermanent Loss: This is the risk of providing liqudity in two assets, of which one is of potentially lower quality than the other. So assume you are providing liquidity in a USDT-USDC pool. Both are stablecoins, both should always trade at $1, so in theory, you might think this is very safe. However, USDC provides monthly balance attestations by an auditor and is regulated in the US. USDT on the other hand has long had questions regarding its actual reserves and may or may not have done shady stuff in the past. So if, one day, it comes out that USDT is not backed or that they received a “cease and desist” order, everyone will flee USDT and go for safer assets. You are providing liquidity, so you will end up with a lot of potentially worthless USDT and no USDC anymore. This is an extreme example, but the basics of this example apply to all pairs such as (Sh1tTokenX-ETH or even ETH-USDC). There is always one asset that is of more quality than the other and in the case of a “bank run”, you will generally be left with the lower quality one. This risk is called an “impermanent” loss, because, over long periods of time, and assuming you will never pull the liquidity from the pool, this should balance out (“it’s not a loss unless you sell”). In reality, with a lot of really attractive yields, it is a key issue.
  • Regulations: There is always a chance of regulatory action either against this entire process or against one of the assets you use (like a stablecoin).
  • Rug-pulls: A scammy project might get you to provide liquidity and pretend its all good, but then they pull their own liquidity and sell all token they have access to against your liquidity so you are now left with the full “impermanent” loss and no way to recover it.
  • Hyper inflation: Most reward token have unlimited supply and high inflation especially at the start. They start out with low liquidity (so that even small buys will increase the price a lot) and then release a lot of new token to the pools early so that APYs are crazy high (like 1,000,000%). But as these APYs are paid in that reward token, the more of these token that are released, the more its price will fall, leading to APY to fall strongly and to the loss on the assets potentially outweighing the gains on your rewards (impermanent loss > reward).
  • Decentralized Pyramid Scheme: I am on record for having called yield farming a decentralized pyramid scheme. That is true, because (as I hope you understand better now), you are buying an asset to provide liquidity in the asset to receive a lot of this asset knowing that others will also receive a lot of this asset and suppress its price. There is no central scammer (and as this process serves a purpose, I do not believe it to be a scam), but just like in a pyramid scheme, the last people to arrive will lose money.

How do I actually yield farm?

You pick a pool you want to participate in on any of the projects that offer this (there are thousands), provide liquidity or the stable asset they want to the contract and watch your yield grow, while monitoring your impermanent loss at all times. Finding the best yield is where most “alpha” comes from. So there is no easy way to do that.

What chains offer yield farming opportunities and how to I use differnt ones?

There are multiple chains, both layer 1 and layer 2, that offer opportunities. Generally, the further you strain from main chains, the higher your risk. In order to farm on a given chain, you will need to have your assets to stake on that chain.

These are the main ones and the information you need to add in Metamask under Networks -> “Custom RPC” to connect to them with Metamask:

  • Ethereum: Self-explanatory, this is the “home base” for most yield faring and the standard network in Metamask. No need to change anything.
  • Binance Smart Chain: Metamask settings below; to move assets from ETH to BSC you can use Binance’s bridge at https://www.binance.org/en/bridge
  • Solana: In this case you will need to use a solana wallet (like sollet.io). They are generally easy to use (and Phantom Wallet is very similar to metamask). Getting assets onto Solana can easily be done via FTX

Many more chains offer such opportunities, but I think these are the main guys.

IMPORTANT: None of this is financial advice or any other sort of advice. This is my personal and not my professional opinion. I am not responsible for any losses you incur and everything I write here could be false as I can absolutely make mistakes. It is supposed to be a resource to do your own research. It is not supposed to replace this research.

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DKCrypto

DKCrypto

Entrepreneur, Fund Manager, Ex-Consultant and Hobby Ice Hockey Player. Child of the Sun. Any opinions personal, never investment advice, sometimes parody

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