Top 4 Strategies For Yield Farming
👋 Introduction
Is it possible to make millions off decentralized finance (DeFi)? Yes! In most cases, you can stand to make a lot of money but you can also lose a lot. In this review, we will discuss & analyze the most common approaches in yield farming so you can decide what’s the best thing to do.
Note: This article is just a review/analysis and is not financial advice. Please do your own research when making investments.
💧 What are Liquidity Pools?
Liquidity pools are smart contracts that allow users to exchange one token for another for a fee. Since they are permissionless and do not need a centralized exchange to function, liquidity pools are essential components of DeFi.
🥕 What’s Yield Farming?
In traditional finance, there is a special kind of market participant called the market maker. They make a ton of money, they provide liquidity meaning that they enable traders to buy/sell some assets at any given time. They also have a constant stream of limit orders during their participation, they buy the assets low and sell them at a higher price and repeat! This allows them to constantly earn the difference between their buy & sell price. In a traditional setting, this requires a lot of capital and expertise to execute properly. Luckily, in DeFi things are a bit easier, anyone can be a market maker even if you don’t have the capital or the expertise. In DeFi, it’s not called market maker, it called providing liquidity.
For instance, if you provide liquidity in the BNB-BUSD Liquidity Pool (LP) at a decentralized exchange, when traders want to buy/sell one of these tokens, they trade it against the tokens in the LP at a price determined by the code of the smart contract. Traders have to pay a small fee on each trade which is distributed back to LP participants. We will discuss this more in a later section.
🧨 The risks of yield farming
Everyone would be doing yield farming if it was free income, right? Obviously, there are risks; one is the smart contract being stolen, while another is impermanent loss, also known as divergence loss.
What is Impermanent loss?
When you supply liquidity to an LP and the price of your invested assets changes after the time of deposit, you can incur an impermanent loss. The greater the magnitude of the change, the more you are subject to impermanent loss.
Impermanent loss isn’t a particularly good way to call this kind of loss. Only after you remove the tokens from the liquidity pool, it’s considered a permanent loss. At that stage, the losses are irreversible. While the fees you receive will be enough to make up for those losses, the term is a little misleading.
Pools of assets that stay within a narrow price range would be less vulnerable to divergence losses. For example, Stablecoins or various wrapped variations of a coin can remain within a relatively narrow price range. Liquidity suppliers face a lower risk of divergence loss in this scenario.
We will see the implications of this later in this article. Now that we have a basic understanding of liquidity pools and their implications, let’s explore a few common strategies
Strategy #1 Max Risk
Most yield farming platforms have a native token that is used to provide utility across the platform. In most cases, the token is used to distribute funds as rewards, manage governance, and all sorts of incentive mechanisms to keep the platform going in the direction it should be going.
When looking at the tokenomics behind these incentive mechanisms, they can be categorized into two main types, endless supply, and fixed supply tokens. The problem endless supply tokens have is that they must maintain a burn mechanism to keep the price at a healthy rate. Platforms have come up with all sorts of creative ways to collect funds to burn their native token. This unending race to burn tokens is not so much of an issue for platforms with a fixed supply, they just have to worry about getting a use case for their native token to create enough buy pressure to mitigate the constant dumping for profits.
Why would you hold rewards that are used to be sold for money? There are too many creative ways to answer this question in DeFi.
Purchasing the native token and staking it for rewards may be a good and risky approach that provides maximum exposure to the project’s success and no issues with impermanent loss.
Strategy #2 Slightly less risk
Platform Native Token + Network Native token = LP Token
When a deposit is made into the liquidity pool (LP), an LP token is issued to represent the deposit’s share of the entire pool. If these LP tokens were to be redeemed, you would end up with the same assets you initially deposited but because of things like impermanent loss, the exact amounts may change.
Most liquidity pools are dual asset pools where the pool consists of two different assets/tokens. Most LPs follow a 50/50 split between the underlying assets represented by the LP token. Every time there is a price change in one of the underlying assets/tokens, the LP token will rebalance itself and maintain a 50/50 ratio between the value of the assets.
If you have 1 EUR and 1 USD in an LP, if the price of USD falls, the pool would sell more EUR to buy more USD and ensure that the value of all assets maintains a 50/50 ratio, and vice versa. Again, the source of impermanent loss is the divergence in value between both assets.
So how do we use the LP token?
We deposit our LP tokens that represent our asset’s portion of the liquidity pool to a decentralized exchange. The exchange will use your assets to do business and fairly share the rewards.
Because there is a chance that the price movement of the platform native token will be correlated to the network native token, the impermanent loss may not be a big issue here, if the interest earned from providing LP tokens can compensate. In some cases where the impermanent loss is too big, you may have been better off just holding onto your two assets/tokens without providing them in a liquidity pool.
Strategy #3 Medium Risk
Volatile token + Stable Coin = LP Token
Stablecoin farming is by far the safest way to have little exposure to the success of the platform. Since most platforms need some representation of the US dollar to allow traders to exit their speculative positions, stablecoins became an important liquidity pool in any platform. Combining a volatile asset/token with a stable one is a safer approach as the exposure to the asset is halved.
Because stablecoins are pegged to a fixed value, creating a volatile token + a stable coin pair is an impermanent loss waiting to happen. If the volatile token’s value goes up, the LP will sell more of the volatile token to keep a 50/50 value ratio between both underlying assets in the LP. You’d end up with less of the volatile token and more stablecoin. This approach works great if you are looking to accumulate $USD on a token that you believe its value will go up.
Strategy #4 Low risk
Stable token + Stable token = LP Token
The rates found on stablecoin + stablecoin LP tokens may not look as attractive compared to some of the strategies above but in comparison, it is a major step up from the rates given in a traditional financial setting.
It’s common to find single asset & dual asset stable coin pools. One key feature in dual-asset stable coin LP tokens is that because both assets are inherently the same although their stabilizing mechanisms are different, there is a negligible impermanent loss in most cases. This means that you have little exposure to the price movements.
💸 How do I earn my rewards?
Rewards are earned either in LP tokens, native tokens, or both. In cases where rewards from staking LP tokens are distributed via native tokens, selling the earned native token periodically can insure good dollar-cost averaging on profits. In my humble opinion, it is preferable to earn in LP tokens in order to reduce exposure to the native token. When you earn in LP tokens, you earn a 50/50 split of the underlying assets, your earnings are instantly compounded with your initial deposit and your risk exposure is split across both assets too.
🏁 Conclusion
The DeFi industry has been all gas no breaks with coming up with new and exciting financial products. It's never too late to participate, there is plenty to learn and earn. Always do your research before making any investment or financial decisions
