Yield Farming provides Opportunities independent of Market Direction
As the cryptocurrency market sentiment turned bearish in early 2022, investors started to look where to park their funds during periods of potentially more volatility. Unlike the traditional financial markets, the cryptocurrency space still offers decent interest rates on stable assets through yield farming.
The Emergence of Yield Farming
Yield farming gained first popularity during the DeFi summer of 2020. MakerDAO had just released $DAI, one of the very first stable coins, and users were trying to figure out how to use $DAI. With time, new protocols were popping up to interact with $DAI and generate yields. Compound and Aave were the earliest protocols of this kind, and they can generally be classified as money market protocols.
Money Market Protocols
A money market protocol allows users to deposit their cryptocurrency assets into a protocol, and in exchange, they obtain a yield for their money. You can imagine it as a bank that lives on the blockchain and is not controlled by anyone.
At the same time, users can borrow against the assets that they have deposited if they wish so. The assets that were deposited act as collateral. If the value of the collateral moves close to the value of the assets borrowed, the user is at risk of getting liquidated. In the liquidation event, the user’s deposited assets get automatically sold to cover the outstanding liabilities.
Yield Farming Strategies and Vaults
Just as MakerDAO was the requirement for the emergence of money market protocols, these protocols were required for more advanced yield farming strategies. Advanced yield farming strategies were first popularized by Andre Cronje and his Yearn Finance Protocol. Yearn Finance provides a tool for retail users to participate in more complex yield farming strategies. Users simply deposit money into a Yearn vault, and the vault applies a strategy to generate yield.
Essentially users desire to collateralize their assets and borrow against them which creates yields in the market. Since the volatility in the space is very high, the interest rates that users are willing to pay are high, resulting in high yields for yield farmers.
Current Rates of Yield Farming Opportunities
Nowadays, the yields that you can obtain for stable coins such as $DAI or $USDC on protocols like Aave or Compound typically range between 2-3% p.a. This might seem a lot for traditional markets, but it is not a lot for cryptocurrency markets. If you look at stable coin yields on money market protocols on Solana such as Projet Larix, the yields are not much different.
As market sentiment is more bearish, less market participants choose to borrow against their cryptocurrency assets, and therefore the yields for stable coins decrease. On the other hand, with continuous price increases, investors are looking to build leveraged positions, and the yields obtained on money market protocols, increase subsequently.
Staking in Proof of Stake blockchains
On top of money market protocols, the emergence of staking has opened up a new way of generating yield for users. While the largest blockchains, Bitcoin and Ethereum, still run on the Proof of Work consensus mechanism, the Proof of Stake consensus has gained momentum.
In December 2020, the transition of Ethereum from Proof of Work to Proof of Stake had started with the launch of the Beacon Chain. Currently Ethereum runs a Proof of Work and a Proof of Stake mechanism in parallel. The migration to Proof of Stake is expected to be completed within 2022.
Proof of Work relies on high energy consumption for solving computational challenges, and rewards miners with the issuance of new coins. Proof of Stake in exchange finds consensus based on the ownership of funds and rewards the token holders.
How to benefit from Staking Rewards
The complexity of staking depends on the blockchain you decide to stake. In order to stake on Ethereum, it is required to set up your node and own at least 32 $ETH. These requirements make solo staking on Ethereum for most people a non-viable option.
However, staking services like Lido Finance exist that simplify the staking process and in exchange charge a fee. Furthermore, centralized exchanges such as Kraken offer to stake for a variety of blockchains.
Proofs of Stake blockchains that allow for staking include Solana, Avalanche, Polkadot, and Cosmos. More than ¾ of all $SOL (Solana) in circulation is already staked versus only 7% of Ethereum. In order to stake on the Solana blockchain, users need to delegate their coins to a validator. This requires that the user exercises self-custody over their funds on Solana.
Whereas unstacking your coins on Solana is possible within a relatively short withdrawal period of only a few days, it is currently impossible to withdraw staked Ethereum.
The staking rewards vary from blockchain to blockchain. The chart below shows the annual rewards obtained from staking a certain cryptocurrency. Note that a higher staking yield typically comes with a higher token issuance, which creates downwards price pressure. Therefore, staking rewards aren’t the only factor to consider when making investment decisions. The token issuance and inflation dynamics matter just as much.
High Gas Fees
The popularity of yield farming in combination with the rise of NFTs has led to high gas fees and congestion on the Ethereum blockchain.
The deposit or withdrawal of a token into a staking protocol typically costs between 40$ and 120$ in gas fees on the Ethereum blockchain, depending on the level of activity. This trend has led towards a situation where it is only profitable for market participants with large funds to participate in DeFi (decentralized finance).
The emergence of higher gas fees has led towards the rise of alternative layer 1 networks and Ethereum side chains such as Binance Smart Chain, Polygon, Solana & Avalanche. Those networks make a trade-off between decentralization and scalability. They offer better scalability than Ethereum but, in exchange, come with less security.
Alternative layer one platforms such as Solana offer way lower fees but, on the other hand, face challenges with reliability. The Solana blockchain has been repeatedly down during periods of peak volatility, which caused severe problems for DeFi users on Solana.
Staking and Yield farming on Layer 2
Since many users were priced out of staking and yield farming on the Ethereum base layer, a lot of activity has migrated to layer 2. Layer 2s are a bunch of scaling solutions that move traffic off the Ethereum chain but inherit the security of the Ethereum blockchain.
For example, users can stake on the zksync layer 2 through Lido Finance. Such staking operation is supported by the Argent wallet, which is a mobile wallet for Ethereum with social recovery built-in.
Besides depositing into money market protocols and staking, users can also provide liquidity in a decentralized exchange. However, due to additional risks such as impermanent loss, this form of generating yields in DeFi is only suited for advanced users.
Risks Associated with Yield Farming
To sum up, let’s look at the risk in yield farming. The interest that can be earned through yield farming is not a risk-free interest rate. In fact, it comes with several risks:
● Smart Contract Risk: the risk that the protocol, where the funds are deposited into, gets hacked and the deposited funds get stolen
● Security Risks: to exploit yield farming opportunities on the blockchain, it is a requirement that users custody their funds. There is a risk that the wallet that is used for storing funds gets compromised, and users lose access to their funds
● Protocol Risk: a bug in the base layer of the protocol used for yield farming might put funds at risk. Additionally, if the uptime of the protocol is not guaranteed, users can experience financial losses since they can’t perform critical operations such as increasing the collateral during periods of high market volatility.
● Market Risks: The risk that the asset used for generating yield declines in value and offsets the yields obtained. While this event seems less likely for stable coins, there is no guarantee that they will maintain their peg to the US Dollar.
The risks for yield farming need to be considered before engaging in yield farming opportunities. Yield farming comes with a bunch of different risks than interest-bearing instruments in the traditional markets. However, users who are aware of these risks and can control them can earn substantial returns through yield farming.