Deep Dive: Yield Farming

More than ten years later, crypto’s primary use case hasn’t changed. Financial speculation is still a major component in the industry, and it has only grown as more products are developed and new sources of yields are invented. As a result, some have styled the crypto market as a global casino, while others consider it a financial world of its own making. For the pragmatist, though, there is money to be made.

What is Yield Farming?

Yield farming is one of the ways crypto investors are speculating. This investment strategy entails maximizing returns on crypto asset holdings by participating in various yield-generating activities in decentralized finance (DeFi) and, sometimes, centralized finance (CeFi).

To put it another way, yield farming involves putting your digital assets to work with the expectation of making money.

Here are the top protocols where you can farm yields ranked by total value locked (TVL) as of October 30, 2023.

Source: Chainalysis

Sources of Yield

Crypto investors can earn yields from the following sources:

• Lending: Lending is a yield-generating activity that allows investors to make their cryptocurrencies available for other protocol users to borrow. In return, lenders earn interest on the loans provided.

Crypto loans in DeFi are offered peer-to-peer. That means no intermediaries are engaged. Instead, the lender deposits their crypto holdings in a lending pool powered by a smart contract. The money is then distributed to borrowers who must repay the loan plus interest. Once a borrower has completed loan repayment, they will receive back their collateral. Crypto lending and borrowing occur on DeFi lending protocols like Compound, Aave, JustLend, Venus, Kava Lend, and Solend.

• Staking: Staking is the process of participating in the consensus of a layer-1 Proof-of-Stake (PoS) blockchain by locking up a crypto asset in a smart contract for a given amount of time. In a nutshell, the role of staking is to validate blockchain transactions in exchange for a reward.

Validators are expected to run their own nodes to engage in staking. However, investors who don’t wish to run a node can stake with centralized crypto exchanges or staking pools that run nodes on behalf of users for a fee. On these platforms, rewards are distributed proportional to the amount staked.

Staking with a pool or staking service enables investors to earn rewards without having to stake the maximum amount, which is generally relatively high. For instance, validators must have 32 ETH to stake on Ethereum. Nevertheless, you can stake way less ether through a staking service or pool. Besides staking on PoS blockchains, you can stake a protocol’s token to take part in its governance process in return for a revenue share.

• Liquid Staking: Liquid staking is a type of staking that allows stakers to remain liquid while their assets are locked. It does this by issuing a liquidity staking token (LST) or liquid staking derivative (LSD) representing the staked amount and the rewards it generates. LSTs are also equivalent to the staked assets on a 1:1 ratio.

• So, while the staked funds earn rewards, an investor can use their liquid staking tokens to earn more yields across protocols through arbitrage trading, restaking, or liquidity provision.

• Liquid staking has gained much popularity since Ethereum transitioned to PoS and has become the largest DeFi category by total value locked (TVL). Lido, StakeWise, RocketPool, Diva, Frax Finance, and Stader are examples of Liquid staking platforms.

Source: DeFiLlama

Liquidity Pools & Liquidity Mining: Market making is another source of yield for investors. It entails providing liquidity to an AMM-based decentralized exchange by depositing funds in a smart contract-powered liquidity pool. The source of yield for liquidity providers is the transaction fees that users pay when they trade against the tokens in the liquidity pool.

• In liquidity mining, liquidity providers earn transaction fees and receive a liquidity provider (LP) token. These tokens give LPs control over their locked liquidity. Moreover, liquidity providers can stake their LP tokens to earn more yields. Investors can become liquidity providers on protocols like Uniswap, Bancor, Curve, Sushiswap, and Balancer.

Yield Farming Strategies

Although the crypto market offers several income-generating opportunities, it’s essential to approach yield farming tactically.

Below are some of the possible strategies you can leverage to boost your returns.

• Options Trading: Traders can apply different options trading strategies, such as covered calls and long straddles, to potentially make money. Covered calls involve selling a call option on a crypto asset you already own, while long straddles entail trading put and call options for a crypto asset with the same expiration date and strike price.

• Farm Across Different Platforms: Don’t put all your money in one protocol. Instead, spread your investment across different protocols with separate sources of yields. For instance, you can be a liquidity provider on one platform and a staker on another. Interest rates and risks vary from one platform to another. Therefore, diversifying your yield farming activities will minimize risks and maximize returns.

• Consider Transaction Fees: Transaction fees can affect the profitability of your yield farming activities. As a result, you must reduce this cost as much as you can to maximize returns. You can do this by using layer-2 networks or timing when gas fees are low on layer-1 blockchains like Ethereum.

• Take Advantage of Auto-Compounding: Compound interest can significantly boost your returns. Hence, consider using protocols with auto-compounding features that will reinvest your earnings to increase returns.

• Maximize Returns with High APY Pools: Choose protocols that offer high annual percentage yields (APYs) to maximize your returns. However, determine the reward-to-risk ratio before taking the plunge, as high-reward protocols could also have high risks.

Managing Risks with Yield Farming

Yield farming is a rewarding but high-risk venture. Therefore, you should mitigate risks with the following tactics:

• Insuring Your Crypto Holdings: Look for a crypto insurance provider to cover your investment against smart contract risks, impermanent loss, and cyber attacks. Impermanent loss occurs when the value of your asset drops below what it was when you made the deposit.

• Know the Relevant Financial Regulations: The regulatory crackdown in the US has shown that DeFi isn’t exactly out of reach from regulators as most people think. Therefore, being aware of the financial regulations in your country can help you determine if the protocol you’re using is breaking any financial laws-

• Utilizing Stablecoins: Use fiat-backed stablecoins to protect your investment from high volatility. This is essential if you want to retain the value of the assets you deposit in a DeFi protocol.

• Conducting Thorough Research: Thorough research allows you to identify serious protocols with sound value propositions, dedicated developers, and strong communities.

LSDFi – Crypto’s Hottest Yield Opportunities

LSDFi is an emerging sector that combines DeFi and liquid staking. It encompasses DeFi protocols that offer a variety of structured products built on LSDs. These products include LST-backed stablecoins, liquidity aggregator indexes, governance aggregators, high-yield indexes, interest rate swaps, and diversification indexes.

The goal of LSDFi, also known as LSTFi, is to give LSD holders more yield opportunities. For example, investors can use their LSTs as collateral to mint LST-backed stablecoins, which can be used to generate more yields.

LSDFi protocols have grown significantly in 2023, recording a TVL of almost $1 billion as of August. This indicates that there is an increasing demand for products within this sector.

Source: CoinGecko

The top protocols are Lybra, EigenLayer, Pendle, Origin Ether, and Raft. Lybra and Raft focus on LST-backed stablecoins, while EigenLayer offers restaking services. Restaking is a mechanism that enables investors to use their staked crypto assets to secure other networks. On the other hand, Pendle allows interest rate swaps, while Origin Ether is a high-yield platform with an index that earns yields from LSTs.

Although LSDFi can potentially boost yields, it poses a few challenges, such as over-centralization, complexity, and security issues. However, as the sector evolves and protocol competition increases, these challenges could be minimized or eliminated.