Yield farming is one the most popular methods for earning returns through decentralized finance and it saw a huge growth in users across 2020 and 2021. However, is the system still viable for investors in 2022? Let's look at yield farming, how it works and if it's still worthwhile for users in the Defi space during the current market conditions.
What is Yield Farming?
Yield farming, also known as liquidity mining, is the process of generating interest on your cryptocurrency, usually through decentralized finance (Defi) applications. Yield farming is actually a form of staking (depositing and locking tokens in a smart contract) and it covers a range of platforms and protocols farmers can engage in this process in many ways including:
- Becoming a liquidity provider and adding tokens to a liquidity pool
- Using lending and borrowing platforms to earn interest by lending or increasing leverage by borrowing
- Arbitrage by taking advantage of the different rates between multiple lending platforms to make a profit on the difference
- Staking their tokens through high APY protocols (usually newer projects that will benefit from an increased number of users staking their tokens to secure the network)
These methods can be used individually or combined to increase an investor's earnings, for example, a user could borrow from a lending protocol and use the borrowed funds to provide liquidity and earn interest.
Yield Farming is popular because a lot of new projects need liquidity for their users to take part in their ecosystems. In order to increase liquidity, these projects create protocols or leverage existing protocols to attract liquidity providers (LPs) through high APY farms. Using these tools, an LP can deposit a set amount of tokens and earn interest in return for providing liquidity. However, the high APYs come with an increased risk to the investors since they're dealing with higher volatility of the projects they're engaging with. It's the classic risk vs reward principle at play here.
When it comes to measuring the number of funds locked into farming protocols, we use Total Value Locked (TVL) to determine this metric. TVL simply refers to the dollar value of the tokens (stablecoins, crypto, reward tokens, farm tokens, etc.) that are "locked" or being staked in the protocol.
When it comes to calculating returns, it's done on a yearly basis, essentially measuring how much one would earn if they kept their tokens locked for a whole year. Whilst returns are calculated on an annual basis, investors can still determine how much they'll make on lower time frames such as weeks and months, and even days in some cases.
The main ways to determine returns are through the annual percentage rate (APR) and annual percentage yield (APY). APR is mostly popular with lending and borrowing platforms but this measurement does not take compounding into account. APY on the other hand includes compound interest when calculating your returns. This is an important distinction since compounding tools like Beefy Finance have become popular with investors in the Defi space.
Another thing to note is that APR and APY often change over time, usually due to an increase of users engaging in the protocols which tend to lower the rate of return. This is why farmers tend to swarm onto newer protocols and start to leave as many new investors start to find out about the protocol and join in on the yield farming.
Is Yield Farming Still Viable in 2022?
Yield farming whilst profitable still has some drawbacks for users in the decentralized finance ecosystem. For one, volatility is the main issue, for example, Bitcoin (BTC) and Ethereum (ETH) have experienced dramatic price swings this year, along with the rest of the crypto market. This volatility affects users who lock their assets into protocols that use these cryptocurrencies and their underlying assets.
Another issue is the high correlation of Bitcoin and Ethereum to other cryptocurrencies, with other crypto coins usually following the price movements of Bitcoin and Ethereum. In a lot of cases, you can look at the charts and see very similar patterns. For example, high liquidations in BTC and ETH show steep drops that are visible in many crypto charts, showing steep drops and recoveries in the same time frames.
Additional issues include downside risk on assets and low yield generation on blue-chip assets like Bitcoin and Ethereum. When it comes to low yield generation, blue-chip assets, whilst still risky, still have lower volatility than newer projects. Due to this, there is less incentive for protocols to provide higher returns since investors are dealing with less risk. This can lead to investors seeking out much riskier assets and protocols in search of higher returns.
There are platforms that users can benefit from in the current market conditions. SYGMA, a weekly market-neutral yield harvest program built by InvestDEFY showed a strong performance despite the recent downturn in the crypto market. The platform houses BTC and ETH assets and from January 21st 2022, to July 1st, 2022, SYGMA BTC generated an 8.52% return with an 8.63 volatility, and SYGMA ETH returned -4.01% with a volatility of 14.6.
This is in contrast to a -50% return for BTC with a volatility of 72 and a -62% return for ETH with a volatility of 90 during the same period. SYGMA uses custom derivative structures to generate yield in the form of premiums and provide returns within a set protection limit, even if the markets move lower over a given week. The combined returns are reinvested each week, compounding over the lifetime of the investment.
Collateral assets are held within the platform's custodian, making it possible for users to engage with the protocol without the need to transfer their assets through multiple counterparties. Due to this, there is less exposure to undue risk for users.
“The past two months' sell-off caught even the most conservative of market neutral funds off guard, evident in their May and June returns. Layer in supposed “no risk” yield farming strategies that turned a blind eye to counterparty risk and the carnage is even more vast and far-reaching,” said James Niosi, CEO and co-founder of InvestDEFY.
“We credit our team’s deep TradFi and crypto trading experience over the last 25 years through numerous global tail events, as well as our proprietary predictive models (D.A.T.A. and DORA), with successfully guiding SYGMA through the May and June spike in volatility and violent sell-off.”
Yield farming is still viable for investors in the Defi space. Investors need to stick to safer protocols and increase their risk management if they decide to engage in yield farming in 2022. There are safer assets (i.e BTC & ETH) that provide lower returns but come with less downside risk than lower market cap projects.
Conclusion
Since its inception, yield farming has been one of the more popular ways of earning interest for investors in the decentralized finance ecosystem. With its variety of tools and methods, it has attracted many users to the various protocols that operate within the Defi space. Despite higher volatility in 2002, yield farming is still a viable way for investors to make a return on their crypto holdings.