The crypto industry offers users a spectrum of investment tools: synthetic assets, liquidity pools, index tokens, lending solutions, yield farming, hodling, etc. From among the big list, yield farming stands out the most because it promises the highest returns promised by any project.
Coming from the traditional financial environment with low interest rates, beginners and small investors are drawn to the idea of quick gains, requiring just a few clicks to start making profits.
But with high returns come high risks and important nuances, like the risk of impermanent loss, the fact that APY is only an estimation that gets adjusted daily, the number of fees, as well as price and smart contract risks. In the end, it's questionable whether yield farming is a good income-generating opportunity for users who have smaller sums of money to play with and not enough knowledge to leverage advanced farming strategies.
So, is yield farming cost-effective? What are the risks and how do you mitigate against them?
Yield farming or liquidity mining is a way to make more cryptocurrency with existing holdings by locking funds in the protocol and earning rewards for it. In basic terms, users usually provide liquidity to a pool and then stake LP tokens to receive rewards.
But it's false to think of yield farming as free money or a passive income. The process implies constant monitoring of the market so as to be able to react to the changes in a timely fashion, understanding the logic of smart contracts and possessing enough knowledge to assess the risks. To get a general understanding of what it takes to make high returns, go through this compilation of yield farming strategies, published by DeFi Rate. Advanced strategies include lending, arbitrage trading, participating in loan pools and interaction with multiple protocols. The delusion about how easy it is to make ten-fold returns on the initial investment results in users getting into an affair they can't sustain.
What a retail investor can do: One of the ways to maximize returns while minimizing the number of iterations is to farm using yield aggregators and automation tools. In this case, a user deposits LP or single tokens into the protocol and the smart contract handles the operations. Here's an example of how it works.
Beefy Finance is a yield optimizer on Binance Smart Chain, HECO and Avalanche. The project runs over 200 vaults, each attributing to a farming project. For example, a user deposits ADA in a vault powered by Venus and forgets about it till the moment they decide to harvest the rewards. Beefy deposits users’ tokens into Venus to borrow against it and redeposits the funds into the platform. The process is repeated several times. Each time, it generates some XVS (Venus’ native token) which is sold to get more ADA. In the end, users get more of the tokens that they deposit and all the work is done by the smart contract.
APY stands for Annual Percentage Yield, which represents the rate a user can earn on an investment in one year, considering compounding interest. The metric is often used together with the Annual Percentage Rate (APR) to calculate potential returns. When choosing your strategy based on APY, it's important to remember that it's only an estimation of what you can earn and the metric changes in real-time, based on the liquidity within the pool. Thus, the rewards can fluctuate rapidly and significantly.
In the yield farming world, the more people know about your strategy, the less effective it is. High yield attracts more users, hence liquidity to the pool and with each user, the APY changes. Thus, high APY either implies high risks that only a small portion of users are willing to take or it is a temporary thing.
As Vitalik Buterin said:
What a retail investor can do: APY and liquidity movement are out of the user's control and the only actions they can undertake is to educate themselves on the risks and find out what is omitted from the equation when solely judging by APY.
The amount of money a user is able put into farming is the key to the amount of rewards they will get. The logic is: to perform a transaction, a user needs to pay Gas fees and it all comes down to the simple math of whether the rewards exceed the fees or not.
Imagine you want to start farming on an Ethereum project. You need to provide liquidity to the Uniswap pool, go to the farm and deposit LP tokens, maybe you'll need to approve tokens, then you withdraw liquidity and harvest rewards before removing liquidity from the pool. Each of these actions require a Gas fee payment. With only small amounts available for staking, you will spend more than earn or the gain will be minimal.
In a study run by Coingecko, 73% of farmers stated that they are willing to spend up to $10 in fees on one transaction. All steps combined, a farmer can spend over $100. Since September 2020 when the study was conducted, Gas fees on the Ethereum network have grown exponentially.
At the time of the survey, it took a minimum of $1,000 to see any returns. Even then, farmers were losing around 10% of their portfolio to fees before earning anything. In this case, the only way for an investor with funds of $1,000 to make solid returns is to stake funds for a much longer period.
What a retail investor can do: Congestion on the Ethereum network and high Gas fees facilitated the development of farming solutions on other blockchains. Users with a small portfolio will benefit from small Gas fees on Binance Smart Chain and Huobi Chain (HECO). Some of the most popular farms on BSC are PancakeSwap, Venus, Beefy Finance and Autofarm. As for the HECO network, there is FilDA, MDEX and Channels Finance.
There are also a number of risks that are relevant to every protocol and type of investment. One of them is smart contract manipulation, as no protocol is 100% secure. This year alone, several DeFi protocols were attacked and in some cases, teams made off with users’ tokens by carrying out rug pulls. These are the types of risks that are impossible to predict. The only way to protect your funds is to rely on audited protocols and take extra security measures.
Since most yield farming solutions rely on liquidity pools, there is also a risk of impermanent loss. The risk occurs when users contribute to the pool and then the price of the token rises. When the time comes to withdraw liquidity from the pool, users end up with a smaller amount of the growing token. Some of the ways to avoid impermanent loss are to provide liquidity to stablecoin pools or choose less volatile cryptocurrencies.
Yield farming, at least on the Ethereum network, is not the best investment tool for users whose portfolios are less than $1,000 and who lack the knowledge and time to assess the options for making well-balanced decisions. Therefore, small investors will benefit most from farming on Binance Smart Chain and the HECO network. But even then, it's important to remember the changing nature of APYs, impermanent loss and the fees required to pay for each transaction.