The Risk and Reward of Yield Farming  by@mkaufmann

The Risk and Reward of Yield Farming

In yield farming, a yearly percentage yield (APY) is used to measure returns on investments. Yield farming tends to have much higher returns due to a protocol's high need for liquidity. However, as you would expect, higher returns come with increased risk. Decentralized lending protocols enable cryptocurrency holders to access their holdings without selling their assets and facing taxes. Liquidity pools are an additional option for investors to earn interest on their crypto in the yield farming ecosystem. Investors can deposit crypto into decentralized exchanges to earn a percentage of the fees generated.
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Matthew Kaufmann

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In yield farming, a yearly percentage yield (APY) is used to measure returns on investments. Yield farming tends to have much higher returns due to a protocol's high need for liquidity. However, as you would expect, higher returns come with increased risk. Due to the high potential for returns, it's common for investors to compare this to the interest rate that a bank offers on a savings account. 

There are a variety of strategies for investors to earn returns through cryptocurrency. For example, Proof-of-Stake (PoS) blockchains like Solana compensates users for validating transactions on the network via staking. Ethereum is also transitioning to PoS, enabling users to stake their ETH and earn additional tokens.

Lending is another area where investors can earn returns on their crypto, utilizing Defi lending protocols to get loans against their crypto assets. They can then use the borrowed tokens to earn interest via staking or providing liquidity. Investors can also earn by lending out their crypto via lending protocols.

Liquidity pools are an additional option for investors to earn interest on their crypto in the yield farming ecosystem. Investors can deposit crypto into decentralized exchanges (DEXs) to earn a percentage of the fees generated. We'll look into each system below.

How staking works in yield farming

It is possible to earn interest by staking the native token of a blockchain project that uses the Proof of Stake (PoS) algorithm. This works by locking up your tokens in a staking smart contract. When users stake their tokens, they have a chance to be selected as a validator for the next block of transactions. The more tokens an investor stakes, the better the chances they have of being selected. Once a validator is selected, they validate the next block and receive additional tokens as a reward.

The relationship between yield farming and lending

There are even bigger returns if you put your crypto assets into a lending mechanism. Decentralized lending protocols enable cryptocurrency holders to access their holdings without selling their assets and facing taxes. On the other hand, by becoming a lender, you can receive interest payments from borrowers who are using the platform. Supply and demand can cause changes in interest rates that can occur on a minute-to-minute basis. In order to keep interest rates from fluctuating too much, certain lenders may use certain procedures.

You'll need to use a Defi lending protocol if you plan on yield farming as a lender. You swap the tokens you wish to lend for the corresponding tokens when you want to lend. As people pay off their loans, the value of the tokens increases steadily. Due to this, your tokens will be worth more than when they were swapped for your initial coin.

How users can optimize yields on their BTC and ETH holdings

There are platforms that users can use to grow their BTC or ETH holdings in the Defi space. For example, InvestDEFY today announced the launch of STACC, a dynamic weekly yield enhancement program for BTC and ETH. Without employing leverage, STACC enables the growth of an investor’s stack of BTC and/or ETH, boasting greater annual percentage yields (APYs) than traditional call and put writing strategies. 

Driven by InvestDEFY’s Digital Asset Trading Automation (D.A.T.A.) platform and guided by its DORA Predictive Explorer analytics platform, the STACC program is optimized to generate attractive APYs each week while allowing for upside participation on the underlying asset.

STACC is also structured to allow all of the program’s collateral and assets to be safely held with its custodian, eliminating the need to transfer assets to any counterparties, reducing exposure to undue risk, and further bolstering the safety and protection of assets.

“STACC harnesses our deep expertise in artificial intelligence and multi-factor model design to create a thoughtful alternative to yield farming,” said James Niosi, CEO and co-founder, InvestDEFY. “We are therefore able to offer very attractive APYs while providing upside participation on the underlying asset.” 

Using a weekly signal produced by DORA, STACC expresses its view by selling one-week options using calls, puts, or a combination of both. Option structures are then automatically deployed into the STACC trading system, which prices the option(s) and routes for execution into the best market, controlling for liquidity, price discovery, and slippage. Yield in the form of premiums is reinvested each week, compounding over the lifetime of the investment.  

“In light of recent events with stablecoins and the inherent risks of yield farming, the timing felt right to launch a program that does not have exposure to the same type of lock up and counterparty risks as traditional yield farming,” continued Niosi. 

“While we applaud the technical design of current DeFi option vaults, our hybrid solution sources both high-touch OTC counterparties as well as low-touch centralized marketplaces, improving price and liquidity discovery.”

Program collateral and assets are not rehypothecated under any circumstance. InvestDEFY also recently announced the strong performance of its weekly market neutral yield harvest program, SYGMA, amidst the volatile crypto market.

The program had greater returns and less volatility compared to BTC and ETH. SYGMA BTC generated an 8.52% return with an 8.63 volatility, and SYGMA ETH returned -4.01% with a volatility of 14.6 from January 21, 2022 to July 1, 2022. 

During the same period, BTC dropped -50% with a volatility of 72, and ETH fell -62% with a volatility of 90. 

Yield farming and liquidity pools: An overview

Investors can become liquidity providers for a decentralized exchange to earn interest on their cryptocurrency holdings. Whenever a user initiates a trade on a DEX, the tokens are taken from and deposited into liquidity pools.

For example, if a user wants to trade USDC for ETH, the DEX will take their USDC, deposit it into the USDC pool, and provide ETH from the ETH liquidity pool. As a result, a decentralized exchange can provide exchanges for almost any cryptocurrency pair without storing any crypto itself.

Liquidity providers get the fees a DEX generates from trades. Regarding the entire liquidity pool, each provider's amount is proportional to that provider's part in the pool. You may see that the value of your trading pair changes over time with volatile cryptocurrencies. As a result, your cryptocurrency may lose value rather than if you had kept it out of the liquidity pool.

Conclusion

Yield farming is one of the many different sectors within the decentralized finance landscape. Whilst there is potential for high returns, it also comes with increased risk.

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