What Is Leveraged Yield Farming and How It Can Bring Higher Returns

Yield farming

Yield farming is putting your crypto assets to work to generate returns. The tokens that sit idle in your account can be provided to the liquidity pool. You will generate more crypto with your crypto for providing liquidity. Yield farming is one of the most popular uses of decentralized finance or DeFi. It usually involves two assets to farm the yield. Say, you’ve both ETH and USDC that don’t earn any income for you. You can start yield farming by providing liquidity for the ETH/USDC pool.

Leveraged yield farming

Leveraged yield farming (LYF) is what its name suggests. It’s yield farming that uses leverage. LYF allows you to borrow and farm those tokens too to increase your return. Say, you put 100 USDT into a yield farming protocol. If you want to do yield farming with only your 100 USDT, this means 1X leverage. If you borrow 100 USDT and put that amount to work, it means you use 2X leverage. Borrowing twice the amount that you put originally is 3X leverage and so on.

LYF is capital-efficient which means that you can borrow more than you put up. This can strengthen your yield farming positions. As of this writing, 1X (that’s standard yield farming) yield farming on BUSD/USDT on Kalmar, a protocol built on Binance Smart Chain gives only 4.7% APY. But if you choose the maximum possible 6X leverage, you’ll get 44.05% APY!

Note that this capital efficiency works not only for farmers but for lenders too. The first DeFi lending protocols were overcollateralized. That is you had to put up more than you could borrow. If your collateral was worth 100 USDT, you could only borrow, say, 90 USDT.

You were able to put those 90 USDT to work for you and generate income, but it would be cool if you could borrow 100 or even more than 100 USDT, right? This means that the utilization rate was low; only some part of the lent money was being borrowed by farmers.

And this in turn means lower APYs for the lenders because there’s a supply and demand relationship between utility rates and interest rates on most lending platforms. High demand for loans that lenders put up leads to higher returns.

With LYF, this isn’t the case. LYF platforms are more capital-efficient because they allow for undercollateralized loans. Since farmers can borrow more than they put up as collateral, they’ll utilize more funds to put to good use to earn extra income. This will drive the utilization rate of loans upwards which in turn will yield higher returns for the lenders. Leveraged yield farming is a win-win both for lenders and farmers.

Risks

As in traditional financial markets, in yield farming leverage is a double-edged sword too. First, there is an impermanent loss risk. Impermanent loss is the yield farmers’ risk that is most discussed. When you provide liquidity to a pool, the dollar value of your token can increase or decrease.

This may result in the amount you withdraw is less than the amount you put up. That’s why it’s a loss, and since it isn’t realized until you liquidate your position, it’s impermanent because the token price can always come back to its initial price. You face the risk of impermanent loss in leveraged yield farming as in standard yield farming.

An investor also faces a higher liquidation risk with leveraged yield farming. Since you borrow funds to farm yield with leverage, even not a very volatile move can lead to liquidations. The table below shows the relationship between the leverage level and a threshold for a potential move in token prices which can result in a liquation. If you’re leveraged with the level of 3, a -31% move will lead to the loss of your funds. If you have been in crypto markets for a while, you may know that 30% volatility is not that rare.

One way to decrease the liquidation risk is to farm the less volatile assets. Farming with stablecoins is much less volatile than other tokens. But note that APY for the leveraged yield farming with stablecoins is also lower than that with the more volatile tokens. You can also choose to add collateral if you’re close to being liquidated.

Other investing uses of LYF

Other than increasing farming returns, leveraged yield farming can be used for different investing purposes. One of them is holding with leveraged yields. Let’s say, you believe that SOL will outperform; you can express your belief with the leveraged SOL 2X, but you may not like the idea of leverage.

That’s where LYF comes to help – you can farm at 2X leverage by borrowing a token different from the token you are holding. If you have $1,000 SOL, you can consider borrowing $1,000 USDC and start to SOL-USDC farming at 2X leverage. Or you may borrow another token, say, AVAX, and do LYF SOL-AVAX at 2X. An investor hasn’t levered up his holding token but is farming at levered yields. When he withdraws his LYF position, he’ll return the borrowed token.

Though holding with leveraged yields will magnify your return, it has the risk of impermanent loss. If the token you’re holding appreciates in value over a short period, you’ll experience an impermanent loss, that you would do better if you just held the token instead of farming. But if you do LYF for a long period, 2X returns can make up for an impermanent loss.

Note that if you do LYF with a token-token (other than stablecoin) pair the change in the price of the borrowed token would also cause an impermanent loss. In our example above, if AVAX appreciates significantly, it’ll result in impermanent loss too. But again, farming at 2X lever can offset this loss. Therefore, think of holding with leveraged yields as a long-term strategy.

Another trading idea you can express through LYF is leveraged long. If you have a strong conviction that SOL (any token for that matter) will perform well, you can do LYF > 2X leverage with SOL-USDC. Say, you have $1,000, and you decide to borrow $2,000 USDC to lever up to 3X. To make a 50:50 proportion, $500 out of your $1,000 borrowing will be swapped to $500 SOL. Now, you have $1,500 SOL which means that you’re 1.5X leveraged long on SOL.

You can do this with a non-stablecoin token too. If you want to borrow $2,000 AVAX, and do LYF with SOL-AVAX pair, $500 AVAX will be swapped to $500 SOL. By holding $1,500 SOL you’ll be 1.5X leveraged long on SOL. But there’s a risk. When part of AVAX borrowing is swapped to SOL, it means that you’re shorting AVAX. This means that you have a short position in AVAX. Whenever you are doing LYF with >2X leverage, you’ll have a short position in the borrowed token. You may consider doing LYF with a stablecoin to minimize this risk.

If you thought that you can do leveraged short with LYF, you’re right. The way of doing it is to deposit a stablecoin, borrow the token that you want to short, and farm the token – stablecoin pair at >2X leverage. If you believe that the SOL price will fall, you can deposit $1,000 USDC, and borrow $2,000 SOL. $500 out of your borrowing will be swapped to USDC to create an SOL-USDC position. Thus you’ll have $1,500 in SOL short position.

Pseudo-delta-neutral yield farming

You can also benefit from leveraged yield farming even if you don’t have exposure to the market direction. Pseudo-delta-neutral yield farming allows you to do it. Think of this strategy as a combination of the leveraged long and leveraged short. First, you create a leveraged long position on an asset, and then you do a leveraged short position on the same asset. Since you’ll earn returns regardless of the market direction, it’s delta-neutral. But sometimes your position can move away from neutral as prices change; that’s why it’s called pseudo-delta-neutral farming.

Say, you want to do pseudo-delta-neutral farming with the SOL-USDC pair. First, you deposit $1,000 SOL and borrow $2,000 USDC which means you have a 3X leverage. You’ll be farming SOL-USDC with $1,500 SOL and $1,500 USDC; thus, you’ll be long $1,500 SOL.

Then, you’ll deposit $3,000 USDC and borrow $6,000 SOL, $1,500 of which will be swapped to USDC. You’ll be farming with $4,500 SOL and $4,500 USDC, and you’ll be short $1,500 SOL. Your long and short SOL positions will cancel out, and you’ll be earning a return on your $4,000 ($1,000 + $3,000 that you have deposited) which is near neutral.