Crypto Crofters: How to Earn More Crypto While Curbing Yield Farming Risks
The DeFi pasture is teeming with yield farming risks, so here's how to stay safe while getting rewards for your crypto.
Updated Jun 25, 2022
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Being a yield farmer isn't easy, but it's honest work. Investing crypto in hopes of earning more crypto is what DeFi is all about, but it doesn't come without risks. While we all want to earn sky-high returns with minimal effort, that's just not how things work on the blockchain.
Yield farming can be more lucrative during a bear market, but such conditions also pose more risk.
Yield farming is a game of managing risk while capitalizing on the best opportunities, wherever they may be. Here's what to look out for if you want to get the most out of DeFi and limit those perilous yield farming risks.
What is yield farming?
What is yield farming?
Yield farming refers to allocating crypto to decentralized finance (DeFi) protocols in a way that maximizes rewards. This often involves depositing cryptocurrencies into several interoperable protocols to enhance yield. While utilizing a combination of DeFi protocols is the best way to optimize crypto yield, each yield farming strategy comes with inherent risks as well.
Most yield farming strategies involve a combination of staking in proof-of-stake protocols, providing liquidity to a decentralized exchange (DEX), and depositing into a crypto lending platform. Each of these varies in terms of its reward potential and risk profile, so it's crucial to formulate your own balanced yield farming strategy.
Pros and cons
Maximize capital efficiency
Earn higher net yield
Maintain custody of assets
Volatility impacts profitability
Numerous risk factors
Isn't necessarily 'hands-off'
Yield farming benefits
The main benefit of yield farming is maximizing the capital efficiency of your crypto assets. Sticking to a single yield source is usually less risky, but also means missing out on potential rewards on other networks and protocols. Fortunately, many DeFi protocols are interoperable, meaning you can earn from using a single crypto asset on more than one platform at a time. This enables you to earn yield from multiple sources using the same crypto.
Every protocol has a different way of distributing rewards and they're usually composed of both in-kind rewards and tokens. Tokens may simply be a bonus for things like lending or borrowing or a governance token that incentivizes participation in the protocol. Most DeFi platforms don't automatically compound rewards, but other platforms offer enhanced long-term yield by automatically compounding your rewards. You can also manually deposit and allocate the tokens you're rewarded to accrue yield from other sources.
The best part about yield farming is that your assets remain fully in your custody while they're earning you rewards.This means you can withdraw and deposit your yield farming cryptos whenever you want since they basically never leave your account. While the best yield farming strategies are passive, you'll want to keep a closer eye on your DeFi portfolio as you take on more risk. A few exchanges like Coinbase and Gemini will pay you interest for holding certain cryptos in your account.
Yield farming risks
Along with rewards, you must also consider yield farming risks for each of these strategies as well as market conditions as a whole. For instance, crypto prices going down impacts all investors, but yield farmers can be acutely affected because their strategy may prevent them from quickly exiting a position during a market downturn. While yield farming can be more lucrative during a bear market, such conditions can also pose more risk for your assets.
Many popular yield farming strategies involve crypto lending and borrowing, but borrowing against your crypto is the riskiest approach because your assets could get liquidated if their price dips too low. You can earn practically risk-free by just lending out your crypto, but using it as collateral to borrow and enter a leveraged position could produce higher returns in exchange for more risk. Choosing a collateral-to-debt ratio you're comfortable with is the key to yield farming on crypto lending platforms.
Being a liquidity provider also has risks, but they manifest differently than other yield farming strategies. Cryptos in liquidity pools can diverge from market prices as a result of being used to trade a high volume of one asset. This is known as impermanent loss and it can reduce gains when the price appreciates and decrease equity when the price depreciates—but this only translates to actual losses if you withdraw crypto from the pool. The best way to avoid this is by depositing highly correlated assets like stablecoins.
Yield farming strategies
Yield farming strategies
The two main types of platforms you'll encounter as a yield farmer are lending and borrowing protocols and decentralized exchange protocols. There are also auxiliaries like liquid staking protocols and DeFi yield aggregators that can be used in conjunction with other protocols to maximize yield. You must know how each one functions to understand how to best use them together.
Depositing cryptos into a liquidity pool—also called liquidity mining— is one of the most popular DeFi yield strategies because it enables traders to instantly swap cryptos on DEXs like Uniswap. Liquidity providers must deposit crypto into a pool to earn fees paid by traders. Equity in a liquidity pool is denoted in liquidity pool (LP) tokens.
LP tokens represent a liquidity provider's proportion of a liquidity pool and holding them entitles you to the fees it generates, but these rewards must usually be claimed manually and this may incur a transaction fee. The solution to this is DeFi aggregator platforms that optimize yield by automatically claiming rewards and depositing them back into the liquidity pool for you. Compound interest is a super effective method for maximizing yield both in traditional finance and DeFi.
Lending and borrowing
Decentralized crypto lending and borrowing platforms are a great tool for earning yield on otherwise idle assets. Most DeFi lending platforms like Aave offer two main functions: supplying and borrowing. First, supplying crypto means depositing assets into the protocol to be lent to other users, but it can also mean posting collateral for borrowing crypto. Second, borrowing means taking out a crypto loan against the collateral you deposited—or supplied—into the platform.
Crypto lending platforms can range from very safe to extremely risky depending on how much debt you take on. Simply supplying crypto onto the platform can be a slow and steady yield farming strategy but is far from rewarding. Contrastingly, you can also use your supplied crypto to enter a leveraged position by borrowing stablecoins and using those to buy more crypto. This is the riskiest approach because your collateral could get liquidated if its value drops below a certain level.
Keeping your debt value well below your collateral value is the best way to maximize yield while minimizing risk. Supplying crypto without using it as collateral for loans is the safest and most hands-off approach, but borrowing stablecoins against stablecoin collateral is also relatively risk-free since their prices tend to stay the same. Lending and borrowing platforms are most bankable when they offer bonus token rewards, but bonus APY is less reliable since it's subject to change.
Liquid Staking Solutions
Liquid staking tokens are derivatives of proof-of-stake tokens locked in deposit contracts and they've become an integral part of yield farming strategies. A famous example of a liquid staking derivative is stETH, which is a token representing staked ETH that's locked in a staking contract until after the Ethereum merge. Liquid staking tokens like stETH can be deposited into other DeFi platforms to earn additional yield.
The best proof-of-stake cryptos allow you to earn yield for helping secure the network by staking coins with a validator, but this may involve a locking mechanism to disincentivize near-term withdrawals. Instead of relegating your assets to a single source of yield, you can use a liquid staking platform like Lido to maximize the yield earned from staked cryptos. Liquid staking tokens can be supplied to a lending platform as loan collateral or provided as liquidity to a DEX.
By depositing liquid staking tokens into DeFi protocols, you can earn staking rewards while simultaneously generating yield as a liquidity provider or crypto lender. Liquid staking helps maximize the capital efficiency of your proof of stake cryptos, but one downside is that liquid staking derivatives run the risk of depegging from the underlying asset. So, while yield farming with liquid staking tokens can be more profitable, it doesn't subtract any of the risks.
The ultimate goal of farming is not the growing of crops, but the cultivation and perfection of human beings.
It's easy for yield farmers to let greed get the best of them. We all want to put our assets to work and get the most out of them, but this can make us blind to the risks lurking in the corner—or staring us in the face. Does DeFi investing favor the bold or the wary?