It’s taken a couple of years, but decentralised finance (DeFi) finally has a killer application… that’s handing investors yields of 100%+ right now.
The way they are making these outrageous returns is through what’s known as “yield farming”.
Take note of that term, because you’re sure to hear it pop up in all kinds of places over the next few months – if you haven’t already.
In today’s issue, we’re going to take a look at what yield farming is, how it’s making people so much money, and assess its sustainability.
Because, as I’m sure you’ve already gathered. As with anything that promises extreme returns, yield farming also comes with equally extreme risks.
So let’s get started.
You lost me at DeFi…
At its core, yield farming works by stacking high-yielding investments on top of each other to multiply their returns.
And in order to explore it, we’re going to need to stack a few crypto concepts on top of each other, too.
So, if you’re not familiar with the term DeFi, then check out my explainer on it from earlier this year: What is DeFi and why is it such a big deal?
And then take a look at my recent article about DeFi lending and the success of Compound’s COMP token here – A new kind of ICO: Compound’s COMP token is up 234% since Monday
Those two articles will give you everything you need to know to get your head around this one.
But, if you can’t be bothered with all that, here’s a very short summary:
- DeFi is short for Decentralised Finance. It is basically taking traditional financial instruments – such as lending and borrowing – and building them on crypto.
- Just as Bitcoin allows two people to exchange money without needing to trust each other, DeFi allows you to build more complex financial arrangements without the need for trust.
- So with DeFi you can mimic whatever you can do in traditional finance – build banks, create stockmarkets, issue insurance – using crypto.
- Why would you want to do this? It means things cam be much more efficient… crypto cuts out the middleman and makes systems more democratic and fairer for everyone involved.
- For example in DeFi lending, the rates are agreed directly by borrowers and lenders, without the third party – the bank – taking a cut.
- This is why lending and borrowing through DeFi usually offers much, much better rates to both borrowers and lenders – often more than 10-times better than traditional banks.
- DeFi allows people to build all kinds of financial products with much better rates than is possible in traditional finance.
- As with most new ideas, it’s taking a while for the world to recognise just how powerful DeFi is, but over time it’s going to revolutionise… well, pretty much everything in finance.
Right, so now we’re au fait with DeFi, let’s get onto its breakthrough application: DeFi lending.
DeFi lending is all about yield
DeFi lending allows you to borrow money at lower rates and lend money out at higher rates than you could get with a bank.
Right now, on compound for example, you could lend out DAI stablecoin at 4.35%, or USDC stablecoin at 1.86%.
compare this to the 0.01% (yes you read that right, source) you would get with your typical bank, and you can see why DeFi lending is making such a splash.
However, DeFi lending has been around for a fairly long time. I remember I wrote an issue of Crypto Wire on in back in 2018 or 2019.
And while 4.35% is a lot more than you would get from a bank, in crypto terms, it’s hardly that exciting, is it? I mean the S&P 500 would return you more than that on average.
But how about 100%?
Now that’s a potentially life-changing yield. And that’s what people are currently making with a new DeFi lending technique known as yield farming.
How does yield farming work?
One of the best terms I’ve seen for yield farming is “money Lego”.
Basically you stack many different DeFi lending products on top of each other to multiply the yields.
And the reason you’re able to do this is because DeFi lending allows you to actually make money by borrowing money.
Remember that article on Compound I mentioned earlier?
If you read it, you’ll see that whenever you use compound’s platform to lend or borrow money, you now get rewarded with COMP tokens.
And here’s where things get interesting.
COMP tokens are worth a lot of money. At time of writing, COMP tokens are trading for $166, but they have been up as high as $350.
The way you get COMP tokens is by either borrowing or lending on compound’s platform.
And in some cases, the value of the COMP tokens you can generate is higher than your cost of borrowing on the platform.
How to make a 100%+ yearly returns by yield farming
So, to use a simplified example (not a real-world example!):
- You could lend out your money on compound, make a 4% yield and at the same time generate the equivalent of a 6% yield in COMP tokens.
- You could then take your 10% return and borrow against it.
- In DeFi lending you can only borrow against money you already have to keep the system stable. I’ll cover this in more detail in just a second.
- You borrow at an interest rate of 5%. But you’re also generating that same 6% yield on your borrowing in COMP tokens.
- So you’re actually making 1% by borrowing money.
- Plus the 10% you’re making by lending out your money. So now you’re making an 11% yield on your money.
- You could then lend this money out at another 10% and borrow against that return and make another 1%… yielding you a total of 22%.
- So you’re adding these yields on top of each other like Lego bricks.
- Keep going and you could get up to a yield of 100%+.
What’s stopping you from adding these yields on top of each other forever?
Well, as I said, the thing with DeFi lending is that you can only borrow against money you already have. You have to put up your own money as collateral.
And you have to keep your loans collateralised at set percentages (which are subject to change) or they will be automatically liquidated.
Here is where we get into the real risks of yield farming
Yes, in theory you can keep stacking these yields on top of each other until you’re making a staggering return. But with every layer you add, you’re increasing your risk.
Many of the best yields don’t come from stablecoins, but from ordinary cryptos that fluctuate in price a lot.
If the price of the crypto you’re borrowing against drops, then your loan could be liquidated unless you add more money into it.
This is fairly easy to keep on top of if you’re just doing basic borrowing. But start stacking different loans on top of each other and it becomes a lot more complicated and a lot more difficult to keep track of.
And then to stick with the Lego analogy, if one of your bricks gets liquidated, your entire Lego castle could collapse.
If you’re a regular reader, you’ll know these kind of liquidations do happen. And sometimes on a massive scale.
Just a couple of months ago we had DeFi’s “Black Thursday” where one of the biggest DeFi platforms, MakerDAO, malfunctioned under market demand and some people managed to buy $8 million of Ethereum for $0.
That $8 million of Ethereum didn’t come from thin air. It was other people’s money that they had borrowed against.
So while yield farming can, in theory – and in practise, to be fair – make you a lot of money, like many things in crypto, it is incredibly risky.
Right now with the yield farming craze, we’re at the point of high risks and high rewards. Much like the ICO craze of 2017.
Over time the risks and the rewards will diminish as the arbitrage opportunities are eaten away and more professional players enter the game.
For example, you can now get DeFi insurance that (in theory) protects you against the risks of liquidation.
But there’s no getting around the fact that right now yield farming is the wild west of the wild west.
As Ethereum co-founder Vitalik Buterin said last month:
Personally, I think it’s an amazing phenomenon that simply wouldn’t have been possible even a couple of years ago.
And I think the people making a killing off it right now are trailblazers that are clearing the way for many DeFi developments down the road.
So I think that for anyone interested in crypto, it’s an important topic to stay informed about… but probably not one to actually get involved in, unless you really, really know what you’re doing.
And I have a feeling it’s going to get a lot of attention as the mainstream catches on to its potential. So watch this space.
Okay that’s all for this week.
Thanks for reading.