Regardless of how much higher DeFi yields are compared to traditional finance, DeFi users are constantly looking for ways to optimize their profits by jumping from platform to platform and network to network in search of bigger APYs. Although we have seen in previous posts that this relationship is not healthy for the community, it is no wonder that leveraged yield farming has become a popular choice for experienced DeFi participants thanks to its higher capital efficiency than traditional DeFi protocols want to optimize their returns.
Let’s dive into this emerging DeFi opportunity. We’ll start by understanding the concept, explaining the mechanics of the strategy while looking at a practical example, and highlighting the risks involved.
Disclaimer Warning!
If you are unfamiliar with the concept of yield farming, we strongly encourage you to first read these articles that we developed a few months ago:
As a reminder, yield farming is a process whereby users (or farmers) receive additional incentives (typically in the form of transaction fees, interest from lenders, or governance tokens) to provide liquidity to a smart contract-based liquidity pool. For example, how a bank gives you interest on your savings, yYou can earn passive income from your cryptocurrency by pegging or locking your tokens to a DeFi protocol.
What is leveraged yield farming?
Leveraged Yield Farming is a mechanism that allows farmers to improve their yield farming position raise external liquidity (money from liquidity pools) and add it to their liquidity to farm. With more liquidity, a higher volume of returns can be expected.
Put simply, it is the practice of using borrowed money for yield farming. If yield farming with X gives you Y yields, then yield farming with 5X gives you 5Y yields. In other words, Borrowing money to increase your position X while using leverage multiplies your profits.
As with any lending service, you must pay interest on the money you borrow. And even compared to TradFi, borrowing rates for crypto can seem insanely high. However, this is where the high capital efficiency of leveraged yield farming comes in to create a great match. Leveraged yield farming offers unsecured loans (the ability to borrow more than you have pledged as collateral), which increases the usage rate, and this allows both farmers and lenders to have higher APYs. In this way, it is profitable to carry out this capital strategy since the rewards can significantly exceed the cost of borrowing. See an example below:
Alpaca Finance shows the breakdown of returns for a CAKE-BUSD pair
Leverage always comes with a risk. DeFi leveraged yield farming with Alpha Homora, Alpaca Finance or any other platform comes with a risk of liquidation. If the price of your token or base cryptocurrency in the pair falls, there is a chance that you could lose all your wealth. We will examine this later.
To understand this strategy, we must first understand the role of all actors involved in the process. Leveraged yield farming has two main players:
(1) Lenders who deposit their tokens into loan pools to earn returns
To understand how lenders can have better APYs in leveraged yield farming platforms, we need to understand lending platform usage (one of the leading indicators of capital efficiency). With traditional DeFi lending platforms, the loans are collateralised. This means you need collateral to borrow the tokens, which limits a borrower’s borrowing power.
Let’s take a scenario where a lending platform has 100 ETH and the farmer can only borrow 10 ETH due to the limited collateral. The utilization of the platform would be 10%. In the case of unsecured yield farming platforms, the borrower could borrow 60 ETH and thus achieve 60% utilization.
This higher utilization is important for lenders as most lending platforms have a rate model that increases with higher utilization, using the concept of supply and demand where higher loan demand results in higher lending rates.
(2) Farmers borrowing tokens from these credit pools to yield leveraged farms.
In a leveraged yield farming protocol, users first deposit any portion of the two tokens. So, taking the previous example of ETH and USDT, users could deposit just one or a combination of both, and the underlying protocol would perform optimal swaps in the background to convert the tokens into a 50:50 split for the LP Convert tokens (a process known as zapping).
To gain leverage, farmers can then borrow one of the tokens up to maximum leverage (1.25x to 6x depending on the pair and protocol). The protocol then uses an onboard DEX to convert all deposited and borrowed tokens into a 50:50 ratio to create the LP tokens for farming. When you stop farming, simply return the borrowed tokens.
Leveraged Yield Farmers (more than 1x position) run the risk of being liquidated as protocols borrow tokens to yield leveraged farms for you. If you open a leveraged position and borrow up to 5x the added funds, the protocol must ensure that you can repay that loan. So the amount you add from your funds acts as collateral, which is volatile and can change as token prices move.
Let’s introduce some key concepts to better understand how liquidation works:
- The debt value is the value of the borrowed tokens
- Position Value is the value of your farming position equal to your Collateral + Borrowed Assets + Earnings.
- The debt ratio is your debt value divided by the position value
- Equity value is your position value minus your debt value
If your debt ratio crosses a threshold called the liquidation threshold (varies by pool, typically around 80% in the market), your position could be liquidated by a liquidation bot – meaning the bot will close your position, the debt repay and return the remaining balance to your wallet. This happens when your collateral (equity value) has become so low that if it falls in value further there is some risk that you will not be able to repay your loan. Liquidation is therefore necessary to protect lenders.
Alpaca Finance has calculated how much a token’s price needs to fall for liquidation to occur at different leverage levels when you open a new position. The table below is beneficial because farmers and investors are mainly concerned about price fluctuations.
Leveraged yield farming is the logical further development of yield farming, offers a better return on investment and is therefore more attractive. There are indeed some risks associated with leveraged yield farming, but the potential returns are unmatched in the current DeFi space and worth a look.
There are advanced features and practices that we haven’t addressed that allow users to create custom positions for their ideal risk profiles, target returns, and market biases. From taking long and short positions to using market-neutral hedged strategies, new DeFi protocols focus their efforts on maximizing capital efficiency while minimizing downside risks for users. We strongly recommend adequate research into these topics.
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