During the Defi (Decentralized Finance) summer of 2020, yield farming gained immense popularity as crypto participants rushed to become yield farmers.
As various tokens and platforms came and went, many key DeFi protocols that we know and love today were launched during this mid-2020 Defi frenzy.
Compound, Yearn, and Uniswap are DeFi protocols that rewarded early adopters with retroactive airdrops and gave users free tokens as a thank you for being the first to use the protocol, while also fueling the next phase of the platform’s growth with liquidity- promoted mining programs.
If you are a company or SME looking to enter the crypto space or generate income from digital assets, yield farming via DeFi platforms can generate significant APY compared to traditional savings methods. It’s also crucial to identify genuine opportunities that may prove too good to be true.
This article breaks down the crypto lingo surrounding yield farming, liquidity mining, the differences between APY and APR, and what it means to wager your digital tokens for rewards.
As projects compete for users and market share, a common launch strategy of many DeFi platforms has been to offer liquidity mining. In short, Liquidity Mining encourages users to deposit their cryptos on the platform and rewards them with a high APY (sometimes >100% per year).
Liquidity mining usually means becoming a Liquidity Provider (LP), which means you help add liquidity to the various trading pairs available on the new platform.
For example, a popular trading pair can be ETH/USDC. This pair allows anyone to trade ETH for USDC and vice versa. If the platform does not have many LPs providing liquidity to the pair, there will likely be high slippage, resulting in a worse price when trading the pair.
If ETH is currently trading at $3000 and liquidity is low (high slippage), it could mean that your buy trade could be executed at $3100, which means you suffered ~3% slippage eh is not great.
To prevent this issue, platforms will offer “Liquidity Mining” incentives to LPs who deposit their ETH and/or USDC into the platform, adding liquidity and reducing slippage in the above scenario. This means traders are more likely to use the platform as it offers less slippage on trades. LPs are rewarded with a high APY in the protocol’s tokens as an incentive to keep their tokens deposited on the platform.
Crypto APY is generally an arbitrary number, just high enough to attract yield farmers and liquidity providers to one platform over another, but not so high that it has a significant negative impact on the token’s price.
If APY were 500%, depositing $1,000 worth of tokens on the platform over a 12-month period would generate $5,000 in platform tokens as a reward. While this looks incredibly attractive compared to the ~2% interest you could get from a savings account, it doesn’t take into account the price volatility the token can experience as rewards are distributed.
Yield farmers and LPs are incentivized to deposit their tokens on the platform to earn a high yield, but are equally incentivized to sell those tokens as soon as they receive them.
Speculation drives this game-theoretic result. Since token issuance is initially high to attract as many users as possible, sustained selling pressure can negatively impact the token’s price. However, as token issuance decreases over time, prices tend to stabilize, resulting in more muted selling pressure and increased usage of the organic platform.
In this recent interview on Bloomberg, Sam Bankman-Fried (CEO of crypto platform FTX and founder of Alameda Research) explains how VCs and trading firms use high APYs to generate income.
In short, no. When you see 600% APR, you could be slightly mistaken in thinking it’s the same as 600% APR, but they are slightly different. While APY (annual percentage return) accounts for compounding, APR (annual percentage/return) does not.
600% APR means you get 600% divided by the number of award periods. If you receive monthly payouts, that means your 600% is divided by 12 months, or 50% per month.
On the other hand, 600% APY is different. Since compounding is taken into account, your monthly reward payouts would start out at just under 50% for the first six months and be just over 50% in the last six months of the year. Ultimately, you still get 600% over the 12 month period, just with a variation in monthly amounts versus the APR.
It should be noted that a return of 600% in 12 months may sound too good to be true (and it could be. However, if the underlying token holds its value over the year, you will return 600% pa, if the token ends If you’re down 80% at the end of the year, your rewards will look more like a 20% return – not bad, but if you bought the underlying token to use for rewards, this would have one generates negative returns.
Another key component of yield farming is known in the crypto space as Impermanent Loss, or IL. As a Liquidity Provider (LP), you can put your digital assets into a two-sided pool that attracts high volume on Uniswap – say ETH/USDC. This means your stake is 50% ETH and 50% USDC in terms of total value when you deposit funds. For example, if the price is $2000 per ETH, you would deposit 1 ETH and 2000 USDC.
As a yield provider, you would be rewarded with tokens for providing liquidity to the ETH/USDC market over time. However, if the price of ETH changes, your deposit would need to be rebalanced to maintain 50% ETH and 50% USDC. Suppose the price of ETH rises to $4000; In this scenario, while the price of ETH was increasing, your ETH balance in the pool would have been rebalanced in USDC.
Ultimately, you would receive around 2800 USDC (an 800 USDC gain) and 0.7 ETH (an 0.3 ETH loss). The total value of your liquidity in the pool would be around $5600. However, if you held your tokens, you would have 2000 USDC (worth $1 each) and 1 ETH (which would have been worth $4000) for a total of $6000.
This example does not include any fees or returns you may have incurred during this period, but is a simple example of what IL is and how it can directly impact your crypto earnings strategies. If you want to calculate your IL, there are plenty of free calculators and tools to help you choose which liquidity pools and return approaches are right for you.
You may have heard that ETH 2.0 and Proof of Stake (PoS) are coming to the Ethereum blockchain in the coming months. Currently, both Ethereum and Bitcoin use a mechanism called Proof of Work (PoW) to secure the blockchain and verify transactions. Each block then rewards the miner with a “block reward” denominated in the native token (ETH or BTC) to incentivize mining.
Since PoW is quite energy intensive, Ethereum is moving to a PoS blockchain and joining other blockchains like Solana, Polkadot, and Cardano. PoS aims to reduce energy consumption compared to PoW by allowing participants to “stake” their tokens to validate transactions on the blockchain compared to using specialized miners to do this. When users stake tokens, they generate revenue that encourages more participants to stake tokens, increasing the overall security of the blockchain.
Hopefully you are now armed with some additional knowledge and ready to start yield farming yourself. Crypto returns are volatile, and as mentioned earlier, if you need to buy a specific token to get a high return, it may not be worth it.
Various strategies such as yield farming while simultaneously shorting a perpetual contract of the same size to “yield harvest” are also popular options for those with a little more crypto experience and knowledge to generate returns with less risk.
If you are looking for more information on how to earn an attractive return with the Unido Liquidity Mining (ULM) program, read on here.
About Unido EP
Unido EP reduces the complexity and cost of digital asset management for organizations with demanding corporate governance requirements. Our patented end-to-end platform seamlessly automates corporate governance and crypto asset self-custody, allowing you to securely store, manage and invest in crypto without massive overhead.
Unido EP features a web-based dashboard and decentralized application (dApp) with a robust set of defi tools, easy-to-setup regimes of authority, and ironclad security. All of this is housed in a complete digital asset management platform, designed specifically for financial institutions but tailored to the needs of any organization or individual.
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