Through Azim Ahmed 11/29/2021, 6:21 PM IST (Published)
Mini
Yield farming, also known as yield or liquidity harvesting, involves lending cryptocurrency. In return, the lender receives interest and sometimes fees, but they are less significant than the practice of supplementing interest with handouts of units of a new cryptocurrency. The real payoff comes when that coin appreciates in value quickly.
Cryptocurrency, the latest trend is going into the business of biblical times, i.e. the business of lending to earn interest. Yield farming in the crypto world is an investment strategy that promises higher returns than most conventional investments available today.
When money is deposited with a bank, it is a loan to the bank, which the bank compensates with interest. Yield farming, also known as yield or liquidity harvesting, involves lending cryptocurrency. In return, the lender receives interest and sometimes fees, but they are less significant than the practice of supplementing interest with handouts of units of a new cryptocurrency. The real payoff comes when that coin appreciates in value quickly. It’s like the banks are luring new savers with the gift of a tulip – during the Dutch tulip craze.
Instead of just waiting for their bitcoins, ether, or other digital coins to appreciate in value, cryptocurrency investors are now actively chasing returns by lending their crypto holdings or using other strategies to generate returns. Such “yield farming” can yield double-digit interest rates, well above those that can be earned with dollars.
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It’s a high leverage bet in a way. Investors run the risk of having their digital assets stolen by scammers or wiped out by sudden fluctuations or the crash of the lent coin. The space is also unregulated. Yield farmers are not protected by a Federal Deposit Insurance Corp. safety net. (in the US) which compensates depositors when banks fail.
The allure of outsized yields in a low interest rate environment has led many to jump on this bandwagon, and some investors equate it with high-yield stocks or high-yield unsecured debt or bonds.
working method
Instead of parking money at the bank, one decides to invest in crypto and lend those cryptos. The most basic approach is to lend digital coins like DAI or Tether through a decentralized app like Compound or Aave, which then lends the coins to borrowers who often use them for speculation. Interest rates vary based on demand, but every day you participate in the Compound service earns you new comp coins, as well as interest and other fees. As the comp token increases in value, so will the returns.
risks
This unheard of 1-10 percent return added with a new coin in the wallet and/or appreciation in value comes with many obvious risks. The first is regulatory risk, which could affect the value of the coin or crypto in general, as most countries are still debating whether to allow private cryptocurrencies. The second is theft. The digital money you borrow is effectively held by software, and hackers always seem able to exploit weaknesses in the code and hijack funds. The third is that most coins have a limited history. Most coins are only a few years old and could potentially lose value, which could cause the whole system to collapse once the easy money scenario dies down. Fourth, early investors hold big chunks in most cryptocurrencies, and their selling moves have a huge impact on prices. Fifth, there is also liquidation risk, particularly because some yield-harvesting strategies use leverage to increase earnings, which could trigger a downward spiral and disrupt orderly liquidations.
In summary, yield farming is collecting pennies in front of a steamroller. For blockchain-based cryptos and coins, and blockchain is inherently immutable, DeFi losses are mostly permanent and irreversible. It is therefore necessary that one really understands the risks of yield farming and conducts their extensive due diligence and research.
—The author, Azeem Ahmad, is Head of Portfolio Management Services and Principal Officer at LIC AMC and manages over Rs 1,750 crore owned by institutional investors and high net worth individuals. The views expressed are personal
(Edited by: Ajay Vaishnav)
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