This article was kindly contributed by Guest Author, Jonathan Wai.
What is Yield Farming?
“Yield farming” is gaining popularity among crypto enthusiasts and has been touted as one of the revolutionary developments in decentralised finance (DeFi). In this series of articles, we take a deep dive into the world of DeFi and explore yield farming strategies.
“Yield farming” isn’t actually a technical term with a precise definition, but simply refers to methods of deploying crypto assets to generate returns. However, yield farming is not to be confused with just buying and holding a crypto asset, as yield farming involves doing more than just holding the asset alone.
While there are many ways to yield farm, the simplest and most popular methods are lending, staking, and providing liquidity.
Lending of Crypto Assets
For investors familiar with traditional finance (affectionately known to crypto aficionados as “TradFi”), lending of crypto assets is easy to understand.
It is similar in principle to a bank, where depositors place assets with a central body (the bank) which then lends these assets out to borrowers. Borrowers pay an interest rate on loans, a portion of which are passed on to depositors as interest, with the difference being kept by the bank.
All types of crypto assets can be deposited or borrowed, ranging from those with volatile prices like BTC and ETH to stablecoins like USDT and USDC. There is substantial demand from depositors who want to earn some yield from their crypto asset exposure, and also from borrowers who wish to obtain liquidity while maintaining exposure to the assets they use as collateral.
For example, an investor who wishes to hold BTC may want to borrow USDT against it in order to engage in trading. This is similar to getting a mortgage against one’s property in order to start a business.
Crypto asset borrowers are usually (but not always) required to put up collateral for their loans, often in the form of other crypto assets. Such collateral is subject to loan-to-value (LTV) ratios, and crypto-backed loans are often heavily over-collateralised.
This means that the value of the collateral posted by the borrower often exceeds the value of the loan by a significant amount, and this low LTV mitigates the risk of crypto assets’ price volatility. Should the value of the collateral fall below a certain LTV threshold, the crypto asset is forfeited by the borrower and liquidated to the loan asset, and proceeds are used to repay the loan.
Consider Depositor Douglas who deposits 1000USDT with a crypto-lending service at a rate of 5%. Borrower Ben then borrows this 1000USDT at a rate of 7% and with an initial LTV of 50%. This means that Ben must post collateral worth 2000USDT and repay 1070USDT at the end of the 1-year loan period. Assuming an ETH price of 4000USDT, Ben deposits 0.5ETH as collateral and the loan of 1000USDT is disbursed. At the end of the loan period, Ben repays 1070USDT, of which 50USDT is paid out to Douglas as interest, and takes back his collateral of 0.5ETH. The crypto-lending service keeps the difference of 20USDT.
However, many crypto-lending services fix a LTV threshold above which the collateral will be liquidated. This may include margin calls along the way, or opportunities for the borrower to post additional collateral to maintain the loan and avoid liquidation. Assuming a liquidation threshold of 80%, Ben’s collateral of 0.5ETH will be liquidated when the price of ETH falls to 2500USDT.
Upon liquidation, the loan is terminated. The crypto-lending service obtains 1250USDT from the sale of 0.5ETH, of which 1050USDT can be returned to Douglas and 200USDT is pocketed by the service or otherwise distributed.
Due to the volatile nature of crypto-assets, it is not unlikely that the fire-sale of ETH upon reaching the liquidation threshold occurs at a price substantially below the liquidation price. The price buffer evinced by the leftover 200USDT protects the crypto-lending service and the depositor in such events.
Note that the above example is only a simplified way that crypto-lending might work. Different crypto-lending services may adopt different business and loan models.
However, there can also be other ways of funding depositor interest besides the interest charged on loans. One key difference between crypto-loans and loans in traditional finance is that crypto assets used as collateral need not remain idle. For crypto assets that reside on Proof-of Stake (PoS) blockchains like ETH and ADA, such collateral can also be staked to earn staking rewards.
Using the above example of a loan collateralised with ETH and assuming an ETH staking yield of 5%, the 50% LTV ratio means that the crypto-lending service is actually earning 10% in staking rewards on its loan.
Combined with the borrower interest of 7%, its total yield is actually 17%, which is significantly higher than without staking. This explains why depositor interest can oftentimes exceed borrower interest, and also why crypto-lending can be extremely lucrative.
Lending and borrowing of crypto assets can take place on centralised or decentralised platforms.
In centralised platforms, a third party (the crypto-lending service) manages depositors, borrowers, and everything in between from setting interest rates to executing transactions. This results in a largely uniform experience where interest rates tend to remain stable over time, and deposits can be made into the service even when there is no borrower to immediately borrow the deposited assets. Here, the crypto-lending service provider pockets a portion of the interest paid by the borrower for arranging transactions and accepting risk.
In decentralised or peer-to-peer platforms, lenders do not make deposits but instead interact directly with borrowers.
Interest rates and other loan conditions are negotiated directly between parties, and a smart contract automatically executes the transaction, transferring the loan asset from the lender to the borrower and collecting the loan collateral from the borrower.
Often, the smart contract also automatically liquidates the collateral should the LTV threshold be breached. There is no middleman between the parties, although the platform on which the lending takes place may sometimes take a cut as service fees.
One implication of the peer-to-peer lending model is that there need not be KYC requirements for borrowers, and anyone with a crypto wallet and an internet connection can potentially borrow crypto-assets.
While this may raise regulatory concerns, such practices are in fact not uncommon in DeFi. This model also means that lenders will only earn interest during the period that the loan is active, compared with a centralised model where the crypto-lending service pays interest even on deposited crypto assets that are not lent out.
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