I’ve been asked about yield farming from a number of people in the last week. That’s usually a good indication that I need to write about it in my newsletter. Here’s some letters where I have addressed yield farming with regards to something else.
I’ve yet to address yield farming in a standalone piece though, so that is the intent of this letter.
I will cover what yield farming is, why 10%+ APY is completely possibly, how it is done, and what risks you’re taking on by deciding to do it. Let’s dig in.
What is Yield Farming?
In short, it is another form of lending. But instead of lending your money to a centralized service provider like a bank or an exchange, you’re lending your funds to a decentralized exchange (DEX). There are two ways that a DEX could operate.
By matching buyers and sellers directly
By allowing traders to instantly execute trades using a “liquidity pool”
How exactly can a buyer obtain an asset if there is no seller immediately available? Easy, they swap the asset they’re holding for the asset they want using the funds supplied to a liquidity pool.
Liquidity Pools
A liquidity pool is basically an account consisting of two cryptocurrencies. For the sake of simplicity, let’s take USDT and BTC for example. When a user wants to trade USDT for BTC, they’re asking the dApp to take some BTC out of the liquidity pool and give it to them, in exchange for depositing some USDT.
In effect, the user just traded USDT for BTC. The amount of money in the pool remains the same, but the amount of BTC and USDT just changed. More on this detail later.
An example.
₿ 1 = $40,000
Liquidity Pool Balances:
BTC Balance: ₿ 0.25
USDT Balance: $10,000
Total in USD terms: $20,000 (50% BTC and 50% USDT)
Enter the user.
User wants to trade $1,000 USDT for ₿ 0.025.
Trade Executes
New Pool Balances:
BTC Balance: 0.225
USDT Balance: $11,000
Total in USD Terms: $20,000 (45% BTC and 55% USDT)
The pool functions optimally when the amount of both assets in the pool are equal in USD terms.
Now, in the example I’ve given above, the pool got out of balance pretty easily after a $1,000 trade. A pool being out of balance is neither good nor bad. It’s actually an opportunity.
When a pool is out of balance, it basically means the prices of the assets within the pool have changed. Now, if the prices of the assets do not match the prices of the assets on other exchanges or platforms, then this becomes an arbitrage opportunity for professional traders.
The opportunity will surely be capitalized upon. Pro traders will make profitable trades that put the pool back into balance. In reality, pools have millions, and/or billions of dollars within them, and so they don’t get out of balance as easily.
Liquidity Pool Fees
When the user trades $1,000 for ₿ 0.025, they will pay a fee to the pool for the service. So instead of ending up with ₿ 0.025, they will instead pay a 0.20% fee and receive ₿ 0.02495 (fee of ₿ 0.00005 is about $2.00).
This fee is charged to the user, and is split proportionately among the people that supplied funds to the pool.
Making Money by Lending to a Liquidity Pool
Yield Farming: The process of making money by lending your funds to a liquidity pool, and receiving fees as payment.
My hope is that I’ve given you a concise description of what liquidity pools are and how they work. Re-read it in order to gain a solid understanding of it because the rest of the newsletter requires you to understand the example stated above.
Here are some screenshots of the liquidity pools I am contributing to. This will help in making sense of how liquidity pools work.
IMAGE AND DETAILS REDACTED — [ May 1st 2022 ]
Impermanent Loss & Risk
It is now time to talk about the risks of yield farming.
There are two risks.
The dApp that controls the money is hacked. In this case I would lose everything.
Impermanent Loss.
The first risk is pretty straight forward; Hack = Bad.
The second risk needs extensive clarification.
Closing Thoughts
In order to follow along with my article you will need to prep yourself with a couple of my previous newsletters. Scroll down to find them.
I am getting a 44% APY return on my CRO-BTC pool. It automatically compounds and I can withdraw the money at any time. A return of 44% means that I will double my money in 1.6 years (72/44 — The law of 72). The one disclaimer that I would have for you is to take it slow, ask questions, reach out to me if you think you need help.
I am not recommending you do this, but if you try it, make sure it is with a small amount of money first. Cheers, and happy investing.
Regards,
Keegan Francis
Recommended Pre-req Reading
Resources
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