According to DeFi Llama, there is currently over US$216 billion invested in the DeFi sector. One of the key mechanisms that has been used so far to garner protocol investment is yield farming, which skyrocketed in popularity around mid-2020. With large risks but large rewards, yield farming has been a gift to those in the right place at the right time; but for projects themselves, getting investment through yield farming is not often conducive to long-term stability.
In this article, we will explain the mechanics of yield farming in order to introduce a newer trend — leveraged yield farming. Here, DeFi participants can leverage funds to receive greater rewards than could be achieved through normal farming. We will look at exactly how leveraged yield farming works, shine a spotlight on some successful projects, and introduce a brand new leveraged yield farming project supported by the INC4 team and NEAR Protocol — PembRock Finance.
Crypto farming explained
Simply put, DeFi yield farming involves lending your cryptocurrency to the most profitable platforms to earn the highest yields. The Automated Market Maker (AMM) model that most DeFi applications deploy requires liquidity, which is in part provided by users in exchange for a return on their investment. Yield farming is often compared to gaining interest from a bank deposit, but there are a few key differences, including:
- Fast-changing rates – while your bank deposit may be slightly adjusted now and then to give you slightly more or less interest, yield farming returns, which are automated through smart contracts, can change frequently and more drastically, depending on the level of investment, price of coins in the liquidity pool you choose to farm, and other conditions regulated automatically by smart contracts.
- Varied reward distribution mechanisms – Each platform operates differently regarding how often rewards are distributed, whether they are automatically reinvested or not, or whether you get some payouts in the platform’s native token, for example.
- Mobility — farming in crypto is chiefly defined by the quick movement of funds in order to chase the highest yield farming rates, calculated in APY. Considering yield farming vs. staking, the latter is more associated with a longer-term or locked-in investment in a protocol (although there are more flexible staking opportunities appearing on the market every day).
This mobility is aided by the fact that you can enter a farming pool manually, but there are also many auto-farming tools out there that automatically invest, devest, and re-invest according to the most profitable returns of the day.
- Lastly, and related to the point above, there is much more flexibility regarding how long a coin is locked up. Noting this, lock-up terms wildly differ depending on the projects you choose to farm with.
How Compound yield farming works
To better understand crypto farming, we can look at the example of Compound Finance. Although not the first, the project is widely acknowledged as having popularized yield farming. They did this through the issuance of the COMP governance token alongside its normal percentage returns for investors, setting a model for other DeFi projects looking to attract crypto holders.
- Compound is a DeFi lending protocol that allows users to deposit and borrow crypto assets.
- A large amount of liquidity is needed to satisfy large borrowing volumes, meaning the platform has to encourage lenders to deposit their coins.
- In Compound’s case, the lender receives interest based on the fees paid by the borrower. They also receive Compound’s token, which can be held or exchanged for other cryptocurrencies, and also gives holders proportional voting rights in the future of the protocol.
Yield farming benefits for users
Yield farming allows users to earn much higher rewards than they would for simply holding their cryptocurrencies. They can also benefit from extra incentives for being loyal to the platform, with giveaways such as token airdrops if they happen to be holding the project’s governance coin at the right time. Lastly, there is an exciting, gamified element to yield farming, whereby rewards can easily multiply with the skyrocketing of a particular coin.
Yield farming benefits for protocols
For protocols, more liquid funds mean more money can be lent, with associated fees helping benefit the protocol’s creators and reinvest in the development of the ecosystem. In addition, for those that issue governance tokens, a greater number of yield farmers results in a more decentralized project, as coins are more widely distributed. All this activity helps make a project popular, often with a positive effect on the price of the project’s native token, meaning more people are likely to stay invested, creating a positive feedback loop.
Yield farming considerations
As mentioned in the introduction, while it can bring huge rewards, there are also some yield farming risks to consider, both for individuals and the DeFi protocols themselves.
- Conditions can change rapidly – With more conventional financial products, terms and conditions aren’t as subject to change as in the crypto world. Written into smart contracts, the percentage return you receive can alter without warning based on coin price, available liquidity, and fees.
- Impermanent loss – Impermanent loss is a constant underlying risk when providing funds to a liquidity pool. In short, the dollar ratio of assets in a pool must be kept the same at all times, meaning that as the coins in the pool fluctuate (unless you’re farming stablecoins), the smart contract rebalances the amounts of crypto to keep the equal ratio.
This rebalancing can leave you holding more of one coin and less of the other, bringing a possible loss compared to if you just held the coins without investing in any liquidity pool. Of course, impermanent loss isn’t a given, and even if you suffer from impermanent loss, this can be made up for by the percentage return offered by the DeFi yield protocol you put your funds into.
If the concept of impermanent loss is difficult for you to get your head around, check out Binance Academy’s explanation, complete with a straightforward example.
- Unstable liquidity – While a project might encourage lots of capital one day, the next day it could be facing ruin should that same capital be moved to a project with a more attractive APY. Not only is this of course bad for the platform, it can also result in an individual’s position being liquidated, with a substantial loss of funds.
As we showed in our recent blog post on DeFi 2.0, 42% of yield farmers exit their positions within just 24 hours! This is exactly the problem that this second iteration of DeFi projects is trying to solve, through slow-release bonds and protocol-owned liquidity.
- Governance token accumulation – This one carries an existential risk for projects, and one we have mentioned before in our article about alternative approaches to governance. Having a project where those with the largest number of yield farming tokens exercise outsized control can present dangers if short-sighted decisions are taken in the pursuit of immediate profits. You could find yourself aligned with a project that drastically changes overnight, jeopardizing your stake.
- Smart contract malfunctions or hacks – High-profile attacks have seen more projects taking smart contract auditing and testing seriously, but nonetheless, DeFi farming is experimental by nature and subject to both malfunctions and different types of attacks.
Despite these risks, conducting some research can give you an idea of which projects are trusted, and which ones are best avoided. Within a project, there are also varying levels of risk tied to different pools; for example, providing USDT will always be a much safer option than farming a low-volume, highly speculative cryptocurrency.
Now that you have a strong foundational understanding of yield farming, it’s time to delve into the world of leveraged yield farming, which offers greater returns through user-friendly Dapps.
What is leveraged yield farming?
Once you have an understanding of yield farming, leveraged yield farming is easy to grasp; it is simply the practice of borrowing external liquidity to farm a larger amount of crypto. This means users have the option to increase their returns by a sizeable amount.
A word that is usually mentioned in association with leveraged yield farming is capital efficiency, or getting the best bang for your buck. Many DeFi lending platforms require users to overcollateralize. In practice this would mean borrowing $1,500 worth of DAI by putting up $3,000 worth of Ethereum, for example. This is prohibitive for some users but also leaves funds dormant when they could be used for further investment in the DeFi ecosystem.
Leveraged yield farming undercollateralizes, with both lenders and yield farmers benefiting:
- With greater utilization of funds, lenders are often rewarded with more attractive APYs.
- Yield farmers take home larger profits due to their initial investment which has been leveraged to double or triple the size.
Here we must mention that borrowing fees of 10-25% are common (depending on the pool and amount of leverage). The high fees are due to the risk associated with the loan and are taken out of the yield farmer’s returns. Some of this fee is paid to the lender themselves, and some goes to the platform.
H3 – Higher liquidation risk
It also goes without saying that the risks associated with yield farming that we mentioned above also relate to leveraged yield farming, although with borrowed funds, the issue of liquidation is a greater threat. As we see in leveraged yield farming projects such as Alpaca Finance and Alpha Homora, bots monitor positions, closing them, repaying the farmer’s debt, and taking a fee if one of the tokens in the position drops by an amount that would put at risk the farmer’s ability to pay back the loan.
As we can clearly see in the table below, the more a user borrows, the less a coin has to fall to trigger liquidation.
Despite the considerations associated with leveraged yield farming, picking a solid project and investing in coins you believe are backed by worthwhile projects can bring fantastic returns, which is precisely why the projects we will look at in the next section have accrued so much locked funds.
Three top leveraged yield farming projects
While leveraged yield farming projects are still in their infancy, we will take a look at three projects that have already gained significant users.
Alpaca Finance (Binance Smart Chain)
At the time of writing, Alpaca Finance has a TVL of US$789 million, and is one of the biggest projects on BSC. Lenders and borrowers are incentivized by the high APYs and ALPACA token, which aside from its valuation, is worth holding on to as it confers governance rights. There is also the auto-farming stablecoin AUSD, which is overcollateralized by a different crypto assets. Currently there are 58 farming pools, offering 2-3x leverage.
Alpha Homora (Ethereum, BSC, Avalanche)
Alpha Homora, with a TVL of US$827 million, claims to be the place that provides the highest APY for lending ETH on the market. It is also sets itself apart from most competitors in that it allows users to provide liquidity or farm with just one asset.
V1 was deployed on Ethereum and BSC, while Alpha Homora V2 has been deployed on Ethereum and Avalanche, meaning users can always interact with the app without having to navigate the prohibitive gas fees of Ethereum. This seems to be a winning strategy, as although there are more farming pools on Alpha’s Ethereum V2, the TVL is just US$300M, compared to the US$600M locked in Alpha’s V2 running on Avalanche.
Apricot Finance (Solana)
Despite getting less exposure than Alpaca Finance and Alpha Homora, Apricot Finance launched just before November on Solana, and currently boasts a TVL of just under US$150M. As with the above projects, participants have the option to lend and farm with leverage of 1.25-3x depending on the pool.
As a point of difference, users can benefit from Apricot Assist if their position is in danger of liquidation. As we saw above, the more coins are leveraged, the less movement can be accommodated before a position is liquidated; however, with Apricot Finance, users can set certain parameters that de-leverage positions, allowing users to keep their profits and continue farming, albeit with a smaller return.
Introducing PembRock Finance
PembRock Finance is the first leveraged yield farming project on the NEAR blockchain, headed by INC4’s Founder and CEO, Igor Stadnyk! After a successful early investor sale and integration with the DEX Ref Finance, PembRock is nearing a launch that will allow users to get sky-high yields on NEAR’s user-friendly blockchain.
PembRock was built for a few reasons:
- Yield farming encourages greater investment in DeFi, which is good for everybody.
- Many established yield farming projects are clunky and difficult to use for new users.
- There are very few leveraged yield farming projects on the market, and as mentioned above, none on NEAR protocol.
NEAR is a great blockchain to build on, not only because it is fast, secure, and cheap, but also because of the guilds — teams of developers that help bring projects to life through development support. This atmosphere of teamwork allows for quicker and better development, which is why the NEAR blockchain is rapidly expanding its ecosystem of Dapps and gaining significant investment.
How does PembRock Finance work?
On launch, two base assets — NEAR and USDT — will be supported, with leveraged farming integrated with Ref Finance. After launch, the number of pools will be expanded, benefiting both lenders and farmers.
- Lenders earn passive income by depositing their crypto into our vaults, which fund liquidity pools. This process is similar to staking; users get rewards from fees charged to leveraged yield farmers by lending funds to the pool.
- Leveraged yield farmers can maximize their profits by opening a leveraged position of up to 3x.
Moving beyond just Ethereum
The leveraged yield farming sector is relatively new and still has lots of room to grow. This is clear when looking at the TVL of the above-mentioned projects in contrast with established DeFi protocols such as Pancake Swap, Aave, and Curve Finance.
Another key difference between yield farming and its leveraged counterpart also comes up when we consider where the concentration of funds lie. Most of the large yield farming projects are built on Ethereum, and this is consequently where the money is; however, new generation projects are not necessarily prioritizing this blockchain. With the increasing ease of transferring funds to different blockchains, as well as EVM-compatibility, projects can launch on BSC, Solana, and Avalanche, either exclusively, or along with Ethereum, without worrying that they are limiting themselves. It is an extremely significant development that users are using the Avalanche blockchain to interact with Alpha Homora more than they are Ethereum.
Yield farming as part of DeFi 2.0
A recent article in CoinDesk argues that liquidity mining in its current form is no longer fit for purpose. The people Andre Cronje describes as liquidity locusts have consequences for the stability and governance of a project. While this was accepted as part of the ongoing experimentation with DeFi, now we are entering a phase where products are maturing and gaining wider usership, meaning relying on long-term stable interaction is more important than ever for the longevity and trustworthiness of a project.
DeFi 2.0, characterized by its protocol-owned liquidity, looks promising in its attempts to at least put the control of funds in the hands of the projects themselves, but there is still the problem of attracting large and sustainable amounts of capital. Bonds, governance incentives, and token lockups are one way to stave off project desertion, but as we have seen with the recent large drop in the price of Olympus DAO’s token, OHM, we are still a while off being able to control large sell-offs and subsequent liquidations.
Despite the challenges mentioned above, crypto yield farming still has a large place in the landscape of DeFi 2.0 and Web 3.0, encouraging the efficient use of capital in what is a fast-growing ecosystem. Worthwhile projects can bring investment to innovative projects and blockchains while handsomely rewarding users, so it’s no surprise leveraged yield farming projects have made a strong start in 2022. Watch this space!
If you want to work with a trusted and experienced team for your DeFi or NFT project, reach out to INC4 today!