Beginner’s Guide to Yield Farming Part 2

Prime 5 Strategies of Yield Farming

TL;DR:

This weblog put up explores the 5 commonest strategies of yield farming in DeFi as we speak: supporting community operations (staking), offering lending capital, offering liquidity to exchanges, delegating tokens to aggregators, and following protocol incentives. The advantages, dangers, and issues for every technique are mentioned, with emphasis on elements akin to APY, counterparty slashing danger, token dangers, financial rebasing danger, liquidity lockup interval, and protocol incentives.

Within the earlier a part of this information, we seemed on the that means and function of yield farming. On this half, we have a look at the 5 commonest strategies of yield farming.

The 5 strategies are: 1) Supporting community operations 2) Offering lending capital; 3) Offering liquidity to exchanges; 4) Delegating tokens to aggregators; and 5) Following protocol incentives. Let’s take a look at each and the place they sit when it comes to danger and reward.

1. Supporting Community Operations (Staking)

It is a pretty secure and predictable yield technique. Right here, farmers allocate their holdings to a community validator to permit the community to run extra effectively and securely. In return, they’re paid by those that intend to make use of the community by staking.

For example this, think about if Uber paid you to hire out your automotive for his or her drivers to make use of. In a approach, you’d be staking your automotive to the community to permit the community to run extra effectively and you’d earn curiosity in your asset (your automotive) in return. When contemplating crypto staking, there are a number of completely different choices: custodial, decentralized, and liquid staking.

1. In custodial staking, you provide your tokens to a 3rd celebration and so they carry out actions in your behalf. Crypto exchanges like Coinbase or Binance are custodial.

• The advantages of custodial staking are that it’s nice for learners, with comparatively simple onboarding and (normally) respectable liquidity.
• The dangers of custodial staking embody comparatively much less transparency and diminished APY.

2. Because the title suggests, in the event you select decentralized staking, the actions are carried out in a decentralized method. On this case, you’d almost definitely run your individual node on the community and act as a validator your self.

• The advantages of decentralized staking embody full management of belongings, greater APY, and the truth that it promotes community decentralization.
• The dangers of decentralized staking embody the info that you need to preserve your infrastructure, your belongings are illiquid, and you’ll be uncovered to counterparty slashing (extra on this later). Additionally, there’s little to no regulatory oversight, buyer safety or buyer assist within the conventional sense, and infrequently no buyer assist – nobody is accountable however your self.

3. Constructing on decentralized staking is one other idea known as liquid staking. For the reason that minimal quantity of cryptocurrency required to interact in staking could be excessive for some protocols, a number of customers could pool their funds collectively and delegate them to a trusted actor. When partaking in liquid staking, the protocol provides you a spinoff asset in change for staking your actual belongings. This spinoff asset is like an IOU that may be exchanged for the unique asset whenever you unstake. On this approach, though your main asset is locked, you keep your liquidity by the spinoff asset. This spinoff asset is a liquid token that you should utilize for different yield farming methods. While you unstake your tokens you change the spinoff asset in your preliminary asset.

• The advantages of liquid staking embody ease of participation, it doesn’t require infrastructure, belongings are liquid, and it may promote decentralization.
• The dangers of liquid staking contain a decrease APY, diminished decentralization, and that it exposes to counterparty slashing.

Staking usually requires a minimal quantity of staked tokens that should be locked up for a interval. Liquid staking could be good for decentralization as a result of a person with out the minimal variety of tokens for totally decentralized staking can nonetheless take part with out using a centralized, custodian account. Nevertheless, if many customers elect to delegate their tokens to the identical validator, these tokens turn out to be extra centralized.

Concerns earlier than staking

Whereas staking is usually a low-risk, mid-yield exercise, there are a number of issues that potential stakers ought to consider earlier than deploying their belongings. Please word that a few of these issues may even apply to among the different strategies of yield farming.

APY: That is pretty self-explanatory, however in case you are contemplating staking your tokens it’s necessary to know the APY even when it can change over time. Take into account the quantity of rewards you anticipate to obtain by staking, and weigh these rewards towards the opposite issues to make sure that the reward is definitely worth the danger.

Counterparty Slashing Danger: This danger is restricted to staking. Individuals in Proof of Stake (PoS) cryptocurrency networks (validators, block producers, delegates) are trusted to take care of the integrity and safety of the community. They’re required to stake a minimal quantity of cryptocurrency as collateral to have the ability to contribute to community operations. In return for performing correctly, they obtain staking rewards. Nevertheless, in the event that they behave maliciously or in any other case violate the principles of the community, penalties shall be levied within the type of slashing. Slashing sometimes entails punishing the participant by completely destroying or confiscating a portion of their staked funds. The diploma of slashing is determined by the severity and nature of the offense and varies by protocol. Slashing generally happens as a result of double-signing (signing conflicting blocks), censorship, or different kinds of malicious conduct that undermine the community’s consensus. So, though staking could look like a secure technique of incomes yield, customers ought to be aware of these to whom they delegate their funds. You probably have delegated your belongings to a validator who’s slashed, you’ll lose your funds as properly! Remember to do your analysis when selecting a selected validator to assist.

Inherent Token Danger: These dangers are sometimes related to the traits, design, and underlying expertise of the token itself. These dangers will apply to all cryptocurrencies. Listed here are some examples of inherent token dangers and their relation to staking:

• Market volatility: The worth of many cryptocurrencies can expertise fast and important fluctuations as a result of elements akin to market demand, hypothesis, regulatory developments, or macroeconomic circumstances. This volatility can simply counteract the rewards gained from staking if one is just not cautious.
• Regulatory dangers: Regulatory uncertainty and modifications pose dangers to cryptocurrencies in addition to staking. Completely different jurisdictions have various approaches and rules concerning cryptocurrencies and staking, which may affect acceptance, utilization, and buying and selling. Regulatory actions, akin to bans, restrictions, or unfavorable rules, may pose dangers to particular tokens in addition to their means to be staked.
• Technological dangers: Tokens depend on blockchain expertise, which continues to be evolving. Vulnerabilities or flaws within the underlying protocols or good contracts used for staking can result in safety breaches, hacks, or exploits. These dangers may end up in the lack of funds, manipulation of token provide, or different opposed penalties for token holders and stakers.
• Governance and consensus dangers: Tokens which can be a part of decentralized networks typically contain group governance, consensus mechanisms, and even staking. The choice-making processes, akin to voting or consensus algorithms, could be topic to manipulation, centralization, or conflicts of curiosity. Disagreements amongst token holders or group members could end in contentious onerous forks, contentious governance selections, or community splits, which may have an effect on the worth and viability of the token and its means to be staked.
• Adoption and utility dangers: The adoption and utility of a token can affect its worth and success. Elements akin to community utilization, real-world functions, partnerships, developer exercise, and person demand play a major position. Tokens that fail to achieve adoption or provide significant utility could wrestle to take care of worth or obtain their meant function.
• Liquidity dangers: Tokens with low buying and selling volumes or restricted availability on exchanges could expertise liquidity dangers, making it difficult to purchase or promote your token and token staking rewards at desired costs if in any respect.

Financial Rebasing Danger: Some cryptocurrency protocols will periodically regulate the availability of tokens within the community based mostly on preset formulation or guidelines, a observe referred to as financial rebasing. The aim is to take care of worth stability and cut back volatility. To perform this, the token provide of every holder is elevated or decreased proportionally. If the worth of the token is persistently greater than the goal worth, the mechanism could lower the whole variety of tokens obtainable by eradicating a proportional quantity from everybody. Conversely, suppose the worth of the token is persistently decrease than the goal worth. In that case, the mechanism would possibly enhance the whole variety of tokens obtainable by including a proportional quantity to everybody.

You might encounter a protocol providing a really excessive APY for his or her yield farm. Whereas collaborating on this farm, you would possibly obtain a lot of tokens. Nevertheless, if financial rebasing is employed, the whole worth of your holdings won’t enhance regardless that you maintain extra tokens. As a substitute, solely the variety of tokens you maintain will increase, leading to an elevated possession proportion of the whole variety of tokens. Which means that you successfully personal extra of the community itself regardless that the worth of your holdings stays fixed.

Liquidity Lockup Interval: Some protocols make use of a lockup interval — a predetermined timeframe through which a liquidity supplier can not withdraw or switch their liquidity. That is used to make sure stability and fixed liquidity by incentivizing liquidity suppliers to commit their belongings to the platform for a selected length. It is very important know the way lengthy this era is earlier than deploying capital to a protocol.

2. Offering Lending Capital

This describes the method of farmers allocating their holdings to capital-constrained debtors in return for charges that may be sponsored by the community. That is probably the most secure type of yield farming and the method is just like a financial institution providing a mortgage.

The most secure alternative can be over-collateralized lending, and some examples of such protocols are AAVE, Compound and Maker DAO. Extra info on this matter could be present in a earlier Shimmer DeFi Training Collection put up Session #3 (Half 1): DeFi Lending & Borrowing.

The advantages of offering lending capital embody pace, liquidity, permissionless, and relative security. Inquiries to ask earlier than lending capital embody:

• Is there a lock-up interval in your deposited funds?
• Is there safety towards insolvency?
• Is over-collateralization (if relevant) applicable for you?
• Have the good contracts been audited, and by whom?
• How steady are the charges?

3. Offering Liquidity to Exchanges

To recap, farmers present liquidity to centralized exchanges in return for buying and selling charges or native tokens.

The most important danger that you just’re going to come across is impermanent loss. This describes the chance price of being a liquidity supplier in comparison with merely holding the preliminary belongings as a substitute and was explored intimately within the Shimmer DeFi Training Collection Session #2 (Half 3): Token Swaps — DEX vs. CEX.

The advantages of offering liquidity to exchanges are that anybody can take part (it’s permissionless) and there’s a excessive potential for yield. Inquiries to ask earlier than offering liquidity to exchangesinclude:

• What’s the break up charge on the pool?
• In what forex are the charges paid? Are you being paid in a local forex or a special token? What’s the danger for impermanent loss?
• What’s the precise buying and selling quantity of the pool? Are individuals utilizing the pool?
• What are the underlying token dangers? (see the related portion of Staking issues)

4. Delegating Tokens to Aggregators

The danger right here is truthful for a good yield. If there’s a yield farming technique that anybody may do confidently, it will probably be delegating tokens to aggregators.

This course of entails farmers offering their tokens to aggregators to make the most of economies of scale for decrease transaction prices and better returns. To do that, a person would deposit their tokens right into a single good contract for yield farming or different DeFi transactions. Doing this collectively leads to decrease prices and better returns. It’s pretty secure however there’s a distinction to be made between a real aggregator and an auto-compounder.

A true aggregator combines and consolidates varied DeFi protocols and providers right into a single interface. It permits customers to entry and work together with a number of protocols, commerce belongings, present liquidity, and entry varied DeFi providers inside a unified platform. A real aggregator presents advantages for passive yields, passive advantages, selection in methods, socialized gasoline prices, and so forth. Yearn is an efficient instance right here. They’ve vaults the place you may deposit your DAI, USDC, ETH, and so forth. and so they offer you a hard and fast APY in return. One draw back right here is that they take a small charge off the highest. Additionally, there’s composability danger: you don’t essentially know the technique that they’re using. When you can dig into their documentation and try and determine it out, they’re nonetheless utilizing a number of good contracts that would have inherent danger.

An auto-compounder optimizes yield farming methods by routinely compounding customers’ funds. It identifies the very best alternatives for yield era throughout completely different protocols and performs automated compound actions to maximise returns. The first operate of an auto-compounder is to automate the method of reinvesting and compounding rewards earned from yield farming. An instance of such a protocol is Convex. By permitting an auto-compounder to handle your funds, it collects the rewards routinely commonly and reinvests them for you. This aggregates your rewards and lets you earn rewards in your rewards. There’s nonetheless the underlying token danger nevertheless it’s slightly bigger right here since you’re solely producing yield from one particular supply. An auto-compounder like it will sometimes have governance or different incentives in thoughts. They’ll deal with a single token to attempt to receive sufficient to affect governance selections.

Inquiries to ask earlier than delegating tokens to aggregators embody:

• Is the protocol you’re contemplating a real aggregator or is it an auto-compounder? Which is extra applicable for you?
• The place are the sources of yield?
• What are the methods being taken? It’s all the time good to know the token move and there ought to be a diagram that illustrates this.
• How dangerous is the technique of the protocol?
• Is there any challenge with composability?
• Have the good contracts been audited, and by whom?

5. Following Protocol Incentives

This construction is a high-risk, high-reward strategy in DeFi. Farmers enhance consciousness and utilization of a protocol and obtain rewards in change. These rewards are provided as a method to seed new networks.

As an example, the Arbitrum Odyssey protocol guides customers by its ecosystem, offering varied incentives and rewards like NFTs and airdropped tokens. The purpose is to familiarize customers with completely different merchandise and encourage their adoption inside the community.

Alternatively, AAVE on Avalanche demonstrates a special strategy. By subsidizing further APY with Avalanche tokens, AAVE incentivizes customers to deliver liquidity to the Avalanche community. This technique goals to draw customers to a brand new ecosystem and presents advantages like free tokens and the best yield alternatives.

Nevertheless, it’s necessary to contemplate the dangers related to these incentives. Firstly, the tokens acquired as incentives is probably not recognized prematurely. Secondly, the long-term worth of the protocol and its related community is unsure. Protocols provide these incentives to draw capital and bootstrap their networks. In the long run, it’s essential to conduct thorough analysis and due diligence to make sure you’re not investing in a Ponzi scheme or falling for misleading practices. Understanding the objectives and dangers of protocol incentives is important for making knowledgeable funding selections within the DeFi area.

Inquiries to ask earlier than following protocol incentives embody:

• The place does the yield come from, and is it sustainable? Watch out of extraordinarily excessive yields, as a result of it may very well be as a result of rebasing. On the similar time, it may very well be a token that has no worth. Don’t get enticed by guarantees of enormous quantities of tokens, as a result of a big quantity occasions 0 continues to be 0.
• Is there any particular platform danger? For instance, if we’re contemplating Solana and the community experiences considered one of its outages, would you be okay with doubtlessly shedding the power to take away your capital for a while?
• In case you’re shifting your capital from one community to a different, how robust is the bridging danger? Have the bridges been in use for lengthy sufficient and not using a hack that you’ve got religion in utilizing them? (See the Lindy Impact dialogue within the subsequent part.)

Now that we’ve totally explored the 5 widespread strategies of yield farming in DeFi, it ought to be clear that there’s probably a possibility for farmers of any danger profile and goal yield. Nevertheless, with all of the protocols which can be at present providing yield farming and the various extra getting into the market each day, savvy farmers might want to make the most of efficient instruments to determine the very best protocols for them. Within the subsequent part, we talk about a few methods that you would be able to assess a protocol by yourself earlier than exploring three completely different common instruments that may help you.

Newbie’s Information to Yield Farming

Half 1: Seeding Success: The Energy of Yield Farming in Crypto Networks

Half 2: Prime 5 Strategies of Yield Farming

Half 3: Analysis and Evaluation Instruments

Additionally on this collection

Crypto Wallets

DEX vs. CEX