Updated: Dec 30, 2021
Decentralized finance is growing rapidly and so are investors appetite for income. In this article I will discuss yield farming and staking, two passive income strategies that offer higher APY than traditional banking. We'll explore these concepts in order to help you get a better sense of which strategy works best for you.
Before getting into strategies, it's important to understand what are liquidity pools. Liquidity pools provide the tokens found on decentralized exchanges. These tokens are crowdsourced by regular people all across the world. The exchange doesn't own any token. Instead, the pooled tokens reside on a smart contract that is completely managed by code. These pools help facilitate trades. If there is no liquidity, there are no tokens to swap.
liquidity provider (LP): is someone who supplies their digital assets to a liquidity pool.
Passive Income Strategy #1: Yield Farming
The newest and most confusing method of the two strategies. Yield farming is a method of acquiring more cryptocurrency by lending out assets to a DeFi platform such as an exchange or lending protocol. In return, the users will earn the fees that are charged on the platform along with tokens from special liquidity pools. The main objective of yield farming is to attract liquidity by rewarding investors who are willing to lend their assets. The platform then redistributes your crypto assets to customers who are interested in using their products. When customers use these DeFi products they will incur fees that are then used to repay yield farmers. These exact rewards are determined by a liquidity pools APY, an interest rate that changes with the pools activity and token value. This APY typically ranges anywhere from 3-60% depending on the pair you deposit. Ultimately, the rewards are proportionate to what you put in. For example, if you own 5% of the pooled tokens, you will earn 5% of the rewards.
1. Exploits in Smart contracts can lead to loss of funds:
Yield farming is a decentralized service that is automated by smart contracts. This means there is almost no risk of losing your assets since developers can not steal or transfer out crypto without your permission. That being said, there are still risks that come from poorly coded smart contracts and someone with enough technical knowledge can steal funds.
Example a protocol may use your assets to fund flash loan services. If the smart contract used in the protocol has an exploit, a hacker can create loans and not repay them. These contracts tend to be created unintentionally. If developers don't catch the attack early on, they'll be unable to recover funds for the yield farmer. This hack can drain liquidity pools within minutes.
2. Impermanent Loss:
A risk unique to yield farmers, and tied to the concept of opportunity cost. An impermanent loss occurs when a cryptocurrency experiences a massive spike in volatility. If the asset rises in value the yield farmer would have made more money by simply holding the asset. You also incur a loss if the asset declines in value, and the yield rate is not high enough to offset those losses. The APY that comes with yield farming is enticing, however users must always consider whether it's better to sell or hold to stay profitable on their investment.
Impermanent loss occurs when you've deposited 2 different assets into a double sided liquidity pool. Both deposits are equal in amount. This is necessary since crypto loans are always backed by collateral (with exception to flash loans). Exchanges need a proportional amount of both tokens so their customers can borrow against the pair.
Example 1 Lets say you lend out 1 ETH worth $5,000 as well as 5,000 USDC. Both deposits equal in value. As the price of your deposits change, so does the proportion of coins you hold. This happens automatically within the liquidity pool in order to maintain that 50-50 proportion. So, let's say Ethereum doubles in value and shoots up to $10,000 a coin. Your USDC stays the same price, since it's a stable coin. In this case your Ethereum will begin to sell off in order to maintain that 50-50 proportion. Now, instead of your original 1 ETH you are left with 0.5 ETH. You still have your initial dollar value of $5,000, but in this scenario it would have been better to hold your initial 1 ETH and maintain your capital appreciation. * This is a basic example, there are many scenarios to consider with impermanent loss, this concept gets much more confusing when lending out 2 assets exposed to price fluctuations. As a lender you want both assets to increase in value, or stay the same price. Any other outcome will result in an impermanent loss*
How to Avoid These Risks:
1. Only lend out to reputable projects- avoid unaudited platforms, look for well established lending protocols with large amounts of liquidity. Some of my favorite platforms include uniswap.io, aave.com, and compound.finance. These platforms practice secure smart contract coding. If there are any exploits, they will be quick to patch them. *No one can predict when attacks will occur, however they're extremely rare and shouldn't discourage you from yield farming*
2. Avoiding Impermanent Loss:
Consider using large amounts of money- Gas fees are incredibly high on Ethereum's blockchain, sometimes costing $100+ to process a single transaction. Yield farming involves jumping from one liquidity pool to another, so these fees can begin to rack up. A small deposit of $500 will definitely result in an impermanent loss, as the rewards won't be enough to cover the gas fee. *High gas fees come from Ethereum's blockchain and their lack of ability to scale. This will change in the future as many developers are working to fix this issue*
Provide to stable coin pairs- The safest way to provide liquidity, these pairs don't move in price, therefore they are immune to impermanent loss. Investors realize this and have since maxed out these pools. Making the rewards relatively small. *Be careful of new stable coins offering massive APY. There have been instances of stable coins going to zero. Also, be aware there are rumors that Tether stable coin is over leveraged and creating too many Tether tokens. This may cause an issue where Tether is un-pegged to one dollar in the future*
Avoid risky asset pairs- They do yield higher rewards, however impermanent loss is maximized with a pair volatile assets
Lend out your coins when the price is low- Providing your coins in a bear market is a great way to earn interest while also gaining some price appreciation. Both assets must rise in price. *Even though you are likely to experience an impermanent loss, it is always best to have this experience when your total value is going up, as opposed to going down.*
Lend to platforms that offer extra incentives- Some lending protocols will offer their own native tokens as a reward for providing liquidity on their platform. These rewards are often called liquidity mining rewards. On top of earning interest LP's earn these additional tokens. Some users lend out these newly acquired tokens, earning interest as high as 55% APY. Amplifying their total possible yield. *These Tokens are extremely speculative. Highly recommend taking a portion of the liquidity mining rewards and converting them to another asset.*
Changing the ratio of the pool you are lending to- Most liquidity pools are 50-50 however their are some platforms that allow you to adjust this ratio or even deposit more than 2 assets. If done properly, adjusting the ratio of the pool can mitigate risk of impermanent loss.
Passive Income Strategy #2: Staking
Now that you have a better understanding of yield farming, this concept will come easy. Staking is a mechanism used by proof of stake blockchains to ensure validators act in good faith. Validators process transactions and create new blocks for the network. They must stake their own money to earn rewards. If they ever stop confirming transactions, they risk getting their stake slashed. Users who stake help fuel the network by providing liquidity. The rewards earned are much less than yield farming, ranging anywhere from 3-18%, but there is almost no risk involved when staking cryptocurrency.
There is no security risk. When you stake your funds you still remain as custodian. The only way you could possibly lose money is if you're staking to a blockchain that requires a time lock. Some proof of stake blockchains require tokens be locked up for a fixed period of time. During this period assets cannot be transferred or sold. This can become an issue if there is a sudden drop in price and investors want to buy back in at a lower price. The rewards earned won't be enough to cover the loss. These time locks are rare in 2021, and projects in the future won't enforce them.
The Cardano blockchain currently sets the standard for staking and makes the process very easy. When depositing ADA to a stake pool, you maintain custody and are able to spend and transfer money as you please. The APY typically ranges between 4-5% on their blockchain. Worst case scenario, the stake pool operator fails to create enough blocks and you miss an epoch. An epoch, to be short, is a rewards cycle of 5 days. If you miss out on any rewards, simply re-delegate your funds to another stake pool. There are many other stake pools that offer higher rewards, cardano is simply an example. *It's important to note, in addition to staking rewards, some projects will reward LP's with free airdrops just for staking ADA in their pool. As of writing this article, you can currently take place in the SundaeSwap ISO by staking your funds. When there mainnet goes live, they will airdrop their supply of tokens to early supporters.*
What are Flash Loan Services?
Flash Loans are the first uncollateralized loan option in DeFi. Designed for developers, this type of lending has become popular across numerous DeFi Protocols. Flash loans are smart contracts that enable instant borrowing with no collateral needed, so long as the liquidity is returned to the pool within one transaction block. This tends to be around 14 seconds on Ethereum's blockchain. Flash lending was first integrated by Marble Protocol, however the concept didn't become popularized until Aave and dYdX introduced these services.
How Are Flash Loans Used:
1. Arbitrage- Prices of cryptocurrency tend to vary across exchanges, this price difference exists because markets are not truly efficient. Exchanges have different fees, trade volume, and liquidity that cause minuscule price discrepancy's. Traders notice this inefficiency and take advantage.
Example lets say you want to buy $100 of Tezos on Coinbase and immediately sell it to Binance for $101. Making a $1 profit. With Flash loans you can borrow up to $100,000,000 of money thats isn't yours, and run this trade over and over again. Your $100,000,000 will then result in a gain of $1,000,000. The platform you are borrowing from will charge a small fee. Aave is one of the most popular liquidity protocols and they charge 0.09% on any profitable trade. A $9000 fee for borrowing $100,000,000. Making your total profit $991,000. This risk free arbitrage is widely known amongst institutions. Coders now write bots that automate these trades, closing up any gaps in price discrepancy's. It is now rare to create a flash loan that takes advantage of this arbitrage. However, it is possible.
2. Swap Collateral -
Example Lets say you have $50,000 in ETH to lend out. You do this to earn interest, and in return you borrow $40,000 of USDC(a stable coin that tracks the value of the US dollar). Well, what if you want to trade your ETH for Litecoin? You would have to payback your USDC to get access to your ETH. Convert your ETH to Litecoin. Deposit the new Litecoin back into the lending protocol, where then you will be able to borrow back your $40,000 USDC. It sounds a bit much. However with flash loans, you can execute all these steps in an instant.
3. Self Liquidation -
Example Lets say you deposited 100 Ethereum into Aave over a year ago. At the time ETH was trading at $300, so you deposited $30,000 worth of ETH into the liquidity pool. You did this because you were bullish on Ethereum, and also wanted to earn free interest on your deposit. Well you still have to pay bills, so at the time you took out a loan based on your ETH deposit. You take out a loan worth of $25,000 USDC, cash it out, and transfer it to your bank account. Fast forward to today and ETH is now trading at $4000 a coin. You now have $400,000 worth of ETH locked up as collateral and want immediate access to it. You would have to payback that original $25,000 USDC loan, however, you don't have any USDC. It has been over a year and you spent that money. In order to get back your collateral, you would have to take out a flash loan of $25,000 USDC to repay the loan and get access to your initial 100 Ethereum. Once you gain access to your Ethereum, you would then immediately convert it to USDC and pay off the flash loan of $25,000 USDC. So now you have withdrawn $375,000 worth of Ethereum without having to front any of your own money. This is self liquidation. You borrowed $25,000 and used code to pay it back within the same transaction. Yes, there is a fee but you are now in profit $375,000.