Intro to Yield Farming
As highly requested, I’ll dedicate this issue to yield farming. Before getting into it some housekeeping items.
Next paid post will be out on Monday morning, and will include (1) farms that I think are worth the risk, and (2) how to position for an upcoming airdrop
I am in the process of building a cheap, user friendly onchain analytics tool that basically incorporates all of my main diligence processes into one solution
If you have suggestions of features you have always wanted to see in an analytics tool, feel free to comment on this post with them or email suggestions to me.
Ok, lets dive in. This post will start out as a basic overview of what yield farming is (so if you already know this stuff, skip to Section #2). In the 2nd section, I’ll cover what to look out for, where to find farms, tools to use, etc.
Section #1 - Intro to Yield Farming
The basic way to think about yield farming (in most instances) is that you are effectively a market maker. Given the decentralized exchanges (Uniswap, Sushiswap, Curve, etc) use an automated market maker model to set prices for token swaps, they need liquidity providers to “make markets” for these on-chain tokens. Decentralized exchanges use smart contracts to replace order books with the automated market maker model, which allows anyone to provide liquidity into a pool and earn (1) trading fees and (2) liquidity incentives.
How does it work? Most AMMs use a x times y = k equation (or the constant product formula) to determine token prices in a particular liquidity pool. Simplistically, in a liquidity pool (which is usually equal parts of Token A and Token B), the multiplication of the prices of the two tokens always equals the same number. This is fundamentally how all DEXs today work. For example, when someone wants to trade APE on-chain, they usually will try to find the best liquidity pairing (which is APE/ETH on Uniswap). When traders want to buy APE, they add ETH to the pool and remove APE from it, which causes the amount of APE in the pool to fall. This makes the price of APE increase (in dollar terms) to fulfill the x*y=k formula. In reverse, when someone sells APE for ETH, the amount of APE in the pool increases, and the price falls.
This model allows anyone to deposit equal parts of APE/ETH into the liquidity pool, and receive trading fees from it. Following our APE example, Uniswap trading fees are typically 0.30%, so on high volume pairs like APE (which traded $67mm in the last 24 hours), the liquidity providers are earning trading fees from people swapping in and out of the APE token. If you go into the pool analytics within Uni, you can see that there is ~$42mm in the pool (people LPing), and that over the last 24 hours, LPs have made $197k in fees, or a ~47bp yield. If the volume stayed the same over the next 365 days (which it probably won’t), thats a APR of ~171%. Easy money right?
Well, when you are providing liquidity, you are taking quite a few risks (so I usually don’t recommend farming unless you know what you are doing). First, there is a risk that the project your farming ends up getting exploited, rugged, or the token price just plummets. Being a LP is not risk free, so if one side of your token pair falls 90%, the $ value of your LP position will fall ~68%! This is why most times when you see a really high APY on some sketchy FTM DeFi project, its best to just stay away, as the token price will probably get hammered, leaving your APY worthless (more on this later).
You also have impermanent loss risks. As prices of the 2 tokens in a LP pair move, so does the composition of your LP. Using an impermanent loss calculator, if the price of APE falls to $7, not only is your dollar value of the LP down 29%, but you now hold 41% more APE tokens and 28% less ETH tokens. If you would have just held equal parts of the 2 tokens outright, you would only be down 25% (instead of 29%), so if you are going to LP, the APY needs to be worth it.
While IL is a meme for some, if you are bullish on one token vs. another, IL can have an impact on what you end up holding. Similarly, IL risks on the upside can be even more painful. If you are farming something more volatile, and lets say your shitcoin paired with ETH runs up 5x, you would have tripled your money just holding equal parts of ETH and your shitcoin, 5x’d if just holding your shitcoin, but with your LP, you would only be up 2.2x - again, you need to have a commensurate APR to compensate for the risks.
If all of this seems over your head, the best way to learn is to take $100 to a low gas chain like AVAX, FTM or Arbitrum and get your feet wet doing it yourself. You will have a much better understanding of how it all works in practice vs. just reading about it (this helped me learn much more quickly).
How do I LP? If you are going to do it, usually you find the “Liquidity”, “Pools” or “Farm” tab on whatever DEX your trading pair is on (Uni, Sushi, Trader Joe, Spooky, etc). From there you can swap into and deposit equal parts of the pair you want to farm, from which you will receive LP tokens, which you then deposit to start receiving rewards.
Another important point to consider is where the “yield” is coming from. On my APE example, I do not believe there are incremental liquidity incentives going on, but on a lot of new token pairs there are. What does this mean? When someone launches a token, they want deep liquidity on it so that “whales” can buy into the token (or for teams to dump on you). If the liquidity is too low on a token, selling large amounts of it will cause “slippage” meaning that the seller will take a potentially large discount on their token sales. But given people don’t want to straight up farm shitcoins (due to the risks I mentioned), protocols will also launch “liquidity incentives” to increase the APR of farming the token pair. Usually these “liquidity incentives” are in the form of the altcoin you are farming, so you need to be very careful - because if the incentives are very high, that means farmers are receiving a ton of the token, and will dump it as quickly as possible, eventually overwhelming any buyside demand for the token.
An example: one of my very first farms that was heavily shilled on crypto twitter was for a token called Dinoswap. This was a DEX on Polygon, backed by a bunch of VCs. To encourage liquidity, they had a very high APR (1k%) on their base trading pair of DINO/USDC. When I started farming it, I was receiving ~2% per day! You can make money on these sort of farms, but you have to get out of dodge quickly (I would not recommend trying). I had a set 20% return I wanted to make (which I hit in about a week due to farming rewards + some price appreciation of DINO). But given the token was heavily incentivizing liquidity, there was way too much supply coming to the market + no buyside demand (as the team never launched anything they set out to build - at least while I was involved). The token went on to lose 60% of its value the week after I stopped farming it, and continued to bleed for a full 99% drawdown. While the 2% per day I was making was great, liquidity schemes set up like this are usually ponzis, and you need to be very careful to avoid getting wiped out.
Section #2 - The Problems with Farming + What to Look Out for
As mentioned, today I don’t recommend farms unless you know what you are doing. The farms on tokens that won’t go completely to zero have way too much money chasing them, and you will see the APR compress very quickly (especially on stablecoin farms). Most farms today of projects that aren’t total garbage rarely see APRs over 100% (yes there are exceptions). What should you be looking out for if you want to start farming? First, I think you need to read my first issue and remember that the game is usually rigged against you. Most farms have an inside group that knows when to start and when to pull out, and you need to make sure that you are not providing liquidity just for some insiders to exit the project. Further, you still need to learn to watch wallets. Farming is not “passive income” and you need to stay on top of (1) what insiders + whales of your project are doing with their tokens, (2) you need to still understand what the token does, why it could go up, and its supply structure and (3) you need to have a firm understanding of “where” all this yield is coming from.
OHM is a great example of this. If you were early, the combination of a rising price and super ponzinomic rebase model sent your $ value up a ton if you bought at launch (just like TIME). But the “source” of the 5-30k% APRs we were all drooling over was just new tokens, that were consistently getting dumped on the market. Back when these were in favor, the price would rise as more people bought into the ponzi, pumping the OG holders bags (that increased multiples just from the “rebases” alone). But as buyside demand dried up, the token prices got punished, as the amount of supply side inflation was just too large to deal with.
To visualize this, the “yield” of OHM over the last 12 months has come primarily from its token supply increasing from ~60k to 19mm (and to my OHMies, yes I understand there is more to it).
How do I know if there are massive liquidity incentives? First, you can calculate it yourself based on the trading volume of your liquidity pair. If the trading fee APR (which will fluctuate with volume) is like 30% but the reported APR is 140% you know that liquidity is being incentivized. You can also search a project’s discord for “incentives” or “liquidity” to see what they are saying about it. For tokens that have a supply schedule on Messari, you can usually see how much of the supply inflation is driven by farming rewards.
You can also use https://vfat.tools/ - which is one of my favorite farming tools. Vfat (which I think only shows incentivized pools or you can toggle it to) will show you daily, weekly and annual rewards (note JEWEL has some of these rewards locked and has its own issues - just showing as an example).
Most pools of alt tokens are incentivized (because no one wants to provide liquidity on them risk free), so you are best off assuming that they are incentivized to some degree. If a project has you deposit the LP token to their own website, then its also another signal that you are likely getting incremental liquidity incentives in the form of the project’s token.
While I’ve made money in some degen farms, most times when I farmed, I would have made multiples more if I would have just stuck with holding the token outright (SPELL, rDPX). I think if the yield is really high, you are probably taking more risk then you realize, while even if its on a “better” token, and you are receiving ~100% APR, it is (1) not guaranteed money, (2) it needs to be actively monitored & managed and (3) you are still probably taking a lot of risk.
Where to find farms? If you are interested in going further down the rabbit hole, you can find farms using vfat, from wallet watching, or from just looking at Uni analytics or the specific DEX website on whatever chain. For example on Spookyswap, on their liquidity tab, you can sort by APR or pool size to look at farms there (DYOR degens).
Additionally, you can use https://revert.finance/#/top-positions to see top LP returns on ETH and Polygon - I’ve used this to farm “Smart LP” wallets before.
I can do a deeper dive on this one, but I think usually the returns are not worth the risk here. There are massive onchain funds like Alameda that will squeeze every dollar of yield they can out of stablecoin farms. For the non-sketchy stablecoin farms, the yield is ~10% or less - and this is not a risk free return. You are taking smart contract risk on the protocol where you are farming it, there are risks that the token you are getting paid in goes down, and there are stablecoin de-peg risks (which could wipe out your principal). I tend to avoid stablecoin farming for these reasons as you are risking principal for a small reward with tail risks of your principal being wiped out.
Farming isn’t typically worth the risk, unless you are very early on a token, or the APR is high enough to justify the risk
You still have to conduct research on the project to know if its quality, what the catalysts look like, what the liquidity incentives look like and token supply side structures
You also need to watch project insider + whale wallets
Farming is not passive income + needs to be actively monitored
Whales typically LP tops (or LP early), and will remove liquidity near bottoms or to push the price higher with less liquidity
Impermanent loss is real, especially if your token starts ripping
You should know if the “yield” of your farm is coming from trading fees or liquidity incentives
If majority of the yield is coming from liquidity incentives, try to check out how many tokens are being farmed weekly in comparison to the token’s weekly volume and liquidity
Hopefully this is a good overview on yield farming for newbies, and includes some tools and tricks to avoid getting rugged. This information is something that I wish I would have had when I started out, so it should have some amount of value to new onchain users.
Reminder for paid subs - Monday I will go into detail on farms that I do like (that are hopefully worth the risk) and how to position for an upcoming airdrop.
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Disclaimer: This content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.