How DEFI achieves such huge yields

1. What the hell is Defi?
2. Layer 2 Farming
3. Defi: Blessing or curse?

How is it possible, wonders the wide-eyed newcomer to the dizzying world of Defi, that it can offer such eye-watering APYs? And not just a single rogue Defi service either: a growing menu of applications give users the opportunity to earn frankly insane yields for doing very little but depositing funds. And more are coming online every day. Surely such schemes are too good to be true? Well, yes and no...

What the Hell Is Defi?

Defi essentially gives anyone with crypto assets access to a complex array of financial services that were previously the privilege of investment bankers and hedge funds. Defi has grown at a phenomenal rate and is showing no signs of slowing. 

Let’s look at a summary of those financial services Defi offers and some of the jargon, then we can try and explain why this translates into insane returns. 

Lending/Borrowing - Nothing new under the sun here. If you own a crypto asset you can lend it to a Defi application and receive a fixed rate of return. They then lend it out, charging other users interest to borrow it. This is familiar territory covered by traditional banks. 

The Average Percentage Yields (APYs) are modest on the Defi spectrum, but way better than your current savings bank account. The level of APY is driven by demand for borrowing, which is highest for stablecoins.

Staking - Specific to Defi, means locking your crypto asset up for a fixed period, in return for a specific return. Defi applications incentivise Staking as it puts a brake on the selling of the asset and limits its supply, both of which protect against a decline in the asset’s value. (Note in this sense Staking is different from its use within a Proof of Stake consensus mechanism).

Liquidity Provision - Someone lending a crypto asset or pair of crypto assets to provide liquidity for a Defi application like a DEX (Decentralised Exchange) and getting paid in fees and a token issued by the DEX.

Decentralised Exchange - A cross between a bank and a familiar centralised exchange (e.g Coinbase). Allowing users to swap almost any token by simultaneously incentivising other users (LPs - Liquidity Providers) to provide the liquidity to make this possible without funds being centrally held.

Yield Farming - Generating the best possible returns from combining/multiplying the yield generating opportunities across Defi - as listed above.

So Yield Farming is just short hand for finding the smartest combination of all the tricks in the Defi tool box.

LPs can profit simply by adding specific crypto assets to a pool (usually in the form of two assets weighted 50:50) which generates an automated market for those tokens. This is why you’ll hear a DEX described as using AMM - automated market makers. 

In return LPs get a return in the form of a new token that can, of course, be quickly swapped into stablecoins (to lock in value), Wrapped Bitcoin, ETH or any other crypto supported by the DEX. Or can be plugged back into the interconnected Defi ecosystem to sweat your funds further, in ever more complex loops, known as composability.

Yield Farming is just short hand for finding the smartest combination of all the tricks in the Defi tool box.

Layer Two Farming

So, back to the original question: how can defi applications possibly manage to offer such generous interest rates? A cursory glance at the yield farm market right now throws up names like Wasabix and Eggplant, two protocols built on Binance Smart Chain (BSC) offering APYs in excess of 4,000%. 

Elsewhere, PolyZap Finance on Polygon (Matic) Network is enticing users with an APY of 2,421.61%; Liquid Driver on the Fantom Network, meanwhile, offers a comparatively paltry 1,893%.

Some pools even compound their APY, meaning the quoted figure applies to the snowballing number of native tokens held by the yield farmer. So if the APY is 1,000% and you earn 100 EXMPL tokens after day one, the 1,000% interest would, from day two, apply to the value of your total assets, collateral plus rewards.

These Defi services are often described as layer two yield farms. Most (though not all) aren’t really offering any new features or functionality. They are simply copying existing services, giving them a cool-name and hoping that market mania is enough to attract liquidity. It is for this reason that some are labelled as little more than Ponzi schemes.

Ultra-High APYs: A Blessing or Curse?

The truth is, it all comes down to the native token. At least, the native token claims the lion’s share of credit for the four- and sometimes five-figure APYs. Because native tokens dispensed as rewards for yield farming are typically highly volatile with low liquidity, farmers must be enticed to stake with the promise of a tremendous return. In theory, a high APY acts as a countermeasure to the aforementioned risks. 

As a general rule of thumb, the higher the APY, the riskier (and newer) the pool. Low APYs might cause some farmers to thumb their nose but certain investors value stability above all else. For them, a single asset pool with 20% paid in a stablecoin or top five cryptocurrency is as good as it gets. 

As more users lock funds into a liquidity pool, and thereby dilute it by reducing the influence of their fellow miners, the APY of even the riskiest pool begins to drop. Of course, if the native token has appreciated in the meantime, a reduction of even a few hundred % mightn’t be much of a blow. But what if your underlying collateral is devaluing - known as impermanent loss - and what if it continues to do so? 

One risk yield farmers run is that their stake depreciates while locked, and the yield isn’t sufficient to mitigate such haemorrhaging. 

Aside from the dangers of these niche crypto assets losing value, you have to account for the costs of being in the game; and let’s face it, a lot of what we’re discussing does sound more like a game than serious financial management.

Connection fees - Most protocols will charge a fee just to connect your wallet

Transaction fees - Every time you deposit or withdraw funds you pay a fee. As most of DEFI happens on Ethereum, active yield farming costs a fortune in fees.

Pool balancing - If you are depositing a single asset to a Pool that is split you’ll need to pay a fee for your funds to be split into the required allocation.

As with any form of investment, there is a real possibility of losing money. (Such an event might seem unthinkable to the awestruck novice contemplating the crazily high APYs.) 

Another ever-present danger is that a project in which you’re farming gets rug-pulled (i.e. exit scams) with the consequent loss of not just yours but everyone’s funds. 

Rug-pulls tend to involve hidden backdoors in a project’s smart contracts, exits that enable shady developers to drain all the tokens locked in a protocol and leave users high and dry. For this reason, many investors are becoming more circumspect and vetting projects thoroughly before FOMOing into attractive-seeming pools. 

Second layer type Defi protocols may look like viable get-rich-quick schemes, but turning a profit from them, once you take staking and unstaking fees and impermanent loss into account, they’re anything but. It’s essential to know everything you can about a project before staking your hard-won crypto – including whether it’s been audited or hacked.

When something looks too good to be true, it usually is. In the case of 1 Billion percent APY, no further explanation should even be needed.

Once More Unto the Breach, Dear Friends

Few industries on earth are as fast-moving as defi. Anyone looking to make a proverbial killing from yield farming should do their best to see past the astronomical APYs and tailor strategies to their personal risk profile. Perhaps you’ll decide that a lower APY offered by a trusted protocol on a long-established (albeit expensive) blockchain like Ethereum is preferable to a high-risk, high-reward pool on a layer-two. 

Or perhaps you’ll dive headlong into a memecoin abyss with reasoning that can broadly be summarised as “YOLO.” 

Either way, good luck and godspeed.