First, What is Yield Farming?
Before we get into what leveraged yield farming is, let’s first, discuss traditional yield farming. Yield farming involves the lending or staking of cryptocurrency into decentralized smart contract-based liquidity pools in order to generate rewards which are expressed in APY (Annual Percentage Yield). Rewards typically come in the form of interest from lenders, a percentage of transaction fees or a governance token.
The practice of yield farming became hugely popular during what came to be known as the DeFi summer of 2020. It was a period that witnessed hundreds of new protocols emerge, many offering eye-watering APYs to investors seeking alternatives that would provide them with a higher return compared to what they could achieve in traditional financial markets.
Compound paved the way in 2020 by launching its governance token (COMP) which distributed weekly rewards to lenders and borrowers on their platform. A flood of other protocols soon jumped on the bandwagon with returns and risk profiles varying greatly from platform to platform.
At the time of writing, the TVL (Total Value Locked) in yield farming protocols is $215 billion with the vast majority of activity taking place on the Ethereum network.
So, What is Leveraged Yield Farming?
One of the biggest issues with DeFi relates to capital efficiency. Specifically, users have been unable to borrow more than they put up as collateral. Let’s say someone puts up $100 of value, is able to borrow $50 against that, then deposits that $50 into a farm. The reality is that they would have been better off just putting the $100 into the farm in the first place as their earnings would be greater. Leveraged Yield Farming (LYF) fixes this by allowing for better capital efficiency by making undercollateralized loans accessible, meaning users can borrow more than their available principal.
In a nutshell, LYF combines regular yield farming with the ability to borrow external liquidity which can then be used to increase a user’s farming position, enabling them to earn multiplied yields. Lenders provide their single assets and in return receive some of the highest and most sustainable yields in DeFi. These above average yields are achieved due to the high utilization rates in the lending pools.
Although LYF loans are undercollateralized, an important feature/safeguard exists. Unlike regular DeFi platforms where borrowers can do whatever they want with funds that they borrow, LYF platforms do not allow borrowers to withdraw borrowed assets from their protocols. The usage and return of the funds are kept exclusively in-house and are tightly controlled by liquidation mechanisms.
Risks
Leveraged yield farming essentially carries all of the same risks as traditional yield farming but with an added kicker.
- Risk of impermanent loss. This is the risk associated with depositing dual asset pairs into DeFi liquidity pools, usually in a 50:50 ratio. Essentially, it’s the difference in value between depositing two different assets into an AMM (Automated Market Maker) versus simply holding onto those tokens independently in your wallet.
- Risk of smart contract exploits/hacks and rug pulls. Unfortunately, there is a growing list of incidents that have occurred amounting to over $1.5 billion in losses. For an up-to-date list of exploits…
