Letter 73: DeFi & Yield Farming (Part 1)
The art of using your money to make more money!
Decentralized Finance (DeFi) is, to me, the single most exciting thing about all of crypto. It’s what really made things click in my brain and made me jump in to the space full time in 2021, and it is what keeps my conviction high amidst all the scammy scummy crimery that tends to take place in the dredges of the cryptosphere.
This is also one the topics that is most requested that people want me to write about, so in order to do it justice (and not force you to read another 10k word monstrosity), I’ll be breaking it up into parts — probably just 2, but we’ll see.
This week we’re gonna focus on some of the bigger picture (and more introductory) stuff:
What is DeFi
Why is DeFi so important?
What is yield?
What is yield farming?
The different ways of earning yield
The risks involved
Should you be trying to yield farm?
Then next week we’ll look at specifics and some of the more advanced stuff, and i’ll also share exactly where my funds are deployed.
But for now…
1. What is DeFi?
In a nutshell, Decentralized Finance (DeFi) is a financial system build on public blockchains. It offers an alternative to the existing financial system which relies on third party intermediaries like banks, brokers, governments, etc.
Bitcoin was created in 2009 as a response to the 2008 Global Financial Crisis and the behaviour of the banks (and governments bailing them out), so you can really make a case that the original ethos and ideals of crypto were to create DeFi.
Since then, much has changed. New blockchains have been developed with smart contract technology, allowing for more sophisticated financial protocols beyond the “storing and sending value” aspect that Bitcoin brings to the table.
Smart contracts are the backbone of DeFi today. What is a smart contract? Basically it is just a bunch of computer code, writing and deployed to a blockchain, such that it is permanent and immutable. It can’t be changed, it is permanent, and it is transparent. Anyone can read and view the code and verify what is going to happen. It is effectively replacing the third party intermediaries with computer code. Beautiful.
At its core, DeFi lets anyone:
Lend, borrow, and trade assets without a bank
Earn yield from lending, liquidity provision, staking, and more
Access derivatives and structured products without brokers or clearinghouses
Control their own funds using non-custodial wallets, rather than relying on third parties
Or another way of putting it: YOU CAN BE YOUR OWN BANK!
2. Why is DeFi so important?
Because anyone with an internet connection can use DeFi, and nobody can stop you.
This might not seem like a big deal to most people reading this. If you’ve lived a nice sheltered life in a western democratic country with a government that you more-or-less trust, you’ve probably never really had any issues accessing the traditional financial system.
You feel good about having money in a savings account in a bank. That’s great.
Not everyone is so lucky. Think about the countries with extremely corrupt governments, the totalitarian regimes, or those with hyper inflated currencies. Imagine the people who have their assets seized or frozen because of their political beliefs. You actually don’t have to imagine — it is happening all around us in the world, and while you might be safe today, who knows what tomorrow brings.
The fact that governments have been increasing in their power, increasing in their surveillance, and increasing in their interference with private citizens and their lives… should be cause for alarm.
There is honestly very little that can be done to fight back against this other than the solution(s) offered by public blockchain technologies.
I recommend watching this video that really hammers this point home. It largely focuses on Bitcoin, but the theory applies to other public blockchains too:
DeFi takes these ideas many steps further — beyond just sending and receiving value, you can now lend and borrow money, provide liquidity, be the bank, and earn fees and generate yield for yourself.
3. What is yield?
There are two terms here that you should know about: APR and APY.
APR stands for Annual Percentage Rate.
APY stands for Annual Percentage Yield.
The main difference is that APR is a flat rate applied to the whole year, and APY takes into account compounding gains.
Traditionally, APR is used when you’re borrowing money and paying a flat fee (ie for a home loan or credit card), and APY is used when you’re earning money (ie in a savings account).
In crypto, they are often used interchangably, and it doesn’t matter that much — what you’re really looking for when yield farming or trying to make money is the return you’re getting on your money. That’s basically what the yield is. Whether it’s APR or APY, if you’re earning 15% on your funds at the end of the year, that’s your yield.
The biggest trap is comparing APR and APY except instead of letting your money compound under the APY model, you’re constantly withdrawing it, resulting in a much lower total return.
4. What is yield farming?
Yield farming is the practice of moving crypto assets across DeFi protocols to maximise the yield you earn.
There are many different strategies you can employ here, ranging from simple and low risk all the way to incredibly complex and risky — but you can also do simple and high risk, and complex and low risk. In other words, there are infinite options. Overwhelming much?
I generally advocate for simplicity, and then each person ought to work out how much risk they’re willing to take on. We’ll cover some of the different strategies you can take in next week’s post.
5. The different ways of earning yield
As you explore DeFi, you’re going to see advertised yields that range from 2-3% per year all the way to 100%, 1,000%, and in some cases, even greater returns. Obviously the higher you go, the greater risk involved. There are no free lunches in life, although, occasionally, you can find some pretty damn free and appealing setups in crypto.
One question I want to hammer into you and literally write home about is to always ask where is the yield coming from?
If you can’t understand and explain where the yield is coming from and find out if it’s reasonable and sustainable, then you’re probably participating in a ponzi scheme or scam of some sort, and will almost certainly soon get burned.
If something sounds too good to be true, it usually is, but sometimes it truly isn’t. You can reasonably find fairly low-risk places to earn a 10-20% return on your money in crypto and while they might not last forever, they are also not scams. Again, more on these exact places next week.
For now, let’s look at some of the different approaches you can take to earning yield in DeFi:
Staking tokens
This is effectively where you utilize some existing tokens to earn emissions paid out in the same token, as a reward for doing something. The most legitimate reason stakers are rewarded is for helping secure Proof of Stake blockchains like Ethereum and Solana. Then there are a billion illegitimate reasons which you should be wary of; I will once again urge you to read this article on this exact topic.
Lending funds to a protocol
This is a simple one where you deposit (lend) funds to a protocol, and earn yield because there are people that are borrowing the same asset and paying interest on it. Your yield is that interest (perhaps minus a tiny fee taken by the protocol).
Most of the time the yield here is on the lower end, but it’s one of the safest ways to make your money work for you — and it can still be combined with other mechanisms (ie protocol rewards or airdrop farming) to spice up the yield generated.
Creating liquidity pools
Liquidity Pools (or LPs) are one of the most exciting albeit complex ways of interacting with DeFi. The basic explanation here is that instead of the usual way people buy and sell tokens via a centralized crypto exchange such as Coinbase or Binance where the platform runs an orderbook to match buyers and sellers and takes a fee, you can become that orderbook and take the fee yourself.
This is beautiful on many levels — mainly that the fee can be lower for the buyer AND the rewards go into the hands of individuals all around the world rather than centralized entities.
A liquidity pool is basically a position you create by adding two assets that you think people will want to trade. For instance, you can create a liquidity pool for ETH and USDC, and then any time someone buys or sells ETH using USDC via your pool, you’ll earn a % of fees.
You can do this with literally any two assets. So if you wanted, you could create a liquidity pool for people wanting to trade between ETH and REKT, or USDC and REKT, etc.
The fees fluctuate wildly depending on the volume of the asset being traded, and the fee rate set for your specific liquidity pool.
You will generally want to manage your LP positions and watch out for something called impermanent loss. We’ll dig into this more next week since it’s a much more complex topic, but just know that providing liquidity is one of the most powerful ways to earn significant yield in DeFi — but it’s also not a passive way of earning yield (like some of the other options).
Depositing funds into a vault
This is basically where you deposit money — usually in the form of stablecoins — into a “vault” where the money is then deployed into some sort of (usually) automated yield generating strategy, and shared with the vault depositors, less a fee taken.
The vaults can deploy automated trading strategies, or be part of a greater protocol like the HyperLiquid HLP vault which earns fees based on market making strategies, liquidations, and platform fees.
Vaults are a nice and generally low-risk way to earn yield, and while usually not crazy, these can range in the 8-15% range quite often.
The vault I am utilizing most at the moment is Liminal, on the HyperEVM, where my 30d APY is 13.96%.
Protocol incentives
This is where things tend to start to get riskier. Often combined with Staking, a protocol may give out rewards in their native token and claim to be offering an APY of something extremely enticing like 20%, 80%, 200%, etc — but what you always need to remember is that in order to realize that return, you have to sell the native token, and by the mere fact that they’re giving out so much of it, they’re usually creating a lot of downward sell pressure.
Not always though — risk goes both ways, and sometimes the token goes up in price too! I’d say that’s the exception rather than the rule, and over the long run, 99% of tokens that provide emissions and incentives like this have a price chart that goes down down down.
Airdrop farming
Similar to the above but usually with less clarity and transparency, you utilize funds in a DeFi protocol in the hope of earning a future airdrop. Sometimes there are “points” given which give you some idea of how you’re tracking, but even then, it’s often anyone’s guess as to what the points will eventually end up being worth.
I like to think of airdrop farming as the cherry on the top — it’s usually not the primary reason I will deposit into a protocol, but if everything else is roughly the same, then I will choose the place(s) which I think give me the greatest chance of a bonus airdrop on top of my immediate yield.
AI Agent Automated Strategies
There are also automated strategies where you can utilize an AI agent to be constantly moving your money around from one protocol to another, checking for where the best yield is, and making the most of your money. An example of this is YieldSeeker.1
These are obviously fairly new but I think the future of DeFi is going to be one where almost everything is done via AI agents. It just makes sense. I wouldn’t necessarily recommend plowing enormous amounts of capital into these agents right now, but it’s worth trying them out and getting used to using them.
6. The risks involved
While this whole movement is intended to be an escape from traditional banks, there’s no denying that there is safety in banks. Often governments will guarantee customer funds (up to a certain amount), and there are all sorts of other safety nets and guardrails in place to prevent a person losing their money.
You get little to none of that when you’re your own bank and you’re doing things the decentralized way. You have to do your own research, take responsibility for the safety and security of your own funds, and understand that there can often be no recourse when things go belly up.
The main thing to understand with DeFi is that while you’re generally not trusting a third party institution, you are still usually trusting the smart contracts that run the protocols. The nice thing is that they are public and transparent and can be audited and viewed by anyone — so the longer a protocol exists, the more battle tested it has been, the safer it is likely to be.
Here are some of the risks to be mindful of:
Smart contract risk — basically bugs in the smart contract, or an exploit that a hacker finds and is able to use to drain the money. Newer protocols are always at greater risk here.
Token incentive collapse — this is where the advertised APR/APY rate is based off emissions given in a token that’s not a stablecoin. If that underlying token goes down in price, so does your return, potentially into the negatives.
Stablecoin depegging — less of an issue with the established stablecoins (USDC, USDT), but as you explore newer and more exotic DeFi protocols, you’ll come across more and more stablecoins. If they aren’t back by something solid and reasonable, they can depeg and be worth less than the $1 you’re assuming and expecting them to be worth — in some historic cases, they can collapse to zero.
Rug pulls / malicious developers — while truly decentralized protocols are meant to be immune from a corrupt actor ruining everything, not all protocols are truly decentralized, so it’s worth paying attention to who built the application you’re using and how it was built. Look for multiple audits done by respected and trusted entities, and again, look for protocols that have been around a while.
Governance attacks — for the protocols that are truly decentralized, often a lot of the important decisions are made via vote, based on who holds their governance tokens. Bad actors can buy up a majority stake in these tokens, or pool their tokens together with other bad actors, and make selfish decisions that harm everyone else. Again not usually an issue with longstanding protocols, but something to keep in the back of your mind.
Blockchain risks — every DeFi protocol is only as strong as the blockchain it is built on top of. The majority of things you’ll interact with are likely to be on Ethereum or Solana, well-established chains with a longstanding history of being secure. As you explore more exotic and newer chains, you ought to consider what might happen if the underlying chain implodes.
And once again…
Always ask where the yield is coming from
Always understand where the yield is coming from
If you can’t explain the yield, chances are, you are the yield.
7. So.. should you be trying to actively yield farm?
I honestly don’t think yield farming is something most people should be doing. It is time intensive, risky, and requires a lot of experience to do well. Just look at the list of risks mentioned above; would you feel comfortable navigating those minefields?
It also generally isn’t the best use of capital if you’ve got a smaller bankroll unless you’re simultaneously farming airdrops, and even then, the best airdrops tend to be linear — meaning that a $500 position earning yield is not likely to result in a $10k airdrop or something insane. Most likely you’ll earn a few extra bucks, but your money could probably have been put to better use just holding a coin or trading a different position.
The good news is that there are ways to passively earn yield in DeFi that are easy, simple, and relative to everything else, very safe. This is in my opinion the approach that most people should be taking. If you have ETH, go stake it and earn 2-3%. If you have SOL, go stake it and earn 7-8%. If you have stables, go lend it or maybe deposit it in a vault and earn 4-15%.
Those are all GREAT numbers for money you have in crypto anyway and that was otherwise likely not doing much. You don’t need to gun for the 20, 30, 100% types of plays.
Active farming involves jumping around from protocol to protocol every few days, weeks, or months, and monitoring your positions to maximize yield. It’s not for everyone; it’s really not something most people should even be considering.
That said, if you do want to get involved, I’ll share some specific strategies in next week’s newsletter. I’ll actually break it down for those who want to be active vs passive, and for different portfolio sizes and risk tolerances; hopefully there’ll be something for everyone.
I’ll also share exactly what I’m doing with my money and the various DeFi protocols I am currently deployed in.
Spoiler alert: most of it is in either Liminal or Project X 🤫.
Disclaimer: The content covered in this newsletter is not to be considered as investment advice. I’m not a financial adviser. These are only my own opinions and ideas. You should always consult with a professional/licensed financial adviser before trading or investing in any cryptocurrency related product. Some of the links shared may be referral links.
You had to mention REKT did you 😏
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