The real crypto opportunity for Wall Street- "Yield Farming"
Updated: Apr 15, 2021
Cryptos are attracting the attention of Wall Street. Banks, asset managers, and corporate treasuries are building crypto infrastructure and crypto reserves- some openly and some stealthily. There is however a bigger opportunity in cryptos that financial institutions are yet to embrace- Yield Farming.
As money printers go brhhh, interest rates are at an all-time low and financial institutions are going up the risk curve in search of yield. Just the term “yield farming” should make them froth in the mouth.
In this article, I argue that financial institutions are well-positioned to take advantage of yield farming opportunities, whether it be asset managers who will themselves yield farm or banks that facilitate the same.
What is Yield Farming?
Yield farming is the moving of assets between protocols to maximize yield.
The DeFi (Decentralized Finance) space is full of protocols offering yield. You can invest your funds in:
* Decentralized exchanges like Uniswap or Curve that entitle you to a share of the transaction fees.
But why stop at parking funds in one protocol? You can keep moving funds between protocols to maximize your returns and wallaaaaah you’re yield farming.
If only it was that easy. Anyone can yield farm, but doing it well is difficult.
What factors do yield farmers have to keep in mind?
I list below some of the factors that make yield farming a sophisticated exercise not to be carelessly indulged in.
I mention them here with the aim to spark the idea that traditional financial institutions are better suited to doing this compared to the current crop of DeFi enthusiasts. I hope that someone with authority at a Hedge Fund reads this article and is inspired to explore DeFi and Yield Farming.
1. Interest Rates - In traditional finance, you get your interest at the end of a fixed term, say a month or year or 10 years. In DeFi, the interest gets credited to you with every block (so ~ every 15 seconds). It’s a great feature to receive interest or share of transaction fees every 15 seconds. This however also means that the rate of interest or share of transaction fees can change every 15 seconds as (a) the size of the liquidity pool changes, (b) the ratio of borrowing and lending on the lending protocol changes, (c) the volume of transactions in the DEX changes, (d) the value of tokens changes, etc.
=> Therefore, when you invest in these protocols, you see a certain rate of return but you can’t know what the rate of return will be even a minute after you invest.
2. Governance Tokens - In order to incentivize usage, DeFi protocols award governance tokens to participants. Compound users get COMP tokens, Aave users get AAVE tokens, Uniswap users get UNI tokens, etc for using the network. The tokens are a welcome additional income. Compound releases 0.5 tokens per block. This is allocated among the different liquidity pools (cDAI, cUSDC, cETH, cWBTC, etc). How much of this any particular protocol participant is entitled to depends on (a) the amount deposited in each of the liquidity pools, (b) the amount of borrowing from the liquidity pools, (c) their share in the liquidity pool they have deposited in or borrowed from, etc.
=> Therefore, when you invest in these protocols, you can’t know in advance how many governance tokens you will get.
3. Collateralization Ratios- When you borrow from a lending protocol, you must be mindful of the collateralization ratios. If your collateral value falls below a certain limit then your deposits can be automatically liquidated without warning.
=> With cryptocurrencies being as volatile as they are, collateralization ratios getting breached is a major risk.
4. Gas - Every time you transfer funds from one protocol to another, it incurs a transaction fee (gas) on Ethereum. The exact amount of gas that will need to be paid will depend on how busy the Ethereum network is at that time.
=> Therefore, when you move funds, you can’t know in advance how much that transaction will cost you.
Yearn Finance - Yield Farming made easy!
By now it should be obvious that you shouldn’t try to yield farm, by physically sitting in front of your computer watching, as interest rates on different protocols move. The only way to yield farm effectively is by building automated investment algorithms.
So what happens if like me, your math isn’t that strong and your computer programming skills non-existent? The good news is that such strategies already exist on Yearn Finance. Yearn Finance provides readymade and audited yield farming strategies. You simply need to invest in Yearn Finance and it will automatically invest your funds for you.
Scope for professionalization in Yield Farming
Yield farming has not become professionalized yet. It is currently being done by hobbyists building/breaking/experimenting in their basements. They’re not competing with the coding, engineering, and math talent at mature financial institutions yet.
The most credible yield farming tool today is Yearn Finance mentioned above. Yearn Finance has been built by a self-taught, lone wolf by the name of Andre Cronje. A super-smart, super-creative, super-passionate, and somewhat volatile individual who says things like “For now it’s fun. Maybe in a month it’s no longer fun and I go back to playing Warcraft”.
Can banks create a competitive product in this market where Yearn Finance is the gold standard of quality? Absolutely. This is what banks do. They get their human capital to build sophisticated tools to exploit arbitrage opportunities in the financial ecosystem. If their math models can find arbitrage opportunities in the chaotic open economy, which is subject to the whims and fancies of unpredictable global characters, then the closed economy of DeFi, governed by rules clearly stated in code, should be a cakewalk.
I believe that Yearn Finance won't stand a chance if the likes of Medallion Fund apply their quant capabilities to DeFi.
New products in DeFi that might appeal to financial institutions
Also, it isn’t just about banks being more suited to dealing with the complexities of DeFi. The likes of Stani Kulechov of Aave are developing tools that especially appeal to financial institutions with refined risk management skills.
Flash Loans - Aave offers a service called Flash Loans where someone can borrow and repay the loan in the same transaction. Why would someone want to do that? Because they can exploit arbitrage opportunities between the borrowing and the lending with effectively zero capital risked.
Debt Tokenization - When you lend in Compound or Aave, you get interest-bearing cTokens or aTokens in return that can be traded in an exchange like Uniswap. In Aave Version 2, you will get debt accruing aTokens when you borrow which will also be tradable.
Native Credit Delegation - Several participants tend only to lend and not borrow. Other participants may want to borrow without lending, but they are unable to as DeFi relies on over-collateralization to ensure repayment. Aave is making it possible to delegate unused credit capacity (of participants who only lend and don't borrow).
=> The above are examples of tools that creative asset managers will find exciting.
Sure, the $25 billion TVL (Total Value Locked) in DeFi at the time of writing, may not be big enough to excite top management at banks, but the first banks that recognize the opportunity and set their minds to developing capabilities in the field will be setting themselves up for a windfall.
Imagine if a traditional financial institution, had back in 2012, started work on a crypto exchange like Coinbase. Brian Armstrong lacked the experience but had the vision. Traditional financial institutions had the experience but lacked the vision. Instead of Coinbase, it could have been them today, working on bringing a crypto exchange to market at a valuation of $70bn.