Yield farming: High Rewards, High Risk?

The world’s largest cryptocurrency fell below the $30,000 threshold early last week, and many fear that  Aeolus’ bag of winds may have opened and we may see new lows. Cryptocurrencies have tumbled since mid-May, wiping some $1.3 trillion off their market value. All of the top ten most valuable cryptocurrencies are down by more than 50% since their recent highs. Bitcoin has faced a range of obstacles, including regulatory scrutiny in China, Europe, and the US and dropping hash rates. But in the last few days, the values of cryptocurrencies have all trended upward, indicating that the cryptocurrency market may be beginning to show signs of recovery. The reason behind the bounce back is Elon Musk, Jack Dorsey, and Cathie Wood speaking during a panel discussion about the future of Bitcoin. Yet, many crypto investors instead of just waiting for the value of their digital coins to grow, are now actively pursuing returns by lending out their crypto holdings or exploring other ways to earn yield and maximize their profits. “Yield farming” can result in interest rates in the double digits, which is far greater than the interest rates available in dollars.

Ilias Louis Hatzis is the founder and CEO at Kryptonio wallet.
Get Kryptonio – the safest and simplest crypto wallet.

Yield farming has been the cornerstone concept for DeFi from 2020. Yield farming, the hunt for passive profits on cryptocurrencies, is already taking shape on a number of new lending platforms. Yield farmers invest their money in the hope of earning high returns, frequently in the double digits. Yield farming is crypto’s answer to traditional lending.

Compound, an Ethereum-based credit market, introduce one of the largest DeFi lending platforms, where users may now borrow and lend any cryptocurrency on a short-term basis at rates calculated by an algorithm. A typical yield farmer transfers assets among pools on Compound, continuously pursuing the pool that offers the greatest annual percentage yield in order to maximize returns. On a practical level, it is similar to a technique used in conventional banking called a foreign currency carry trade, in which a trader attempts to borrow the currency with a lower interest rate and lend it to the currency with a greater rate of return.

In early July, Coinbase unveiled a savings account with a 4% APY (annual percentage yield), taking aim at U.S. banks, fintechs, and other brokerages alike. To use the high-yield savings account, savers will need to convert their dollars to USDC.

Rivals like Celsius, Hodlnaut, and Nexo offer yields of 8.69%, 10.5%, and up to 12% on USDC accounts, respectively. Amber Group, a Hong Kong-based startup became a unicorn, worth $1 billion, after a June fundraising round, in just four years since it launched.

However, there’s a big catch with all of these savings accounts. These crypto brokerages use their savings deposits to fund margin lending against crypto assets, so your savings are still subject to the downside of a crypto crash. Coinbase is guaranteeing the principal balance of these USDC savings accounts, so savers can take comfort in the stability of their savings at Coinbase relative to other higher-yielding crypto exchanges.

Coinbase’s guarantee is great, but there is a significant difference between Coinbase’s guarantee of your principle and the guarantee offered by major U.S. banks on savings accounts and money market accounts. What’s the difference? Federal deposit insurance provided by FDIC protects checking and savings accounts up to a maximum of $250,000 in value.

Coinbase’s new savings account is not insured by the Federal Deposit Insurance Corporation (FDIC) because Coinbase is not a bank. While it’s highly unlikely, this means that if Coinbase was to go bankrupt for some reason, there’s no guarantee that your savings account principal at Coinbase would be safe.

Price volatility is not the only risk when it comes to yield farming. Investors run the risk of having their digital wealth stolen by scammers. From Jan-April, DeFi fraudsters stole $83.4 million in DeFi fraud losses, according to CipherTrace. In June, Mark Cuban “got hit” as a yield-farming operation imploded. After peaking at $60, the underlying token became worthless, in what some called a crypto bank run.

Hacking is another big problem as DeFi applications are open source and can be vulnerable to hacks. There is also the risk of joining DeFi platforms with young, unproven tokens that have a high chance of losing their value, leading the entire dApp ecosystem to crash.

While regulators appear to be on the attack, New Jersey, Texas, and Alabama served a cease and desist order to BlockFi, the market is highly unregulated. Regulators seem to point to BlockFi’s Interest Account (BIA), which offers rates that consumers are now becoming accustomed to in DeFi, but that have blown traditional banking rates out of the water. Regulators will have difficulty dealing with yield farming. Considering the fragmented and diverse nature of the market the task for regulators seems almost impossible. Who and what is there to regulate? From a regulatory standpoint, the yield farming market poses several serious and multifaceted risks and challenges, that will become more serious as the market further grows.

Any investment requires a balancing act, between risk and reward. Yield farming is a high-risk, high-reward investment option that is worth pursuing, as long as you understand the various risks associated with it and develop a strategy to deal with them.

Image Source

Subscribe by email to join the other Fintech leaders who read our research daily to stay ahead of the curve. Check out our advisory services (how we pay for this free original research.

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.