In the second part of this yield farming series, we discussed how yield farming works and how to calculate yield returns. In Part III of the series, we will discuss where to harvest yields.
Where to Harvest Yield
There are three places where you can harvest yield: money markets, liquidity pools, and incentives.
Money Markets (Lending and Borrowing)
Lending tokens is the standard method of earning yield, and decentralized money markets, such as Compound and Aave, top the TVL list on DeFi Pulse. You can deposit stablecoins and start harvesting instantly.
DeFi marketplaces require borrowers to over-collateralize their loans. This means that you have to deposit more than you can borrow. But why should you want to do that? Well, after summing all the fees, rewards, and incentives, it will be worth your time.
On lending protocols, it can cost you $500 worth of collateral for a $250 loan. DeFi Borrowing causes a lot of confusion, especially for those from traditional finance. Since DeFi needs over-collateralization, newbies often ask, “Why on earth would I deposit more tokens to receive less back?” Well, this is where yield farmers do their magic.
Over-collateralization ensures that lenders do not lose their investments should borrowers default. The crucial point to grasp regarding over-collateralization is that the lender must maintain the collateralization to avoid liquidation. Such loans are not the “set and forget it” type. Borrowers must keep an eye on the collateralization ratio.
Liquidity is so crucial in DeFi protocols. Fees, slippage, and user experience increase with liquidity. Most significantly, liquidity allows founders to borrow from their users instead of relying on venture capital firms.
Liquidity pools generate high yields than money markets. But, higher risks go hand in hand with greater returns. For instance, Uniswap is an automated market maker (AMM) that lists several ERC-20 tokens for trade. DeFi is mostly associated with Lego building blocks, and when one platform is successful, others can borrow from it to create new products.
Incentives are also one of the ways of earning yield. For example, Synthetix created a pool providing its SNX token as a reward. Currently, the sUSD and sBTC pool on Curve offers SNX as an extra incentive. On the other hand, Ampleforth rewards LP’s in Uniswap’s AMPL-WETH pool with its AMPL tokens.
It is advisable to evaluate these incentives well to find the most profitable projects and avoid the low performers.
Temporary loss and liquidation are significant threats to yield farming. Tight collateralization ratios call for closer monitoring to avoid liquidation. The same applies to the risk of temporary loss on Uniswap. Luckily, there are several strategies you can exploit to mitigate cryptocurrency derivatives.
It would be best if you also considered the time horizon to benefit from yield farming. You cannot be bouncing from one protocol to another, consuming gas fees all the time, as the cost of using Ethereum blockchain is high right now. Based on aspects, such as the liquidity pool and protocol you are in, it may call for more extended holding periods to harvest adequate APY to cover the gas and trading fees.
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