Staking and Farming: Part Two

Farm It Out

To “farm something out” is defined in the dictionary as “to give work to other people to do”. The capitalist version of this is to put your money to work — if you don’t need it right now, lend it to others who do and make a profit.

What is Liquidity Provision?

If you’ve ever worked in a shop (or even just been to a shop) you’ll have seen a cash register. Imagine the first customer arrives and wants to pay for a $10 t-shirt using a $20 bill. If the cash register is empty, there’s a problem, and the t-shirt is either not sold, given away for free or sold at twice the price. That’s why the cash register is filled at the start of the day to provide liquidity to all the dollars that will need to be exchanged.

Impermanent What?!

This is essentially the difference between just hodling an asset and providing liquidity. The price of an asset in a pool depends on the ratio of token quantities. For example, if one of the tokens in the pair increases significantly in value on centralised exchanges, arbitrageurs will rush in to buy the token cheaper from the pool and sell it on the other exchange. This video does a good visual job of showing how the ratio of tokens in the pool has changed and that it leads to a net loss compared to just hodling.

Rake It In

So if there’s all this risk of impermanent loss why should I bother to provide liquidity at all? Well the key, as always, is to make sure the risk to reward ratio is favourable. Protocols like Compound, Balancer and Sushi all incentivise liquidity providers by awarding them with their own governance tokens. The first simple strategy starts to take shape: can I find a set-up where the transaction fee yield plus the rewards yield outweighs the risk of impermanent loss?

Compose Yourself

It’s not just providing liquidity to DEXs where you can generate a return. If you remember the article on lending and borrowing, those protocols also need liquidity. In fact, DeFi applications are being designed to work with and on top of each other in a modular “money Lego” approach. So what can we do to make the most of what’s possible and truly develop a yield framing strategy? You can take a manual or a semi-automated approach.

  • Some of your token is sent to a lending protocol and used as collateral to borrow another token
  • The new token is sent to a pool and used in liquidity provision with your original token
  • The LP tokens are staked in order to earn a governance token
  • The governance token is then used to purchase more of your original token
  • Liquidity pools are located on smart contracts and so run the risk of being hacked
  • Impermanent loss can obliterate your liquidity if one of the tokens is very volatile
  • Yield farming on newer projects might result in a complete loss if the developer rugpulls
  • If you have loans on borrowing platforms the maximum loan to value ratio needs to be respected or you run the risk of having your collateral liquidated

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