Leveraged Yield Farming: Everything You Need to Know
Thasni Mayaon June 16, 2022.
Leveraged yield farming has increasingly become popular among experienced DeFi users. While the term may sound intimidating, it’s not complicated if you’re familiar with DeFi and yield farming basics. It offers a brilliant way to strengthen your financial position and maximize your earnings. That is not to say it is risk-free, of course. In this article, we take a look at what leveraged yield farming is and how it works.
What Is Leveraged Yield Farming?
Leveraged yield farming is a subset of yield farming where you use borrowed money to improve your position and, in turn, yields. It allows you to tap into external liquidity pools, opening up the possibility for higher returns. Let’s try to understand it better using an example.
You are a tomato farmer; you plant 50 tomato seeds every month. Each tomato seed gives you a tomato in return, and each tomato sells for $1. That brings your monthly income to $50. One month, you decide to borrow an additional 50 tomatoes. At the end of the month, you earn an income of $100. Borrowing the tomato seeds allowed you to improve your earning potential and leverage your position.
Then again, leveraged farming is riskier. In the event of a flood or a drought, you lose 100 potential tomatoes. Leveraged yield farming has a high risk/reward ratio.
How to Leverage Yield Farming
First, let’s analyze why leveraged yield farming is important. The relevance of this new DeFi service lies in addressing the industry’s capital inefficiency. Since DeFi apps stand for anonymity and privacy, it is difficult to offer lending and borrowing services. The risk of default in payments is higher in this case as the platforms don’t have access to the participant’s identity, address, credit score, financial statements, or other personal information.
To tackle this, most DeFi lending and borrowing platforms offer over-collateralized loans, requiring you to stake a larger amount than your loan. For example, if you want to borrow $500, you may have to stake $1000. While this is an excellent risk mitigation strategy, it curbs the adoption of DeFi lending. Not everyone can afford to pay that amount. If they could, they may not ask for a loan in the first place. Over-collateralization limits the use cases and growth of the industry. Leveraged yield farming addresses this issue to a great extent.
It has two players mainly–lenders and farmers. While lenders stake tokens in lending pools to earn interest, farmers borrow tokens from the pools to leverage their position. It creates a win-win situation while bringing down the chances of credit and fraud risk. Let’s say you have an idle 100 ETH in your hand. You don’t want to leave them in your wallet to collect dust. Instead, you can lend it to yield farmers for an interest. A regular yield farming platform offers you a 3% yield on your deposit. The higher the collateralization requirement, the lower the reward. How do you strike a balance between APY and risk? You must consider the best yield farming strategies.
Leveraged yield farming platforms like Stable offer a good solution. Since these platforms are under-collateralized, you earn higher APY as a lender. On the other hand, the borrower has access to more funds, enabling them to maximize their ROI. So you decide to add your coins to a leveraged yield farming platform for an APY of 10%. And the platform distributes the fund among borrowers. For example, if the leverage is 2X, the borrower only has to hold 25ETH to add 25ETH to their position. Given that their yield strategy promises an APY of 8%, the leverage allows them to earn 4ETH instead of 2ETH. The system empowers investors with low initial capital to make the most of yield farming. Since the leveraged fund is not handed over to the borrower, the risk is limited too.
Is Leveraged Yield Farming Profitable?
Yes, leveraged yield farming is profitable if done right. It allows both lenders and farmers to earn more compared to regular-yield farming. Leverage increases the capital efficiency of both the lender and the farmer. In the above example, a regular yield farming platform would have given the lender a yield of 3ETH. However, by switching to leveraged yield farming, they’d be able to earn 10 ETH. And as discussed, the borrower earns 4ETH instead of 2ETH.
Disadvantages of Leveraged Yield Farming
Leveraged yield farming is a double-edged sword. Just like it can increase your returns, it can increase your risks too. If your prediction goes wrong, you end up paying more. In addition to market unpredictability, it comes with the risks of yield farming, protocol vulnerability, hacks, and theft.