What Is Leveraged Crypto Yield Farming And Why Could It Act Like The Carry Trade Blowups?

Written by Dana Sanchez
yield farming
What Is Leveraged Crypto Yield Farming And Why Could It Act Like The Carry Trade Blowups? Image: iStock

Yield farming is the Wild West of decentralized finance, an increasingly popular way of using your crypto to make more crypto by lending your funds to others through computer programs called smart contracts in return for fees in the form of crypto.

Also called liquidy mining, yield farming involves staking or locking up cryptocurrencies in return for rewards. It’s not for amateurs. Yield farmers use very complicated strategies and are secretive about it, according to Binance Academy, a blockchain and cryptocurrency education portal from the Binance crypto exchange.

The popularity of yield farming has been compared to the initial coin offerings boom of 2017. Per the laws of supply and demand, users flock to each new project that offers new tokens or ways to earn rewards, hoping to get a piece of the pie. In turn, this creates demand, pushing up the value invested in the project and the tokens.

Yield farmers move their cryptocurrencies around constantly between different lending marketplaces to maximize returns and they’re very secretive about the best yield farming strategies. The more people know about a strategy, the less effective it may become.

The most successful yield farmers maximize their returns by using more complicated investment strategies, according to CoinTelegraph. These strategies usually involve staking tokens in a chain of protocols to generate maximum yield. Yield farmers typically stake stablecoins such as Dai, Tether (USDT) or USD Coin (USDC), because they offer an easy way to track profits and losses. However, it’s also possible to farm yield using cryptocurrencies such as Ether (ETH).

Earning yield on investments is nothing new, but the overall concept of yield farming arose from the decentralized finance sector, or DeFi. The DeFi movement is at the forefront of blockchain innovation and its applications are unique because they are permissionless, according to Binance. Anyone or thing, such as a smart contract with an internet connection and a supported wallet can interact with them. They also usually don’t require trust in a custodian or middleman. Anyone to earn passive income using the decentralized ecosystem of “money legos” built on Ethereum. 

Leveraged yield farming is using borrowed money to yield farm. For example, a platform allowing the investor to borrow $2,000 worth of crypto off $1,000 is 2:1 leverage.

Alpha Homora is a protocol for leveraging DeFi farming strategies, and it claims to make leveraged yield farming easy, enabling users to borrow ether to take higher liquidity positions with up to 2.5x your initial portfolio size, according to dExplain. “As a result, you can earn more trading fees from the swaps going through the pool. Additionally, your provided liquidity is going to generate more rewards.”

DeFi farming with leverage via Alpha Homora puts you at risk of being liquidated, dExplain explains. If the token or ETH price drops, you could lose all your assets. “Essentially, it is like margin trading but for yield farming so will require much more monitoring than usual. However, if you’re bullish on an asset … you could stand to earn more trading fees by borrowing ETH.”

A carry trade is a trading strategy that involves borrowing at a low-interest rate and investing in an asset that provides a higher rate of return. An example of a carry trade is when you sign up for a credit card that offers a 0 percent cash advance to invest the borrowed cash in assets with a higher yield. This carry-trade strategy may net you a profit or a loss.

“This tactic is the siren call of the carry trade,” James Chen wrote for Investopedia. Carry trades can go horribly wrong if you misread the fine print about transaction fees or there’s a market correction.

Carry trades typically involve currencies. You borrow in a low-interest rate currency and convert the borrowed amount into another currency. Generally, the proceeds would be deposited in the second currency if it offers a higher interest rate, according to Investopedia. However, the proceeds also could go into assets such as stocks, commodities, bonds, or real estate denominated in the second currency.

Along with financial rewards, carry trades come with significant risks, such as the price tanking on the invested assets, or exchange or currency risks when the funding currency differs from the borrower’s domestic currency. “Because of the risks involved, carry trades are appropriate only for investors with deep pockets,” Investopedia urges.

Dangers of Leverage to Yield Farm (How NOT to blow yourself up)
Source: YouTube / Kerman Kohli, DeFi Weekly

Carry trades are popular when there is a lot appetite for risk but if the financial environment changes suddenly and speculators have to unwind their carry trades, this can have bad consequences for the global economy. For example, the carry trade involving the Japanese yen reached $1 trillion by 2007 thanks to near-zero interest rates. However, virtually all asset prices collapsed in the 2008 financial crisis, undoing the yen carry trade. The carry trade surged as much as 29 percent against the yen in 2008, and 19 percent against the U.S. dollar by 2009.

Weakness in both the dollar and euro presents a dilemma for investors about which is the best source of funding for emerging-market carry trades, Bloomberg reported this week. Carry trades have languished at a time when yields were at rock bottom around the world. As economies recover from the coronavirus pandemic and central banks start tightening monetary policies, the challenge is to find the best funding currency.

Yield farming became popular in the summer of 2020 thanks to Compound, a decentralized, blockchain-based protocol that allows you to borrow and lend crypto and have a say in its governance with its native COMP token. Compound announced it would start issuing its COMP governance token to lenders and borrowers who use the Compound application. It was an instant hit, pushing Compound to the top of the DeFi rankings, Cointelegraph reported. 

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Other projects have followed suit, creating DeFi applications with associated governance or native tokens and rewarding users with their tokens. These copycat tokens replicated COMP’s success, such as Balancer’s BAL token, which gained 230 percent immediately after launch. Each new successful project fuels more innovation and competition for users.

It’s also extremely risky using leverage to farm, said Kerman Kohli, an advisor for early-stage crypto and DeFi startups, and author of the DeFi Weekly blog.

“When you say you’re using leverage to farm something, like to game a protocol, that is the surest way to lose money,” Kohli warned on a YouTube video posted in July 2020. “I hope that if you are doing this, you close out your positions because when things go sour, unfortunately, in the DeFi space, there’s not much reconciliation.”