With the explosion of complex yield farming products shifting risk to the next link in the chain, how can yield farmers prepare for a new harvest season? DeFi asset-backed lending is the answer.
A New Harvest Season for Yield Farmers?
The transformation brought about by DeFi has opened up a world of opportunity for investors looking for innovative ways to generate returns.
One of them is yield farming.
As it stands, yield farming is a rewarding activity that also comes with its fair share of high risks, as investors burned by the Black Thursday 2020 DAI crash can attest.
This episode shed light on some fundamental issues with the current model and technology. They are the reasons many have retired from yield farming altogether and those with less risk-taking refrained from doing so.
But a tough first season doesn’t mean the field will never be reaped.
I believe there are better and safer ways to earn returns with DeFi. The aim of this article is to discuss them.
But before we do that, let’s take a look at the state of affairs with yield farming, its biggest risks and pain points — including the systemic issues that caused the DAI’s Black Thursday.
State of affairs in yield farming
Yield farming is driving the growth of the entire DeFi sector – taking its market cap from $500 million to $10 billion in just one year (2020).
Similar to banks in the traditional financial system, yield farmers in the DeFi economy lend their funds (as cryptocurrencies or crypto assets) at an interest rate that allows them to make profits.
The word “farming” refers to the annual profits made for introducing the liquidity into the market that other companies are seeking.
This differs from the practice of staking that many people in crypto are familiar with. With staking, users remain in control of their wealth. In yield farming, users lock up these assets temporarily in order to generate higher returns.
And if you’re wondering what it means to freeze funds, here’s the answer. When funds are added to a liquidity pool, the wallet containing those funds is locked into a smart contract. Once this step is done, the funds are converted into tokens so they can be traded, loaned, borrowed, etc.
Currently, most yield farming transactions are conducted in the Ethereum ecosystem.
There are different smart contracts with different ways to add value. As we have seen, the main one is charging an interest rate on a cryptocurrency loan.
As a common practice, many yield farmers are moving their funds to track the DeFi protocol (or smart contracts) that offers them the highest percentage of returns — this is known as “crop rotation.”
Understandably, this was one of the factors contributing to the sector’s high volatility.
To counter volatility, coins pegged to the dollar were introduced to anchor assets and provide stability – the most widely adopted is DAI, created from the MakerDAO protocol.
And while some yield farming projects are well established, new DeFi protocols are constantly being launched.
The competition between them is fierce. This increases the pressure to release new contracts and features without the necessary audits and security steps. Sometimes even competitor logs are copied.
Hence the vulnerability to hacks and fraud that many have reported.
With that preamble, it becomes easy to explain what happened on that infamous Black Thursday when $4.5 million worth of DAI was left without collateral and users lost millions.
This is the chain of events that led to the crash:
- On March 12, 2020, Ethereum price plunged 43% from $194 to $111, posting its biggest loss in a single day
- This triggered a wave of demand that swept the Ethereum network
- When grid capacity was reached, gas prices skyrocketed
- The unusually high gas prices shook the price oracle (responsible for constantly monitoring assets) and rendered it unable to update the feeds
- When the oracle feed updated, the price immediately fell over 20%, causing many wealth owners to be liquidated immediately
- Due to the lag in the system, some liquidators (who paid higher gas fees to “skip the queue”) were able to win the liquidation auctions without paying a single DAI
As a result, these liquidators got their hands on more than $8 million worth of Ethereum…for free. While wealth owners suffered losses in the millions.
Pain points of yield farming
Black Thursday’s crash highlighted just how reliant the current system is on Ethereum gas fees and the ability of high-capital users to take advantage of opportunistic situations.
After the incident, a class action lawsuit was filed against the Maker Foundation on behalf of investors.
The lesson learned is that some form of regulation is necessary. In order to take advantage of the opportunities offered by DeFi, investors need some form of protection or guarantee.
Now let’s get to the technical side of things.
More and more real world asset originators are trying to profit from the DeFi protocols. However, these RWAOs find that the technical integration of these protocols is complex and they lack the specific knowledge required.
They are often forced to use manual processes to access liquidity or lack efficient tools to manage liquidity pools.
The other problem is the cost of entering the market due to the high investment in the resources required.
Ethereum has been the smart contract blockchain of choice for crypto projects since its inception and has fueled some of the incredible innovations we see today. However, Ethereum is currently plagued by extremely high transaction fees due to network congestion.
The other consideration is that margin trading has been the most active area of DeFi to date. Simply put, lock crypto to borrow more crypto to buy more crypto.
But there is a fundamental problem with using crypto assets as collateral.
As Centrifuge CEO Lucas Vogelsang explains, “The average crypto user who bought bitcoin when it was a few hundred dollars and uses DeFi to trade and manage their wealth is a very different user than a company that is actually pretty tight on cash.”
“These companies are looking to DeFi for a way to get money faster and on their own terms without having to go to a bank. They don’t have crypto to get their DAI loans, so they need to be able to use their bills or inventory.”
What the yield farming sector needs
Investors want more transparency about their investments and want to improve their access to real assets and a variety of investments.
They also want to reap significant DeFi returns without the high risk of the current process. This is especially true in the current environment where interest rates are at record lows.
Asset-back lending is the catalyst that will unlock these opportunities.
Imagine investors injecting money into a pool that companies can access when they need funding to run their businesses. Then think of asset creators who are able to convert the physical value of their assets into digital tokens.
Asset back lending does just that. It allows liquidity providers to lend to companies using real assets as collateral for their borrowing. In this way, liquid providers and yield farmers can achieve above-average returns on crypto assets.
This offers liquid providers a layer of security and means their investment is backed by tangible, physical assets. In connection with the additional insurance cover, we prepare the field for a productive harvest.
With better access to capital for asset creators and opportunities to outperform crypto asset returns for yield farmers, is the DeFi world ready for a new harvest season?
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