A new study by Desautel’s Faculty of Management professor Patrick Augustin shows that investors often don’t know how to take advantage of the benefits of blockchain when they chase farms advertised with high profits and yields — and don’t get what they are getting have expected.
Yield farms are decentralized financial platforms where transactions are settled via smart contracts: pieces of computer code that are automatically executed when certain conditions are met. Unlike in traditional markets, these transactions take place directly between the parties. It is not a trusted financial intermediary like a bank or mutual fund that checks the legitimacy of transactions and reduces risk by spreading it across investments and loans.
“The risks in yield farming are not very transparent,” says Augustin. “On average, farms in our sample reported yields of about 78 percent, but investors don’t always understand the risks or how to maximize yields.”
Liquidity and volatility in decentralized markets
In the research paper, Reaching for Yield in Decentralized Financial Markets, Augustin analyzed trades from a yield farm platform called PancakeSwap. The colorful interface features smiling cartoon animals and promises millions in prizes. PancakeSwap looks like a game, but billions of dollars worth of cryptocurrencies have been traded. On the platform, investors can make their cryptocurrencies available in liquidity pools where other investors can buy and sell.
“Investors provide liquidity; They don’t actually buy and sell, they provide cryptocurrencies for others to trade,” explains Augustin. “Traders pay a fee for each transaction and investors collect it. Since it is a flat fee, the return increases as the trading volume increases. That is her motivation.”
Investors ensure liquidity; They don’t really buy and sell.
Augustin adds that this process is similar to securities lending in traditional financial markets. There, security owners can lend shares to someone who wants to sell short or own a share. “They rent it out as a service without actually selling it and get paid for it,” he says.
However, there is a price risk centered on the volatility of the cryptocurrency. The invested cryptocurrency is held in the pools of a yield farm, which always consist of two different cryptocurrencies. Each investor provides an equal dollar amount. However, while their investment is in the pool, investors remain subject to the price fluctuations of the cryptocurrency, which are affected by the liquidity of the pool.
So when investors withdraw their cryptocurrencies, they may redeem them at a lower value than their original investments, although they receive trading fee compensation.
Staking claims on the blockchain
Despite these disadvantages, yield farming remains popular. Yield farming takes place on a blockchain that provides extensive information about individual transactions. A blockchain is a ledger made up of individual “blocks,” each containing information available to any user. Although the identities of the participants are not disclosed, the blocks contain details of the transaction conditions and past actions of the participants.
Augustin’s analysis found that investors’ decisions do not depend on the magnitude of downside risks. When new risks are uncovered, investors tend to stick with their chosen income farm, even if the risk/reward trade-off has changed.
Investors also make clear mistakes, says Augustin. One of them is leaving money on the table by not taking action or “putting your investment” where they benefit. He explains that once an investor becomes a liquidity provider, they receive a certificate called a liquidity token, which is similar to a certificate of partial ownership of the pool.
“You can leave it on the blockchain, but that doesn’t do you any good,” says Augustin. “Or you can pawn it, so you can lend it out a second time and get extra income. This is the real part of yield farming. But about a fifth of investors don’t.”
Your cryptocurrency is already invested, so there is no benefit in not wagering.
He explains that investors must choose to “stake the token” and that they are always better off if they do: “Your cryptocurrency is already invested, so there’s no benefit in not staking.” It is a mistake. And on the blockchain we can see who is betting and who is not.”
Transactional data reveals performance and risk
The blockchain also allows for the analysis of investors’ actual returns. When you break down the performance of the yield farms, it turns out to be much lower than advertised.
“We found that when high-yield farms advertised, there was an influx of investors to these farms,” Augustin says. “People chase the yields, but the farms that advertise the highest yields systematically produce worse results. Your higher risk doesn’t actually pay off.”
This indicates unproductive behavior on the part of many investors. When investors “go for yield,” they take on excessive risk in order to seek higher returns. This often backfires, not just for retail or crypto investors.
We have found that when high yielding farms advertise, there is an influx of investors into these farms.
“We also see that with institutional investors, such as pension or investment fund managers,” says Augustin. “They have a mandate and are sometimes encouraged to take higher risks to show they can outperform the market or beat a benchmark. But if they do, they can systematically underperform.”
For private investors, the pursuit of yield is like a behavioral bias, Augustin explains. Because retail investors are attracted to product features that are aggressively marketed, such as price, they tend to overemphasize the value of those features and may disregard other features, such as risk: “They ignore risk and are disappointed when they actually occur.”
Regulatory frameworks could help investors understand risks
Yield farmers could clearly benefit from a better understanding of the risks. But decentralized finance platforms like PancakeSwap currently have no fiduciary duty to their customers. You are under no obligation to disclose specific risks or to act in your best interests. However, this responsibility exists in traditional finance, for example with financial advisors.
“There are many similarities between yield farms and traditional financial products, but there is no clear regulatory framework for them. If individual investors are allowed to participate, we have to examine how the products should be designed,” says Augustin.
“If a low-income person has $100 of savings to invest, they should be aware of the risks involved in investing in a yield farm,” he adds. “We have had similar experiences with other products that include financial innovations. Consider the complexities associated with subprime mortgage-backed securities. This allows us to get to know this context more quickly.”
However, some unique challenges may stand in the way of regulating decentralized finance.
“It is very different from the regulation of traditional financial services. Because it’s decentralized, you don’t know who the developer actually is,” explains Augustin. “And there’s little taxonomy of what we’re talking about. Is a cryptocurrency token a currency or a commodity? That has implications and is not necessarily clear.”
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