What Is Leveraged Yield Farming and How Can It Bring Higher Returns?
In DeFi, while it’s not necessarily true that bigger is always better, the beauty of a high APY never fails to turn heads. And regardless of how much higher DeFi yields are compared to traditional finance, there’s no shortage of DeFi users eager to maximize their profits, chasing higher yields from platform to platform and […]
In DeFi, while it’s not necessarily true that bigger is always better, the beauty of a high APY never fails to turn heads. And regardless of how much higher DeFi yields are compared to traditional finance, there’s no shortage of DeFi users eager to maximize their profits, chasing higher yields from platform to platform and network to network. Therefore, it’s no surprise that leveraged yield farming, with its superior capital efficiency to alternative DeFi products, has become a popular choice for experienced DeFi participants to maximize their yields.
The concept behind leveraged yield farming isn’t as complicated as it might seem at first mention; If yield farming with X yields you Y returns, then yield farming with 5X yields you 5Y returns. In other words, borrowing funds to ramp up your position X, aka using leverage, multiplies your yields. Of course, it’s not for free; Like any lending platform, you have to pay borrowing interest for the privilege to use borrowed funds. Yet, where leveraged yield farming shines is in its capital efficiency–the ability to borrow more than you put up as collateral.
For anyone who’s used one of the major DeFi lending platforms, you’ll know that one endemic issue within DeFi lending is the lack of capital efficiency; If you put up $1 as collateral, you might only be able to borrow 50 cents. So if you then use that 50 cents to yield farm, won’t you just be earning less than if you used that $1 from the start? This limit is prohibitive for many lending use-cases. However, this is not the case for leveraged yield farming.
Unlike most traditional lending platforms, leveraged yield farming allows for undercollateralized loans. This higher capital efficiency means not only higher APYs for farmers but also lenders, as a result of this undercollateralized model creating higher utilization rates, which are a major factor in lending APYs within most lending platforms. The benefits are clear at a glance, higher APYs, and that’s also why leveraged yield farming platforms such as Alpaca Finance and Alpha Homora have gathered billions of dollars in TVL, becoming two of the most used DeFi platforms.
Yet, levering up your farming position to earn multiplied yields is only the simplest way to use a leveraged yield farming platform. There are advanced features and practices that allow users to create customized positions for their ideal risk profiles, target returns, and market biases. From taking long and short positions, to using market-neutral hedged strategies, it’s all possible through the customization of leveraged yield farming, and the best part is that no matter what you do, with leveraged yield farming–you’ll always be earning yields!
Leveraged Yield Farming Explained
Leveraged yield farming has two key participants: (1) lenders that deposit their single tokens within lending pools to earn yields, and (2) farmers that borrow tokens from these lending pools to yield farm with leverage.
Lenders. Lenders in a leveraged yield farming protocol can find among the highest yields in DeFi for single assets (Above figure). As stated before, such high APYs can be sustainably achieved due to higher utilization on the lending pools in general. What does utilization mean?
Well, if a lending pool has 1,000 ETH, and there are borrowers that want to borrow 100 ETH, the utilization of that pool will be 10% (100/1000). Where undercollateralized loans and leveraged yield farming have an edge is that each respective borrower can borrow much more, thus achieving said higher utilization.
Using the previous example, if a traditional lending platform has 10 borrowers that are limited to borrowing a max of 10 ETH each due to collateralization limits, they will borrow a total of 100 ETH. Within an undercollateralized leveraged yield farming platform, these same 10 borrowers could perhaps borrow 50 ETH each, creating a utilization of 50% (500/1000). Higher utilization is important for lenders because most lending platforms have an interest rate model that slopes upwards at higher utilization, using the concept of supply and demand where higher demand for loans leads to higher rates for borrowing. This means at 50% utilization, the borrowing interest paid to lenders will be much higher than at 10%.
Through an undercollateralized model, utilization rates can and sometimes do hit as high as 90%+. Meanwhile, on overcollateralized lending platforms, the overall platform utilization can’t be higher than the weighted-averaged collateralize ratio of all the assets. It’s mathematically impossible. So for example, if a protocol has 2 asset pools, each with a 50% LTV limit (Deposit $1 of collateral to borrow max .50), then that platform’s overall utilization can never be higher than 50%. Leveraged yield farming has no such limitation, leading to much higher APYs for users!
Yet, although the loans are undercollateralized, this model as utilized by modern yield farming platforms has proven very safe for lenders, because unlike other lending platforms, borrowers cannot withdraw the borrowed funds from the protocols. As such, the usage and subsequent return of the funds are tightly controlled by the protocols and their liquidation mechanisms, ensuring lenders receive their funds back. This is in contrast to traditional lending platforms that allow borrowers to take and use their funds anywhere.
Farmers. Leveraged yield farming is similar to the standard farming of LP tokens but with additional features. In standard farming, a user “provides liquidity” to an AMM by depositing a pair of tokens in 50:50 proportion (e.g., $100 worth of ETH and $100 worth of USDT). This is necessary to create LP tokens. Users then receive LP tokens, which increase in value over time as trading fees are accrued into these LP tokens. Users can also stake some LP tokens in farming pools on DEXes that offer them to earn additional token rewards.
In leveraged yield farming, users can borrow tokens to increase their farming positions and therefore, capture additional farming yields. The process is simple: in a leveraged yield farming protocol, users first deposit any proportion of the two tokens. So in the aforementioned prior example of ETH and USDT, users could deposit only one of the two, or a combination of both, and the underlying protocol will do optimal swaps in the background to convert the tokens into a 50:50 split for the LP tokens (a process known as Zapping).
Then, to get leverage, farmers can borrow one of the tokens up to a maximum leverage(1.75x-6x depending on the pair). 1x leverage means without leverage, such as with standard yield farming. 2x leverage means borrowing as much as you deposited as collateral; Your total position value would be 2x your equity value.
Once you’ve selected your leverage and opened a position, the protocol would then use an integrated DEX to convert all deposited and borrowed tokens into a 50:50 proportion, adding them as liquidity into the DEX’s pool, and staking the received LP tokens in the subsequent farm. Yet, all of that happens in the background. For you, it’s one simple click when opening a leveraged yield farming position.
Farmers earn yield farming rewards from the integrated DEX (e.g, CAKE), trading fees and additional ALPACA rewards, and pay borrowing interest to earn a net APY that can be quite substantial.
Although using leverage can bring greater profits, it also carries greater risk. Specifically, one of the top concerns of users when using leverage is the risk of liquidation.
Leveraged Yield Farming Protocols
Leveraged yield farming protocols have taken hold of users in all the largest DeFi ecosystems.
The chart below compares the largest leveraged yield farming protocols on BSC, Ethereum, and Solana.
Table 1. Comparative metrics among the leading leveraged yield farming protocols on 3 of the top chains in DeFi (8/18/21)
*outstanding loans is correlated to the protocol’s revenue
*data as of August 18th, 2021
Sustainability in a Bear Market
There is another dimension in which leveraged yield farming shines, and that involves how it gives users the capability to create advanced strategies through shorting and hedging. In other words, through clever use of leverage and position customization, users can generate high yields while holding short or even market neutral positions. The implication of this is significant, which is that leveraged yield farming allows you to profitably yield farm in bear markets.
Besides for capital efficiency, this ability offered by leveraged yield farming addresses another major issue within yield farming which is sustainability; more specifically, yield farming’s lack of sustainability in various market conditions.
In all other yield farming platforms, you typically have to hold long-only positions on tokens in order to provide liquidity and yield farm. That also means that in bear markets when prices are dropping, the yields may not offset the equity losses you’d take from holding the tokens. Leveraged yield farming platforms are a solution to this problem and may become included in a handful of DeFi havens where it’s still profitable to yield farm during a bear market.
For more information on advanced strategies with leveraged yield farming, please see our article on the subject.
Leveraged Yield Farming in DeFi and Its Future
From our above run-down, it is clear leveraged yield farming provides unique opportunities to earn among the highest yields on your crypto assets in DeFi. Furthermore, the strategies can range from conservative (farming stablecoins or hedging pseudo delta-neutral) to high-yield high-risk speculative (levering long and shorting), thus appealing to a wide spectrum of users.
At its foundation, because much of the yield in leveraged yield farming is generated not from platform token rewards but from higher capital efficiency, it is safe to say leveraged yield farming is one of the most sustainable segments within DeFi.
Leveraged yield farming is also one of the few platform types that allows under collateralized loans. It can achieve this safely by limiting the usage of the loaned funds within the protocol for yield farming on integrated exchanges. While this use-case might seem narrow at first glance, in practice, it accounts for the majority of the DeFi activities today. The applications for the loans may also be expanded in the future. There is no technical limitation, so once new yield sources arise, LYF protocols will be ready to capture those opportunities by offering on-chain leverage to users.
Currently, the user base in leveraged yield farming platforms is diverse and not limited to risk-seekers. When deploying capital with the right strategies, users can generate substantial profits in all market conditions with mitigated risks! There are various methods that can appeal to anyone regardless of their risk profile, target yields, or knowledge level.
In summary, leveraged yield farming not only addresses major DeFi problems of capital efficiency and sustainability, but also currently offers mature products with high earning potential. Thus, we believe leveraged yield farming protocols are well positioned to continue growing as a fundamental building block and DeFi LEGO.
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