Yield Farming on the Crypto Plains

Yield Farming – heard of the term? How about DeFi? Apparently it is the future of finance, but do you really know what it means? I was asked what they were the other day and by now I’d sort of worked out what they referred to and was able to provide a basic explanation, but it wasn’t always the case.

For a long while these terms puzzled me, I could get the sense of what they were about and how they worked, but the details and mechanics eluded me. I knew they operated on other blockchains (primarily ETH), but being a BSV maximalist and not prepared to pay ridiculous transaction fees in order to use the networks they were hosted on, they remained something of an enigmatic mystery to me until I eventually inadvertently stumbled into one and without realising it become a yield farmer myself.

As to the original question, Yield Farming and DeFi? I’ll start with the second one first. DeFi is just the short name for ‘Decentralised Finance’ which is the all encompassing name for the industry or notion that all the traditional financial instruments in our existing financial system, can be recreated on a decentralized basis using the blockchain architecture and thereby bring about immense efficiencies… although in the extended cyber punk version those, imho flawed, beliefs that DeFi would also remain outside companies and government’s control.

The reality is that DeFi is unlikely to bring into existence another legal structure to compete with Companies. This is because the characteristics of most DeFi projects can if not already fall under the description of being a Company, otherwise be caught under existing legal definitions of a partnership, limited partnership, loan, annuity or some other such combined legal undertaking for which rules already exist. As with my scepticism in regards to Crypto or BTC being censor and government resistant, I remain very doubtful that DeFi will deliver the cyber punk dream of creating a newly defined legal entity or escape the hand of government i.e. the Law and especially taxes.

Yield Farming on the other hand is a subset of activities taking place within the DeFi space, that involves the of staking or lending of crypto assets in order to generate high returns or rewards in the form of additional crypto currency. The premise is that liquidity providers are incentivised to “stake” or lock up their crypto assets within in a smart contract-based liquidity pool, to act as a form of working capital that allows the pool to undertake some commercial business activity – making a market and trading for instance.

The DeFi nature of these cyber constructs is that they are largely automated and all the activity take places and is recorded on the blockchain. Basically the pools have various rules that limit the size of trades that can be put on, in order to limit the risk to the insurance pools (‘impermanent losses’), spread risk among farmers, etc. All designed to essentially mitigate risk – although one of the biggest risk with DeFi projects has been founders setting up a secret backdoor that they can then use to drain all the pools funds.

One of the oldest examples of DeFi in the crypto space is Uniswap. This is an automated protocol that runs on the Ethereum blockchain that facilitates automated transactions between various ETH cryptocurrency tokens basked on the ERC-20 token protocol. Uniswap uses liquidity pools, mainly consisting of “ETH” coins that users or ‘yield farmers’ have ‘staked’ to enable the protocol to perform the role of a market maker. Although it was only created in November 2018, by October last year the average daily trading volume was $220m and by March of this year was generating fees for all liquidity pools of between $2m to $3m daily.

However as the popularity of DeFi applications like Uniswap have grown, especially those hosted on the Ethereum blockchain, the limitations with ETH’s ability to scale has started to impede on the efficiency and cost of transacting in these swaps and pools, via network congestion and high fees, has become more and more apparent. This has resulted in other DeFi projects being launched in competition on other blockchains, Cardano, Avalanche and especially Binance coin.

As these projects came online over the past 18 moths there has been a veritable explosion in DeFi as a use case across the crypto space, first really beginning in March of last year and then really commencing to accelerate through August 2020 and into this year, correlating with a large portion of the Crypto markets overall upward movement.

My own experience of DeFi and how I stumbled into becoming a ‘Yield Farmer’ was with the arrival of smart contracts commencing on the BSV blockchain – essentially the original BitCoin protocol before Core removed most of the features that enabled all of this sort of activity to take place on it, and which in turn spurned the creation of all these other competing blockchain products.

Tired of just HODL’ing BSV and with an explosion of activity starting to take place on it, I came across a new decentralised exchange, TDXP, being launched on BSV which had a wide variety of products, not just of crypto, but commodities, stocks, indexes and FX. Essentially TDXP was launching as a decentralised CFD provider, where the users bet on price and take possession of a CFD as opposed to taking possession of the underlying physical (a strategy that many crypto exchanges, decentralised or not, have started to pursue). As the exchange was new and seeking to increase the bets that users could put on, they also offered opportunities to invest in the various liquidity pools offering guaranteed returns for ‘staking’ coins. The guarantee was higher for initial small investments, and tapered off for larger investments made later.

Currently I’m earning around 13% pa on the total cumulative amount that I have staked – a return which I am comfortable with in terms of the small amount that I have staked, and also in respect of it not being so unrealistically high that I fear I have bought into a blatant debt pyramid or barely disguised ponzi.

Okay, so that is essentially what DeFi and Yield Farming are about. So what are the advantages over other more conventional finance and CFD bucket shops?

The biggest advantage as a DeFi product user is in regards to credit risk. If you are entering into a smart contract there is very little credit risk – you are not sending your money to someone like Robinhood to hold. Consequently you are not exposed to the credit risk that Robinhood represents if it suddenly goes bankrupt, in which case your trading account with them would instantly transform you into an unsecured creditor. With most of these DeFi products you enter into a trade e.g. bet on price of BTC/USD. The margin associated with that bet comes out of your own personal crypto wallet and is held in escrow on the blockchain until the conditions of the smart contract have been met, or you cancel or end the trade, after which the coins you staked as your margin are either returned to you wallet plus any gains or losses.

Credit Risk should not be under-estimated, and it is in this area that blockchain technology could have some of the biggest impacts in the mainstream finance space.

When most large financial institutions enter into derivative contracts with each other, they are required to stake collateral with each other or with clearing houses. This collateral is used to mitigate the risk of loss to the counterparty, should you yourself go broke. However the staking of collateral itself also creates a credit risk, being the risk that the person holding your collateral goes broke and you effectively become an unsecured creditor (so much of financial plumbing is a daisy chain of credit and liquidity risk).

Consequently banks and financial institutions are required to take a capital charge for collateral that they stake to mitigate the perceived credit risk, by reducing the amount of shareholders capital that they can deploy to other projects, like say lending to borrowers. As shareholder’s capital is the most expensive form of capital for corporations, this can be a big expense to banks and financial institutions, and one of the advantages of a blockchain is that theoretically collateral that is posted in a smart contract to the blockchain in satisfaction of collateral obligations, is effectively devoid of counterpart risk or credit risk, and thus conceivably it is possible to reduce capital held in reserve to mitigate non-existent credit risk.

There are also theoretical savings in terms of processing and transaction fees, in that a whole swath of middle men are removed from the plumbing aspects of how these financial markets operate and the overheads that they must support. However as we have seen with ETH, while there may be savings in that respect, often the congestion charges that arise from using on a non-scaling network end up more than offsetting these gains.

Now for the problems and risks.

The biggest risk I see is the fact that the value in these volatile coins that are staked in these schemes, serves as the working capital for these DeFi projects. That means that their ability to pay out their smart contract obligations depends on the value of the underlying ‘staked’ coins, such as ETH, ADA or BSC all at least maintaining their value and hopefully rapidly increasing.

If there was a market disruption and say the price of these coins fell by 50% then that would wipe out 50% of the working capital backing these DeFi projects, while the obligations in respect of the smart contracts requiring to be paid out could conceivably move in the other direction. Now there are are various ‘insurance pools’ and rules to socialise losses like impermanent losses, that are meant to mitigate these risks, but the fact is none of these DeFi projects have yet been tested through a severe market correction that have frequently been a feature of the crypto space, where price falls of 80-90% are not uncommon (especially for the alt-coins).

The other issue is the nature of ‘staking’ coins is itself a self generating liquidity tightening event. Essentially you are removing coins out of the market in order to have them tied up in these smart contracts, which helps to contribute to tighter supply and higher prices in the underlying coins being staked e.g. ETH.

So while DeFi is currently (or has been) in a virtuous cycle, as HODL’ers have found a means to earn some money other their leaving their crypto stash under their cyber bed, it has helped drive the price higher as other crypto users also sought to buy into the DeFi craze and become yield farmers themselves, and found fewer shares coins to buy. Another compounding problem is that most of the chains on which this DeFi activity is taking place are already fairly liquidity constrained markets, with the original founders who established these chains still often holding most of the overall coins in the market.

Consequently it is hard to determine how much of the boom in alts like Cardano and Avalanche or the like is the result of genuine demand and usage or FOMO being driven by sky rocketing prices in an increasingly liquidity constrained market, that is seeing coins bought and the removed from supply as they are “staked” to various DeFi projects. In my opinion the risk is that there will come an event that throws this whole virtuous cycle into reverse and the whole market seeks to unwind at the same time, or that somewhere in this daisy chain of leveraged risk, something will blow up. It is for these reasons that I’ve refrained from going ‘all in’ on DeFi, until I see how it all performs during a market sell off – Warren Buffet’s words of it only being when the tide goes out that you see whose been swimming naked. I suspect there are lots of nudies in crypto.

Finally there are specific issues with the coins or blockchains themselves. As I’ve mentioned previously Ethereum, as a state based blockchain, simply can’t scale in any meaningful way, and as the popularity of DeFi has surged on that chain it has become increasingly crippled by high transaction costs. This effectively ends up making many of these DeFi transactions on ETH far, far more expensive than the cost of doing a similar trade a conventional exchange like Robinhood. Other chains like Cardano and Polkadot have other issues, but some do provide a superior cost platform compared to Ethereum in which to transact on.

Finally there is the current market golden child, Binance Smart Chain, which has tokens on it delivering truly ridiculous returns of up to 5378.21%!!

Honestly these sort of returns are both truly unsustainable and about the biggest warning sign possible of leverage built on leverage, built on ponzi’s built on ponzi’s. I’ve spent some time trying to understand how these returns are possible and that is the best explanation that I’ve been able to come up with, I’ll try to illustrate what I mean.

But first a couple words on Binance. This is imho one of the most dodgy exchanges in operation with probably the highest credit risk in the market. It’s founder Changpeng Zhao, started it in China and then progressively relocated around; first Japan, then HK, then apparently Malta, then honestly who knows where? The reality is CZ currently lives out of a suitcase with no one quite sure where he really is, as he scampers around the world to stay just out of reach of authorities. He is a China exile following his branding as a “pro-bourgeois” intellect and has been named in a lawsuit against Binance alleging that Binance is involved in facilitating large scale money laundering.

Binance also plays a significant roll in the Tether Ponzi, in that it allows Tether to be used as cross collateral for BTC. Binance users can “stake” their BTC, which has high transaction fees or whose sale might trigger CGT events, for Tether, which they can borrow for 0% interest and then use to purchase other cryptos, like…. BNB or Binance coin (more of this later).

If you check out the BTC traded volume on a site like Bitcoinwisdom and compare it to the last boom that occurred in 2017 you’ll notice that this boom has taken place on much, much lower BTC volumes. This has been part of the reason – BTC is being bought up and ‘staked’ for Tether, and then on traded into other cryptos. So the same dynamic with DeFi staking reducing liquidity is also at play in the BTC market.

But back to BNB, BSC and all the various BSC tokens.

BNB is Binance Coin and was launched in 2019 to facilitate fast, decentralised trading on Binance’s decentralised exchanges. With limited liquidity in the face of rapidly rising demand (using the coin delivered perks like lower exchange fees) and an industry tendency to HODL, meant that BNB rapidly appreciated in price. However while BNB was a state based or ETH style coin, it was a bare-bones network that focused on transactions speed and sacrificed broader utility like smart contract features which can’t be performed on that chain.

Enter BSC or Binance Smart Contract in 2021, which is a new Binance blockchain that runs in parallel to BNB and which as the name implies, enables smart contract activity to take place on it. Furthermore BSC is a PoS chain, or a “Proof of Stake chain”. Specifically it uses something called ‘Proof of Staked Authority’, where participants stake BNB in order to become validators of BSC!

So BNB is essentially the first layer of DeFi pyramid – note that BNB is also not an inflationary blockchain, no more coins are supposedly being made, so while there is the ongoing transactional demand to facilitate trade on Binances DEX changes as one of the base transactional pairs eg BTC/BNB, ETH/BNB or USD/BSB, there is now an additional incentive for crypto enthusiasts to buy BNB and then ‘stake’ them as BSC validators, effectively removing them from transactional liquidity and placing upward pressure on price.

Next is BSC itself. Just as with ETH being staked as the base coin to provide the liquidity in all the DeFi activity taking place on the ETH blockchain and the various ERC-20 tokens, so too are holders of BSC encouraged to stake their BSC in the liquidity pools to enable trading to take place on the BSC blockchain and the various BEP-20 tokens that it hosts. This is the Second layer of the DeFi pyramid and just like with BNB, the staking process encourages more liquidity being withdrawn from the BSC environment as those coins are staked in various liquidity pools.

Then there are higher levels of the pyramid, distributed apps (called DAPPS) where the trading takes place – Pancake Swap or Bakery Swap – which are essentially the Binance version of UniSwap. But it doesn’t end there, there’s more! You can also farm Pancake Swaps Governence tokens, called CAKE.

Thinking about this some more and going back to the start, arguably the first layer to all of this is BTC which as I mentioned is cross collateralised to Tether. Tether is then used to purchase Binance coin BNB, this is important because BNB is a non-fiat operating exchange – Tether makes it possible for Binance to exist. BNC is then used as POS for validating BSC, 3rd layer down, then there are there all the BEP-20 tokens including CAKE, 4th layer down, and finally there are is the Crypto Industry version of CDO’s squared, which are tokens specifically designed to jump from yield pool to yield pool, eking out the best possible return.

Honestly the scammy end of DeFi has more layers down than Chris Nolan’s film Inception. Is there any real value being created? Frankly I doubt it – I just can’t see where the value is being created. To me it has the appearance of speculation built on speculation built on speculation, being carried out on top of one liquidity constrained market after another. When you peel back the layers on which most of these chains are being carried out on, there is virtually no real world work being done, and in my view it is all going to end in tears.

Whether it simply be a market unwind of the current boom or a systemically important player like Tether or Binance being taken down, just like Inception at some point people are going to realise that all this ‘wealth’ is simply just a dream.

*Disclaimer: This is all in my honest opinion (IMHO). I am far from an expert on these matters, and while I’ve tried to make a fist in understanding the flows, by no means I am over everything.

Not all of the DeFi space is scam – I’d love some further insights from other people interested in this space, as there are some solid commercial projects on other blockchains – especially Ethereum. But while there are some legitimate DeFi projects being built on all the blockchains, there are some absolute scamcoins too – Mooncoin is another example imho.

With regards to Binance(s) coin, I really, really tried to understand what is going on there, and while I am certain most of the enterprise and trading that operate on top of it are legit, the problem I have with it is the market structure and pyramid of inter-related liquidity risks and dependencies that I described.

Anyhow, if there are any other DeFi users or farmers out there in EZFKA, please tell me of your experiences below!