Understanding The DeFi Yield Farming Time Bomb

If we told you that you can get a loan with a small collateral, and use that money to trade and keep on getting loans would you try it out? Would you do it if your collateral were denominated in a certain currency and the loan was in a different one?

How about if I give you some plastic poker chips for your collateral? This line of questioning might sound weird, but it is relevant, especially now that DeFi yield farming is exploding.

But before we go into those questions, let us establish what is DeFi, what is yield farming, how you can participate in it and why we recommend you don’t touch it with a ten foot pole!

What is DeFi?

DeFi is short for decentralized finance. It is supposed to be about financing through decentralized platforms instead of banks and other financial institutions. Nevertheless, this is a broad definition that does not tell us enough.

To understand the DeFi craze, it is necessary to explore what yield farming is all about and how cryptocurrency is involved.

What is Yield Farming?

Yield farming is about using smart contracts and cryptocurrency collateral to profit on decentralized loans. Some use these loans to either invest or get another loan putting up the money they got from the first one as collateral. Others lend money and get an interest payment for it.

Usually these loans are denominated in a different cryptocurrency or token. DeFi yield farming basically relies on arbitrage. On some platforms, the interest rate is higher than on others. Farmers take out loans, move their money where the arbitrage opportunity is, take the profit and do it all over again.

Since the loans they take allow them to leverage themselves on the collateral, they can make money on several loans on other platforms with funds they would not have otherwise. Platforms use native tokens to “multiply” the amount of money people can have access to on their collateral.

This Sounds an Awful Lot Like The Big Short

This sounds like that Selena Gomez and Richard Thaler scene in The Big Short. It is about betting on the bet of a bet, being a few levels removed from the real market price of the collateral and hoping enough people will jump in to keep this going. These are basically synthetic CDOs with a cryptocurrency twist.

How do you Participate in DeFi Yield Farming?

So, if you are in crypto to make a quick buck, you might want to try DeFi yield farming out. To do so, you just have to come up with the collateral and then pick your preferred platform to get your loan. After that, you are free to move your tokens around looking for arbitrage opportunities.

This is what you will be doing when you engage in DeFi Yield Farming:

  • Deposit your collateral – generally it is denominated in ETH
  • Borrow funds through your chosen token scheme – Dai is a popular one
  • Exchange that loan to your cryptocurrency of choice to get another loan – rinse and repeat part

Some platforms give you additional perks like points or voting tokens within the scheme just for participating in it or for putting up funds for others to borrow.

Warning: DeFi Yield Farming is a Ticking Time Bomb!

Of course, your collateral can disappear in the blink of an eye if it drops below certain price. That is due to the fact that the smart contracts locking your collateral up, are designed to release the funds to the lender if the market price of the funds on the contract dip below a certain point.

Given that the price of your collateral is volatile – even ETH prices experience sharp fluctuations – you might end up losing the money you put up as a collateral. If that happens, you will be left holding bags.

Why, you might ask. After all you are getting funds on the loan! The issue here is that the funds you get are denominated in a different cryptocurrency or token. Often times these tokens have:

  • Smaller market caps – not a lot of trading
  • More volatility – riskier
  • No real use case beyond going around the DeFi yield farming Ferris wheel, just like synthetic CDOs back in 2007!

Do Not Get Burnt in the DeFi Yield Farming Craze

DeFi yield farming will collapse. It is just a matter of time until a price crash wipes out a critical mass of collateral tied in smart contracts. If it happened to the traditional financial system in 2008-09 why wouldn’t it happen to DeFi now?

After all, these platforms are emulating the system that has failed before. They are just a different form of market gambling. The only difference here is that DeFi is not regulated and the scale is way smaller.

In fact, these DeFi yield farming schemes might be illegal. The SEC as well as other regulators around the world might go after those who created these schemes if they are not properly registered, just like they did with ICOs.

That is just another reason why you should stay away from it. We recognize that people will profit from DeFi yield farming. After all, Wall Street types profited from synthetic CDOs and other toxic derivatives.

Nevertheless, this is far from a slam dunk and if you want to get into it, you should research the matter beyond this piece.