REPORT: Does crypto farming and staking stack up?

The old and highly irritating phrase, if it looks too good to be true, it probably is, is no doubt on the lips of regulators, financial institutions, ordinary investors and now billionaire Mark Cuban as an increasing number of cryptocurrency platforms offer eye watering returns in excess of 1,000%.

We are referring to the world of yield farming and staking.

Let’s explain what each of these terms mean and look behind the scenes to assess whether yield farming and or staking are a legitimate investment that should be on an investors’ radar.

Staking

Staking is a mechanism derived from the Proof of Stake consensus model, an alternative to the energy-fueled Proof-of-Work model where users mine cryptocurrencies.

Centralized and decentralized exchanges alike offer their users to stake their assets without having to deal with the technicalities of setting up a node. The exchange in question will handle the validating part of the process on its own, while the staker’s only job is to provide the assets.

The main goal of staking is not to provide liquidity to a platform but to secure a blockchain network by improving its safety. The more users stake, the more decentralized the blockchain is, and hence, it is harder to attack.

Whilst staking is often associated with proof of stake networks it has taken on a life of its own. Many crypto projects have introduced staking as a way of creating ‘stickiness’ on their platforms. By providing users a way to earn income from holding their currency this deters them from moving their funds to another platform, that is the theory anyway. Of course high returns have another effect. They encourage investors to buy the token causing scarcity and driving up the price.

Staking income is offered in the form of interest paid to the holder by way of tokens. Rates vary from one network and or platform to the other depending on several factors including supply and demand.

Crypto staking has grown in popularity lately due to the attractive rewards investors receive. Currently, interest rates offered by staking can range from 6% per year offered by well-reputed networks like Ethereum (ETH) and Cardano (ADA) to over 100% offered by platforms such as PancakeSwap (CAKE).

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Risks of Staking

High crypto staking returns don’t come without risks as multiple factors could affect the performance and security of the staked tokens.

The first risk is the possibility of a cyber security incident that could result in the loss of tokens held. This happened recently with Pancake Bunny, a project that was once riding high (we in fact tipped the project a few weeks before the incident!) before a massive attack sent the price plummeting over 90%.

Another risk of staking results from potential downturns in the price of the crypto asset during the staking period. Since staking works by locking tokens, investors will be unable to liquidate their holdings in case the market falls, exposing investors to the risk of losing a portion of their principal without being able to mitigate losses by selling.

 

Case Study

 

Polywhale (KRILL)

On April 29 we tipped Polywhale as a project worth closer attention. Polywhale at the time of our selection was the first and largest decentralised yield farm on Matic. It had amassed $75 million of Total Value Locked which rapidly escalated to over $300 million in only a few weeks. This was driven by APRs in excess of 1,000%. With a market value of $35 million and a token price of $133 at the time of our selection the project looked like a steal. That price increased to $237 within a few days of our tip. But then the price began to slide. Within 2 days the price was down to $62 and it now sits at a pathetic $0.17. Of course as the price falls so does the TVL. That is now languishing at a measly $2 million.

We singled out Polywhale to demonstrate the tried and tested saying, all that glitters is not gold. In the case of Polywhale that means that there is significant risk chasing high APRs. The higher the APR the higher the risk. What Polywhale shows is that whilst high returns creates some small level of stickiness when the asset price starts to fall investors are as loyal as a Vegas hooker.

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Yield Farming

Yield farming is the practice of staking or lending crypto assets in order to generate high returns or rewards in the form of additional cryptocurrency. This application of decentralized finance has exploded in popularity recently thanks to innovations like liquidity mining. Yield farming is currently the biggest growth driver of the DeFi sector.

In short, yield farming incentivizes liquidity providers (LP) to stake or lock up their crypto assets in a smart contract-based liquidity pool. These incentives can be a percentage of transaction fees, interest from lenders or a governance token. As more investors add funds to the related liquidity pool, the value of the issued returns rise in value.

Liquidity mining occurs when a yield farming participant earns token rewards as additional compensation, and came to prominence after Compound issued its COMP governance token to its platform users.

Most yield farming protocols now reward liquidity providers with governance tokens, which can usually be traded on both centralized exchanges like Binance and decentralized exchanges such as Uniswap.

As you can see there is some crossover between staking and yield farming with the introduction of governance tokens and the move away from proof of stake.

Risks of Yield Farming

Yield farming is usually subject to high Ethereum gas fees however with the popularity of Binance Smart Chain and their low gas fees there has been an expansion of opportunities for investors.

Users also run further risks of impermanent loss and price slippage when markets are volatile.

Yield farming is susceptible to hacks and fraud due to possible vulnerabilities in the protocol’s smart contract. These coding bugs can happen due to the fierce competition between protocols, where time is of the essence and new contracts and features are often unaudited or even copied from competitors.

There has been a rise in risky protocols that issue meme tokens offering APY returns in the thousands. Many of these liquidity pools are scams which result in rug pulls, where the developers withdraw all liquidity from the pool and disappear with the funds.

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Case Study

Tedd.Finance

Tedd.Finance is one of the most recent meme tokens offering APYs of 100,000% + made possible apparently by investing in farming pools. In their brief history they have managed to amass over $500,000 in TVL. The highest return on their website is 17,200%. Of course this is a new project and investors are taking the bet that they will be able to quickly liquidate their tokens if the need arises. That is unlikely to be easy.

Impermanent Loss

Impermanent loss happens when an investor provides liquidity to a liquidity pool and the price of the deposited asset changes compared to when it was deposited. The bigger the change, the more the impermanent loss.

Pools that contain assets, such as stablecoins, that remain in a relatively small price range will be less exposed to impermanent loss.

Impermanent loss can still be counteracted by trading fees. Pools on Uniswap for example which are exposed to impermanent loss can be profitable thanks to trading fees.

Uniswap charges 0.3% on every trade that directly goes to liquidity providers. If there is significant trading volume in a given pool, it can be profitable to provide liquidity even if the pool is heavily exposed to impermanent loss.

 

Case Study

Yam Protocol

Yam Protocol was a DeFi protocol launched in August 2020. The YAM token was supposed to keep parity with the U.S. dollar as well as be used for on-chain governance.

The YAM team said that they had created the YAM Protocol in just 10 days. The team also warned that no formal audit had been conducted on the Yam protocol. Within one hour of launch, $76 million was invested in the YAM protocol. Within 24 hours, nearly $300 million. The YAM token hit an all-time high price of $167.72.

Shortly after YAM’s all-time high, the YAM team found a significant bug in the protocol. They announced that if the community locked up 160,000 YAM in a governance proposal smart contract that the vote would allow them to execute a bug fix.

However, after raising the required 160,000 YAM to execute the proposal, the team admitted that they had discovered that the smart contract that would fix the bug was faulty and that there was no way to solve the problem.

The YAM team announced that the project was dead. YAM’s lifespan was less than 48 hours. The YAM token dropped to $0.81, a 99.4% decrease from it’s all-time high.

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Table of current Staking and Yield Farming APRs

A Note on Risk

Risk is relative. The risk assessment on this table is based on the relative risk of holding cryptocurrency as an investment. As an investment cryptocurrency is high risk. Staking through Coinbase for example is low risk compared to staking a newly minted memecoin but is still high risk compared to other investment classes.

One other important point to note is that although a platform may be rated as low risk investors must remember that the higher the return on offer the higher the risk. In other words low risk platforms can offer high risk investments.

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Final Word

Staking and yield farming were once two entirely different worlds. However in recent times the definitions of both have tended to merge. While yield farming focuses on gaining the highest return possible with the objective of creating liquidity, staking has expanded its purpose from helping a blockchain network stay secure to staking a token on a given platform for the purpose of earning rewards.

There is a place in cryptocurrency for yield farming and staking, however investors have to be aware of the risks and avoid the temptation of high APRs. Platforms such as PanckaeSwap justify their generous yields by pointing towards the share of fees from their pools. Other projects which offer massive APRs are not so fortunate. They do not have the large community that PancakeSwap benefits from, its depth of product and the big trading volumes that allows them to generate lucrative revenue streams.

Many new projects are one trick ponies with high APRs as their only trick. The prices of these tokens are inextricably linked to their TVL. The TVL drives up the price of the token and allows them to continue to offer a generous rate. But as soon as the price weakens then the decline sets in and that fall can be rapid as we saw in the above two case studies.

Before investing through any staking or yield farming platform it is important you assess the volume and thus liquidity of the currency you are staking. Liquidity is imperative. You must also consider whether the project has more depth than simply a staking platform. There are many meme type projects that have emerged recently offering eye watering returns but with no fundamentals. You are asking for trouble staking through these platforms.

Not Financial Advice

This article does not constitute financial advice or a recommendation to buy in any way. Always do your own research and never invest more than you can afford to lose. Investing in cryptocurrencies is high risk, and you could lose 100% of your investment. The article should be treated as supplementary information to add to your existing knowledge.