This post could be titled one of many themes, but I went with SciFi because this is crypto. The following principles will prepare individuals looking to get involved in the Ethereum ecosystem, specifically yield farming, for how to efficiently accumulate and hold on to ETH earnings.
These may seem obvious, but with the plethora of new Ethereum opportunities and innovations occurring on a daily basis, it’s valuable reference and use these like a checklist before deciding to deposit or invest.
Borrowing - When it comes to finance, borrowing assets sounds scary. We’ve gotten comfortable with mortgages, credit cards, and car payments, but borrowing against your assets to make positive expected value investments can be an unfamiliar proposition. In Ethereum’s DeFi, borrowing is considerably different due to the overcollateralized nature of crypto loans. Crypto banks in DeFi typically require 1.5X more collateral than the amount borrowed because of the historical price volatility. Borrowing tokens can be especially helpful when a new yield farming opportunity arises that requires tokens you don’t hold. Borrowing various cryptoassets from DeFi banks like Aave, CREAM, or even bZx is usually well worth the origination and interest fees. Borrowing is often much cheaper than swapping because you maintain the exposure to the underlying collateral (ETH). If ETH goes up 25% in a week, and your interest rate is 25% a year (0.48% in a week), it’s a no brainer you are better off borrowing against your ETH than swapping it for a different token and suffering an opportunity cost. Whenever borrowing assets against your collateral, you must account for several factors to prevent your collateral from being liquidated.
Crypto volatility - Historically, crypto volatility can move upwards of 30% in a week. Long term monthly average for bitcoin is 17%, and as distribution broadens, the volatility is falling. However, price fluctuations in your collateral can quickly change your loan to value (LTV) ratio. Keep an eye on the price and have additional collateral available, or be ready to pay back your loan. This also works in the opposite direction. Should the value of the assets you borrowed increase relative to your collateral, you will need to add additional collateral to keep your LTV ratio healthy.
Harvest when gas is cheap - Ethereum network fees are increasing as the blockchain becomes more congested with transactions and the price increases. Being efficient with when and how frequently you harvest (claim) your rewards can save you hundreds/thousands of dollars and protect your ETH gains. A good resource is https://ethereumprice.org/gas/ to evaluate when the lowest gas prices occur during the week. Sundays are always the best for harvesting.
Install Gas Now Chrome extension and use their gas prediction tool when transacting. This is an excellent optimization tool to make sure you spend enough gas to get your transaction approved (not too little to get it stuck for hours and not too much when gas is expensive). This is useful for entering new farms, exiting farms, and harvesting yields.
Safety - I typically check for any 3rd party smart contract audits before deciding to enter a new yield farming opportunity. Smart contract audits aren’t 100% exploit proof, but they are more reputable and trustworthy than new, unproven contracts. Most of the new farming contracts are forks of existing code, and can quickly be compared to the original code using tools using Etherscan’s contract diff checker. I also check for the amount of total value locked (deposits) to verify other well known Ethereum users are comfortable putting their assets into a new protocol.
Pool 2 - Pool 2 is crypto yield farming slang for a 50% new token/50% ETH (or other) token which helps distribute liquidity. Pool 2 typically has the highest token emission rate (rewards), but also can be extremely risky due to the risk of impermanent loss (IL). Impermanent loss occurs when the price of the two staked assets move in different directions or at different paces, meaning the depositors effectively are buying the asset that is less valuable to keep the ratio at 50%/50% USD. Unless you are confident you want to become a bag holder of the new project’s token, avoid being in Pool 2 because you’ll potentially lose ETH as other farmers use you as their exit liquidity.
Liquidity - Speaking of liquidity, always make sure you’re farming with protocols that have deep liquidity available in Pool 2. This ensures you can both buy and sell without incurring slippage (overpaying). “Slippage” is a concept that is specific to automated market makers like Uniswap and Sushiswap that determine prices based on liquidity depth of token pairs. An illiquid pool will have a price that moves severely when buyers or sellers interact with the smart contract.
Take profits in ETH - Not financial advice, but Ethereum is already the most transacted and developed smart contract based blockchain, and the roadmap looks bright. ETH will become a deflationary asset once Proof of Stake and EIP-1559 are completed, which means accumulating now will give you a bigger piece of the pie later.
Source: Justin Drake on Twitter
Only invest what you’re willing to lose - This is a principle that applies to investing and yield farming. If you’re in doubt or uncomfortable with a new protocol for any reason, trust your gut and pass. There are many well established yield farming opportunities that have DeFi insurance coverage available already.
APY% isn’t the whole story - New yield farms will often show triple and quadruple digit APY when they launch because there is very little liquidity in Pool 2 (price is inflated) before Pool 1 stakers start to sell and depress the price. Yield farming and liquidity mining high quality projects often provides tremendous upside as they mature. A good example of this is yEarn and its token $YFI. $YFI could have been bought for $250 after its fair launch (tokens were given away), and is now worth over $37,000. A recent example of a phenomenal fair launch project has been Alchemix ($ALCX). The token launched at $200 and is worth over $1,800 now even with constant sell pressure on Pool 2 from yield farming.
Understand Taxes - It’s important to know the tax burden from generating yield
Claiming rewards is taxed as ordinary income
Appreciation or depreciation of price on claimed rewards is treated as capital gains/losses
E.g. if you claim and immediately sell to ETH, you only pay ordinary income (earned interest) tax, but if you hold the token and it goes up before you sell, you’ll also have to pay capital gains taxes
TokenTax wrote a great guide on the subject
NFTs - I am a big fan of NFTs, but these should be considered digital art, nothing more. Farming NFTs will generally not lead to ETH returns because there are not liquid market set up yet. There are many protocols, like ShardingDAO and Drops, that are looking at tokenizing NFTs backed by collateral, which would make them far more liquid with DeFi. If you find a farm that is offering NFTs as rewards, you shouldn’t ETH returns are a given.
Read the rules - Ask yourself these questions, and make sure you thoroughly read the token distribution information. All projects will have documentation links or a whitepaper. If they don’t, avoid!
Is there a vesting period for earned tokens that prevents you from swapping for ETH? If so, are you comfortable with that?
What are the tokenomics and how long are the emissions going to last for? Is this a governance token with voting rights? What are the value capture mechanisms?
How many tokens has the team allocated to themselves and what are their vesting schedules? You certainly don’t want to be a casualty of team tokens being sold, especially if you’re a depositor in Pool 2.
How much VC investment was included, what was their token allocation, what are their vesting schedules? See point above!
If you don’t grok, don’t play - If anything about the project or token seems foreign, or you just don’t understand the value proposition/problem solved, stay away. Why earn a token on a project you don’t intend on using or contributing to?
Use public resources - Teams and community members are very accessible to answer questions or receive support through Discord, Twitter, and Medium articles. The alpha is usually right in front of your eyes if you know where to look.
Pay it forward - Ethereum is providing a once in a generational wealth creation opportunity. It’s important to give back to the builder community, and fund new projects. Gitcoin has open funding rounds for new projects all year long, and many of the contributions are matched through something called quadratic funding. This makes your donation go a lot further for emergent DeFi primitives that could change the world! Another way to pay it forward is by sharing the projects and yield farms you discover and love with your friend, family, and the Twitterverse.
Follow these guidelines, practice discipline, and the hard part is finding the best, safest, newest, and highest yielding opportunities to allocate your capital. This is part of what Ethropy provides to premium subscribers so please consider joining.