Dec 17, 2021
As crypto assets gain in popularity, financial institutions are finding new ways to profit from them. One such method, yield farming, is garnering most of the attention.
First, let’s try and simplify what yield farming is. Let’s say you have an asset that I want to borrow. Maybe I believe that asset is going to appreciate by 100% in the next few months but I don’t want to spend the money to actually buy the asset. Instead, I make you an offer. If you lend me your asset (or deposit it with me), I’ll pay you 10 or 20% in interest. After all, I’m expecting the asset to appreciate 100%, so giving back a little in exchange for not having to actually buy the asset outright seems fair.
So long as the asset increases in value, we both make money. And because I don’t want to be too concentrated in just one asset, I might borrow several other types of assets from other people. That is basic yield farming. Borrow for a fee in hopes the speculative returns exceed the borrow rate. In all likelihood, some of those firms borrowing assets are creating more complicated packages of assets which are then sold to even more aggressive investors looking to generate alpha. That’s just how the system works. Speculate on speculation, charge a fee and just don’t get caught without a chair when the music stops.
I swear I’ve seen this movie before. While I can’t recall the title, I seem to recall it ended badly.
Creating new ways of generating wealth is good. Offering investors a return on their assets is good. But when the rates of return being offered from unregulated institutions become disproportionately large relative to anything else out there, maybe that’s a good time to quickly glance down and make sure you haven’t run off the side of the mountain.
Crypto is the wild west of finance. That’s not necessarily a bad thing. A lot of people made a lot of money during the gold rush. During that same period though, a lot of people got scammed and lost everything. It’s good to embrace risk, but you have to understand it.
If crypto prices fall, the speculators paying interest on borrowings; the speculators dependent on asset prices increasing in order to make those payments, are in trouble. It’s challenging enough to understand the extent of speculation in regulated markets. In an unregulated market, all bets are off, or something to that effect. So before depositing your crypto with someone offering you a very high rate of return, ask some questions. Understand your exposure and risk. Then ask yourself if it makes sense.
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