What is behind 1000% APY ?

What is Yield Farming ?

Providing liquidity to AMM in return for trading fee, and governance tokens has been a standard way of generating yield for stablecoins since defi summer in 2020. This operation is nicknamed as “farming” as liquidity providers often would “harvest” the interest in order to compound it back to the principle to maximize gain.

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Why we no longer see 1000% as much as earlier?

In the early days of 2020, stablecoin farming was very lucrative due to high valuation of the governance tokens of new protocols, as the market was still relatively small and capital inflow was sizeable. Fast forward to now, with only a few exceptions, many AMM protocols (a.k.a farms) cannot maintain their high APYs due to the fact that their governance tokens can no longer maintain the hype and thus high valuation.

Added into the reasonss of reduced APY is the clustering of capital over a few battle-tested protocols, as people getting to realize the many types of risk over farming on new and unproved protocols.

This article would explore some of the common risk of stablecoin farming with examples.

Price Risk: when stablecoin does not equal to $1.

ALL stablecoins are engineered with the purpose to peg to $1. However in reality, the price of stablecoins would vary within a tight range around $1 on a weekly, if not daily basis. This is due to arbitrage and trading activity as supply and demand fluctuates. In most cases, the price would repeg back to $1 very quickly. In rare occasions, or during volatility or some news-driven movements though, stablecoins would depeg from a few basis points to a few percentages.

When would price fluctuation be risky?

IN the SHORT run, price fluctuation is NOT a risk, but benefit. If the stablecoin works as expected, price fluctuation does not harm any stablecoin farming positions. In fact, price fluctuation would benefit the farmers by bringing additional trading fee as long as the stablecoin repegs to $1 later on. For example, USDT, DAI, USDC all faced major depeg at certain points, and they all repegged back later on. This created arbitrage opportunity, as well as sizeable trading fee for liquidity providers.

In the LONG run, though,  extended and major price fluctuation would cause confidence issue, and thus reducing the strength and price floor at which arbitrageur would step in to recover the market price of the stablecoin. This would further reduce the price resilience. For example, 90% of time MIM’s price is discounted and investor would expect certain discount in its price now, same for arbitrageur.

Liquidity Risk: When you cant sell whenever you want without hair cut.

Assuming you have $1000 DAI, and you would like to sell it for $1000 into your bank account for a lovely Chrsitmas. How? In the case of DAI, which follows the deposit → mint procedure, you cannot redeem DAI for USDT/USDC directly unless you have put down collateral in the first place; thus you are left with the only option: trade in existing AMMs.

In most time, you should be able to trade $1000 DAI to $1000 USDC. But like what is mentioned in the price risk session, if it happens to be the volatile time where people are selling $DAI as well, you may not find enough liquidity in the market to back $DAI to $1. It may be only $0.99., $0.98 or whatever. In that case, you would be forced to take a hair cut because you have a time constraint to sell $DAI to buy your wife’s Christmas present.

For whales (investors with sizeable positions), liquidity risk is more daunting relative to that to retail investors, since their positions are big enough to feel the slippage first when everyone is pulling money.

Oracle Risk: when oracle feeds a delayed or wrong price.

Oracle refers to the smart contract that feeds price data from the real world to the blockchain. While for centralised stablecoins like USDC or USDT, oracle risk is not applicable since they hold real-world USD asset as collaterals, for stablecoins that hold risky assets (anything that is not USD) as collateral, like DAI, LUSD etc. They would have to reflect the price of the underlying risky assets all the time for book keeping.

This price reflection can be maintained by the protocol itself, or sometimes the protocol would rely on a third-party oracle networks for this operation. Famous oracle protocols are Chainlink, API3, UMA etc.

If the oracle price is wrong, or delayed, the protocol would have a risk of turning a over-collateralized positions into an under-collateralized one, and suffering bad-debt, leading to Collateral Risk, which would be mentioned below.

For example, USDH on Solana suffered an oracle attack which leads to a loss of 1.2m.

Collateral Risk: When liquidation does not work (or not timely enough)

Collateral refers to the liquid assets that back the amount of minted stablecoin. Collateral risk refers to the general insufficiency of those assets to cover the totalSupply of the stablecoin. This can be caused by failed business endeavours, or some of the above risks like oracle failures/hacks, freezing of funds due to sanction etc. For protocols that accept risky assets (non USD) as collaterals, simply delayed liquidation leading to bad debt would also incur collateral risk, if their own treasury cannot cover the bad debt. A famous example was MakerDAO DAI’s 2020 black swan collapse, where ETH plunged 50% in within 24 hours. Since DAI was using ETH as collateral, a lot of positions went sour and had to be covered by auctioning $MKR. Subsequently a lot of positions were exploited due to zero-bid in the market for $MKR.

Regulation Risk: When government chips in.

Centralized stablecoin issuers are registered company that would have to be compliant with the jurisdiction at which they are registered.

For example, in the incident of the Tornado Cash sanction issued by OFAC (Tornado Cash is a protocol that facilitates anonymous transaction), while Tether(USDT issuer) ignored the sanction, Circle (USDC Issuer) complied quickly to that, since USDC is registered in the United States, while USDT is registered in British Virgin Island, and held by a Hong Kong based mother company.

Since many decentralized stablecoin protocols have already accepted USDC as a collaterals for minting their own stablecoin, holding decentralised stablecoin would also be impacted by regulation risk now. So if one day your favourite stablecoin protocol get sanctioned by US government and Circle decides to comply with that, then the USDC in the treasury might turn sour, leading to bad debts.

Smart Contract Risk:

Last but not least, smart contract inherently have risk of vulnerability due to logic missing, bridge hacks or malicious insiders. While some decentralized protocols dont permit unbacked stablecoins, some centralised stablecoin that takes real-world assets or bridge assets, do not hold this guarantee within one blockchain. If some stablecoins are minted out of a bug without proper assets backing, the newly minted stablecoin would also flood the market, as well as the the price of the stablecoin.

Example: Recent Hacks of aUSD on Acalas and Beanstalk on Ethereum.

Summary:

There are many risk associated with yield farming, this article tries to cover some of the common risk category that a stablecoin farmer would be exposed to. Make sure what you get pays off for the risk you take.

Disclaimer: Not financial advice. Do your own research.