Lesson #4: Yield Optimizers

In my previous lessons I mentioned the concept of “yield farming”, but what is it exactly?

The practice of yield farming consists of providing liquidity (in other words depositing crypto) to different types of protocols, so as to generate passive income. The yield comes from protocol usage fees (such as interest from loans or fees on swaps) and the from the distribution of the protocol’s native token.

Picking the right tokens

To do so, it is very important you pick the right tokens to farm, as if they lose 90% of their value no amount of farming will save you, and study the yields available on different protocols, as well as the transaction fees of the chosen blockchain. A transaction on the Ethereum blockchain could cost you $100 in transaction fees at times of high usage, while only $0.70 on Avalanche, Fantom or BSC. Therefore a yield farming strategy on Ethereum would have to be executed with higher amounts or a lower frequency of transactions.

APY vs APR

The amount you can earn are usually defined in two ways: APY (Annual Percentage Yield) or APR (Annual Percentage Rate). APR is the percentage of yield you will earn over one year on your originally deposited amount only, while APY is the percentage of yield you will earn over one year if all your yield is reinvested, also known as compound interest.

‍ Keep in mind that yield rate are often variable and can change depending on emission reductions, the amount of crypto deposited into the protocol and the volume of usage a protocol gets. Being that the amount these protocols earn is not infinite, the more liquidity is added the lower the rate will become if usage remains the same, as the same amount of yield is divided between a higher amount of tokens.

Impermanent Loss

There is a particularity when providing liquidity to AMMs, as this practice is often subject to what we call "Impermanent Loss". But what is IL exactly?

‍ Well, the idea of impermanent loss is relatively simple: you have provided two tokens in quantities of equal value. However, if one these two tokens increases or decreases in value independently from the other, then it is possible to lose money in dollar value.

In such circumstances, you will find yourself with a higher quantity of the least valuable token and a lower quantity of the most valuable one, since more units of the cheapest token are necessary to obtain the more valuable one, and vice-versa. If the gap between the two tokens widens too quickly, it may overtake the amount of fees you earn on swaps and you will find yourself at a loss in dollar value. Therefore, the best pairs are of course correlated assets, such as stablecoin pairs.

In simpler terms, this is the idea
In simpler terms, this is the idea

We call this loss impermanent because most LPs will be subject to it when starting out, but will eventually be covered by pool arbitrage and swap fees on pools where assets move similarly. It is therefore usually normal to lose money when starting to provide liquidity, to then make money. However if choosing the wrong pair impermanent loss could become very much permanent, so choose your tokens wisely.

Yield Optimizers

Yield optimizers are protocols built to manage your yield farming on other DeFi protocols for you, using strategies specific to each protocol, in order to maximize your yield, and therefore often provide higher rates than the protocols themselves.

This optimization generally consists of an efficient and grouped management of transaction fees, allowing for more frequent compounds, as well as active management of AMM liquidity in order to minimize impermanent loss and maximize earnings.

Examples:

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