Asset-Backed Lending; The Future of Yield Farming (Alejandro Gutierrez)

With the explosion of complex yield farming products, which move the risk to the next link in the chain, how can yield farmers prepare for a new harvesting season? DeFi asset-backed lending is the answer.

A new harvesting season for Yield Farmers?

The transformation brought about by DeFi has opened up a world of opportunities for investors looking for innovative ways to generate returns.

One of them is yield farming.

As it stands, yield farming is a high-reward activity, which also comes with a fair share of high risks, as investors burnt by the DAI’s crash on the Black Thursday of 2020 can confirm.

This episode has shone a light on some fundamental issues with the current model and technology. They are the reasons why many have withdrawn from yield farming altogether and those with lower appetite for risk have steered clear from it.

But a first tough season doesn’t mean the field will never be harvested.

I believe there are better and safer opportunities for earning yield with DeFi. The goal of this article is to discuss them.

But before we do that, let’s look at the state of play on yield farming, its major risks and pain points — including the systemic issues that caused DAI’s Black Thursday.

State of play on yield farming

Yield farming is propelling the growth of the whole DeFi sector — bringing its market cap from $500 million to $10 billion in just one year (2020).

Similarly to the banks in the traditional finance system, in the DeFi economy, yield farmers lend their funds (as cryptocurrencies or crypto assets) at an interest, which allows them to make a profit.

The word “farming” refers to annual gains received for introducing in the market the liquidity that other companies are seeking.

This differs from the practice of staking, which many people in crypto are familiar with. With staking, users remain in control of their assets. With yield farming, users lock these assets temporarily to generate higher returns.

And if you’re wondering what it means to “lock funds”, here is the answer. When funds are added to a liquidity pool, the wallet including these funds gets locked into a smart contract. Once this step is taken, the funds get converted into tokens so they can be exchanged, lent, borrowed, etc.

At present, most yield farming transactions are carried out in the Ethereum ecosystem.

There are different smart contracts with different ways to generate value. As we’ve seen, the main one is to charge an interest rate on a cryptocurrency loan.

As a common practice, many yield farmers move their funds around to chase the DeFi protocol (or smart contracts) that offer them the highest percentage of return — this is known as “crop rotation”.

Understandably, this has been one of the contributing factors to the high volatility the sector is experiencing.

To counteract volatility, dollar-pegged coins have been introduced to anchor the assets and provide stability — the most adopted of which is DAI, created from the MakerDAO protocol.

And while some yield farming projects are well-established, new DeFi protocols are constantly introduced to the market.

The competition between them is fierce. This brings pressure to release new contracts and features without the necessary audits and security steps. Sometimes protocols are even copied from competitors.

That’s where the susceptibility to hacks and frauds that many have reported comes from.

With this preamble it becomes easy to explain what happened on that infamous Black Thursday when $4.5 million worth of DAI was left unbacked by any collateral, and users lost millions.

This is the chain of events that led to the crash:

  1. The 12th March 2020, the Ethereum price plummeted 43% from $194 to $111, registering its biggest loss in a single day
  2. This triggered a wave of demand that overwhelmed the Ethereum network
  3. As the network capacity was reached, the gas prices skyrocketed
  4. The unusually high gas prices jolted the price oracle (responsible for constantly monitoring the asset values), leaving it incapable of updating the feeds
  5. When the oracle feed was updated, the price instantly dropped by over 20%, causing many asset owners to be liquidated immediately
  6. Because of the lag in the system, some liquidators (who paid higher gas fees to “skip the queue”) were able to win the liquidation auctions without paying a single DAI

As a result, these liquidators got their hands on more than $8 million worth of Ethereum… for free. While asset owners were left with millions of dollars in losses.

Yield farming pain points

The Black Thursday crash made apparent how much the current system relies on Ethereum gas fees and the ability of users with high capital to take advantage of opportunistic situations.

Following the incident, a class-action lawsuit was filed against the Maker Foundation on behalf of investors.

The lesson learnt is that some form of regulation is necessary. To take up the opportunities offered by DeFi, investors need some form of protection or guarantee.

Now let’s move on to the technology side of things.

More and more Real World Asset Originators are trying to benefit from the DeFi protocols. However, these RWAOs find that technical integration of these protocols is complex and they lack the specific knowledge required.

Often, they are forced into using manual processes to access liquidity or don’t have efficient tools to manage the liquidity pools.

The other issue is the cost of access to the market, due to the high investment in resources required.

Ethereum has been the smart contract blockchain of choice for crypto projects since its inception and has fostered some of the incredible innovation we see coming to fruition today. However, Ethereum is currently plagued with extremely high transaction fees due to network congestion.

The other consideration is that so far, the most active area of DeFi has been margin trading. Put simply, locking up crypto to borrow more crypto to buy more crypto.

But there is a fundamental issue in using crypto assets as collateral.

As Lucas Vogelsang, CEO of Centrifuge, explains: “The average crypto user that bought bitcoin when it was a few hundred dollars and is using DeFi to trade and manage their wealth is a very different user from a business that is actually quite cash-strapped.”

“These businesses are looking to DeFi as a way to get money quicker and get it on their own terms, without having to go to a bank. They don’t have crypto to get their DAI loans, so they need to be able to use their invoices or their inventory.”

What the yield farming sector needs

Investors want higher transparency on their investments, and aim to increase their access to real-world assets and diversity of investments.

They also want to reap substantial DeFi yields without the high risk of the current process. This is particularly true in the current environment where interest rates are at a record low.

Asset-back lending is the catalyst that will unlock these opportunities.

Imagine investors injecting cash into a pool that companies can access when they require funding for their trades. Then think about assets originators capable of converting the physical value of their assets into digital tokens.

Asset-back lending does exactly this. It allows liquidity providers to lend to firms which use real-world assets as collateral against their borrowing. This is how liquid providers and yield farmers can earn an outperforming yield on crypto assets.

This offers a layer of security to liquid providers, and means their investment is backed by tangible, physical assets. When that is coupled with the extra protection offered by insurance, we are preparing the field for a fruitful harvest.

With greater access to capital for asset originators and opportunities for outperforming yields on crypto assets for yield farmers, is the DeFi world ready for a new harvesting season?