What is yield farming?
At its core, yield farming aims to maximize the rate of return on capital by leveraging DeFi protocols. In the context of TendieSwap, yield farming relates to the use of liquidity pools to earn yield in the form of transaction fees and emissions. To participate in the liquidity pools, users must turn their tokens into “LP tokens”.
What are LP Tokens?
LP Tokens are tokens that are made up of 2 tokens that are paired together. Each side of the LP token holding a 1:1 dollar value ratio of the other. These LP tokens, in turn, represent “shares” aka a claim of ownership over the share of the funds found inside a liquidity pool.
What are the risks associated with LP tokens?
The biggest risk when using LP tokens is the risk of impermanent loss. Impermanent loss simply refers to the loss and/or gain of tokens inside of an LP token. Impermanent loss can also occur when a token appreciates in value. To better understand how impermanent loss works, it is best to first understand how liquidity pools work.
Understanding liquidity pools:
The first thing to consider when yield farming on TendieSwap is to understand what a liquidity pool actually is; to put it simply, liquidity pools are lockers where value is stored. These lockers allow people to trade against them by swapping tokens and removing or adding tokens to the “pooled” tokens.
To put this into perspective, imagine one GREEN bucket filled with 100 units of Token A, and then imagine a RED bucket filled with 1000 units of Token B. Now imagine that these 2 buckets are inside a big blue box. In this analogy, the big blue box represents the “Liquidity Pool” the green bucket represents the “Token A reserves” and the red bucket represents the “Token B reserves”.
With the aid of this visual representation, it is much easier to explain what happens to your tokens inside the liquidity pool. When people trade against the liquidity pool what is actually happening underneath is simple. The liquidity pool will simply “swap” tokens with the “customer” and charge a small fee for doing so.
Using the image above as reference let’s run through a transaction where Person A wants to trade 20 units of Token B for the equivalent units of Token A. In this scenario, the liquidity pool will add/deposit those 20 Tokens (B) to its Token B reserves in order to finalize the “swap” with person A the pool will remove 1.97 Tokens from the Token A reserves and pay them out to person A. Once the transaction is complete the liquidity pool will have a “new” balance in its “reserves” and as a result, the price of these tokens relative to one another will change too. If that explanation was a little confusing please refer to the image below for a visual representation of the transaction.
As can be observed the value of the liquidity pool GREW after the trade/swap, this is how LP token holders generate yield. As a rule of thumb, the more trading volume the pools generate the higher the yield for liquidity providers will be since fee income will increase.
Understanding Impermanent Loss:
Since the liquidity pool receives and also pays out tokens, the balance of tokens inside the LP may change and as a result, you may either have more or fewer units of a specific token than what you initially deposited into the LP. This change in the balance/ratio of tokens inside the liquidity pool is what is known as “impermanent loss”.
Since the ratio inside the LP dictates the price of both tokens relative to one another, this also means that if one token increases in price relative to the other the people inside the liquidity pool will suffer from opportunity cost. This is because the ratio of tokens held inside the liquidity pool relative to what users initially deposited will be skewed. LP token holders will hold more units of the token that depreciated in value against the other token and fewer units of the token that appreciated in value against the other token.
Impermanent loss happens due to the fact that the price of one token vs another is based on the ratio in which tokens are held inside the liquidity pool. If we look at the example below initially, for every 10 units of token B inside the liquidity pool there is 1 unit of token A; this means that 1 unit of token A is as valuable as 10 units of token B. However, if the ratio changes so that for every 5 units of token B inside the liquidity pool there is 1 unit of token A, it would mean that Token B is now 2x as valuable as it was now and the liquidity pool would now hold 141 units of Token A and 709 units of Token B as shown in the diagram below.
Assuming that 1 token A is worth 100 USD before and after the liquidity pool experiences impermanent loss the opportunity cost of holding LP tokens would be:
Token B price prior to IL: 1/10 of token A or 10 USD per token
Token B price after IL: 1/5 of token A or 20 USD per token
Impermanent loss for the entire pool = ((total token A reserves post IL* price per token post IL) + (total token B reserves post IL* price per token post IL)) — ((total token A reserves prior to IL* price per token prior to IL) + (total token B reserves prior to IL* price per token prior to IL)) = =((100*100)+(1000*20))-((141*100)+(709*20)) = $30,000 — $28,280 = $1,720
In this example of IL the pool doesn’t lose money, in fact, the liquidity pool is worth $8,280 more than what its starting value was but since the ratio of tokens changed the pool has experienced impermanent loss. Please note that this example doesn’t account for fees and/or emissions received. After fees and emissions, LP token holders should be able to have generated a higher return than by simply holding 1 of the two sides of the LP token.
I want to become a farmer, should I sell some of my $Tendie and make LP tokens?
The short answer is no, and let me explain why, and no, the reason is not that you will get a lower return than by holding $Tendie alone. It is because by selling your $Tendie tokens you are increasing the ratio of Tendie tokens per BNB/BUSD/ETH token in the liquidity pool and then RE-ENTERING those same tokens into the liquidity pool @ that altered ratio. What this means is that Tendie now has DEEPER liquidity (meaning it’ll take more value coming in to increase the price) at a lower price, and as a result, this hurts other $Tendie token holders.
What is my role as a farmer if I want to help the TendieSwap Protocol?
Your role as a farmer and liquidity provider to the TendieSwap protocol is a crucial one. Our liquidity providers are the backbone of our project and without a healthy level of liquidity, TendieSwap wouldn’t be the amazing protocol it is today. As a liquidity provider, your role is to keep your liquidity in for as long as possible and try to earn as much $Tendie as possible.
As a liquidity provider to the TendieSwap protocol, it is important to use your rewards wisely. Many liquidity providers often find themselves wanting to sell their rewards as a way to create more LP tokens. However, we advise strongly against this. When liquidity providers sell their rewards they inadvertently end up hurting the protocol and the price of the $Tendie token. This is because what liquidity providers are doing is extracting tokens from the BNB/BUSD/ETH reserves held inside their respective liquidity pools and as a result increasing the ratio of Tendie tokens per BNB/BUSD/ETH token. In addition to this, liquidity providers who sell their rewards are in essence taking BNB deposited into the pool by other liquidity providers and taking it for themselves.
If I can’t sell my rewards, how do I earn yield?
As a liquidity provider, 85% of the fees generated from the trading activity go towards you in the form of increasing LP token value (fees increase the total value locked inside the liquidity pool). In addition to this by not selling your rewards, you will be able to stake your rewards in one of our buckets and earn even more yield. Eventually when features such as Lending and non-native reward pools emerge there will be many more ways to monetize your rewards without the need to sell.
Written By — Frn, Head of Farming @ Tendieswap
TendieSwap is a DeFi powerhouse bringing the best of traditional financial markets and centralized exchanges to the DeFi space. Furthermore, TendieSwap offers fun and high-yielding prediction markets on BNB, Doge, and BTC and a revolutionary P2P decentralized prediction feature called TendieBets that enables users to speculate on various binary or ternary events in a fair and decentralized way. $TENDIE is the utility token of the TendieSwap ecosystem.