How to Use Smart Farming to Leverage Frax Yields

Samuel McCulloch
Samuel McCulloch
Nov 13, 2023
How to Use Smart Farming to Leverage Frax Yields

What is Smart Farming?

The team at Metronome has built Smart Farming, a yield looping engine that leverages the power of Metronome’s synthetic assets and Vesper. It’s a big upgrade for those who want to increase their yield returns and save gas. 

Smart Farming allows you to easily automate looping of yields for various crypto assets, Frax included, all in a single transaction. The feature was built originally to support Vesper, Metronome’s sister project, but has expanded to include other assets. 

What is Looping Yield?

Yield farming is a great way to increase returns for your assets. It’s typically accomplished by depositing a single asset or a Curve/Uniswap liquidity pool into a staking contract that gives rewards. The core of Frax’s veFXS system is built around this strategy, paying users to lock their liquidity and FXS in return for yield. 

Once a farming position is opened, you might want to increase your exposure by using leverage. This is done by borrowing a similar reference asset against a pair, selling it, then using the proceeds to buy more of the original asset. The reference asset should be similar to the collateral asset to maximize leverage and reduce risk. 

The first major strategy used for farming at scale was the stETH/ETH trade in 2021/2. Traders used Aave and Compound to deposit stETH, then borrowed ETH to sell for more stETH. As long as the price of stETH remained close to the ETH price and the yields for borrowing ETH were low, it was a great arbitrage trade. Unfortunately, due to stETH’s illiquidity at the time, the price dropped to 92% of ETH’s price and resulted in many liquidations for those with too much leverage. 

Done safely, looping yield with moderate leverage can produce extra returns with manageable risks. The problem with looping is that it requires several manual transactions to enter and exit a position. And on Ethereum this means paying hundreds or thousands of dollars to open, manage, and close positions, all for a few extra percentages of yield. It’s these gas costs which keep smaller farmers from opening leverage positions, as the the potential yield income will be less than the fees paid for the position. 

How Does Smart Farming Work?

Smart Farming makes this expensive and complex looping strategy simple. You only have to select the type of asset and the amount of leverage you want, and the protocol does all the rest. 

Metronome uses Vesper to gain exposure to yield. FRAX is one of many assets supported by the yield protocol. Current FRAX yields on Vesper are 16%.

Start by choosing your base assets or vTokens for use in Smart Farming including different forms of ETH (such as vacbETH, varETH, and vastETH) and other tokens like vaFRAX, vaUSDC, and vaETH. 

For our Metronome to the Dome series on This Week in Frax, we used FRAX as the collateral asset. 

Then choose the amount of assets you want to use as collateral. We used 500 Frax for our demonstration, but it's probably better to start with a few thousand dollars of FRAX at a minimum to ensure gas fees won’t cut into your profits that much. The price of the transaction when we made it was $500, but this is entirely dependent on what gas fees for Ethereum are at the time you make the transaction. 

Next step is to choose the amount of leverage you are comfortable with. All Smart Farming positions are overcollateralized, you cannot borrow more than you deposit. This overcollateralization is crucial for maintaining the stability of these positions. Different collateral assets have varying collateral factors. These factors determine the maximum amount of synthetic assets that can be generated from a deposit. For instance, stablecoins like USDC and DAI have an 85% collateral ratio, while different forms of ETH vary from 83% for ETH to 67% for vacbETH. These ratios are crucial in determining how much of a particular synthetic asset can be generated.

Five variables are considered in asset assessment – Issuance/Market Cap, Open Market Liquidity, Lindy Score, Peg Volatility, and Rehypothecation. Assets are scored from 0-3 on each variable, with higher scores indicating higher risk. The risk scores for assets translate into specific collateral ratios. For example, a risk score of 0 results in an 85% collateral ratio for stablecoins and 83% for ETH. As the risk score increases, the collateral ratio decreases.

With a max collateral ratio of 83%, this means you can get up to 4.75x leverage on FRAX. However, at max leverage, liquidations may take place when the price of FRAX is lower than (approximately) $0.99, which is just a penny off the peg price. A healthier leverage amount might be 4x, where liquidation would occur if FRAX ever declined to $0.95. This is the level we chose for our Metronome to the Dome experiment. 

After choosing the deposit amount and leverage, you can execute your transaction. Metronome will automatically borrow, sell, and leverage your position. 

What are Synths?

In the Metronome protocol, "Synths" refer to synthetic assets that users can create by depositing various forms of collateral into the system. These synthetic assets are digital representations of other crypto assets, enabling users to gain exposure to those assets without actually holding them. For example, by depositing USDC into Metronome, a user can mint a synthetic version of another cryptocurrency like ETH or BTC. This process allows for greater flexibility and diversification in investment strategies. Synths can be traded or used within the Metronome ecosystem for various activities such as yield farming and slippage-free swaps, providing users with a versatile tool for managing their crypto holdings. 

What are the Risks?

Using Metronome involves several risks, primary among them being the risk of liquidation. Liquidation in Metronome Synth occurs when the value of a your collateral, multiplied by the collateral factor, falls below the value of their outstanding synthetic mintage. This can result in your position being partially or entirely closed automatically, as per the rules set in the Metronome dApp. You can mitigate this risk by improving their loan's health factor, either by depositing more collateral or redeeming some of the outstanding deposited collateral. The health factor, which is a measure of the safety of your position, is always visible on the Metronome Synth dashboard.

Our Metronome to the Dome position has a Health Factor of 1.06. As yield accrues to the position, it should increase. 

Another significant risk is the occurrence of 'black swan' events, characterized by rapid and extreme price changes in either a synth’s underlying asset or a collateral asset. Such events can lead to situations where users are unable to adjust their positions quickly enough to avoid liquidation, like when USDC depeged during the Silicon Valley Bank collapse, leading to FRAX hitting a price of $0.92.

Additionally, Metronome Synth relies on Chainlink for its oracle services, which monitor the prices of underlying assets for synthetics and collaterals. While Chainlink is a leading provider in this domain, oracle disruptions are still a potential risk. These disruptions can lead to failed transactions, asset pairs falling out of their intended peg, and incorrect price information that could result in unwarranted liquidations. Although Metronome employs measures to minimize such risks, the inherent nature of relying on external oracles means that these risks cannot be completely eliminated.

Lastly, there could be bugs in the Metronome Smart Farming and Synth contracts that are unknown and could lead to a loss of funds. 

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