Risks of Yield Farming
Published April 9, 2022.
Yield farming refers to the staking or lending of cryptocurrency assets to generate rewards or high returns in the form of more crypto.
While this form of DeFi is innovative, it’s also somewhat volatile, and investors must be aware of its risks.
Risks of Yield Farming You Should Be Aware Of
Yield farming is one of the most significant growth drivers of the DeFi sector today, expanding from a market cap of $500 million to $10 billion in 2020.
Yield farming protocols incentivize LP, or liquidity providers, to contribute or lock their crypto assets in yield farming pools based on a smart contract. Incentives typically include a certain percentage of transaction fees, a governance token, or interest from lenders.
While yield farming can be quite profitable, there are also several risks you’ll need to consider.
The Risk of Impermanent Loss
One of the most prominent risks of yield farming is impermanent loss. If you’ve been asking yourself, “Can you lose money with yield farming?” The answer, in short, is yes.
You add liquidity to the pool in pairs of equivalent values. For example, if you add one ETH in an ETH/USDC pair, and one ETH is 2000 USDC, you would be required to add 1ETH and 2000 USDC. Although, the volatility of crypto can affect the fiat value of your coins at any time.
If the value of ETH were to fall to 1000 USDC, the coins in the liquidity pool would shift to make up for that change. When you have a huge loss, you risk impermanent loss or IL. IL is when you receive a lower value than what you originally put in. Anytime the value of a cryptocurrency drops, you run the risk of impermanent loss.
Were you wondering about recovering impermanent loss? The impermanent loss is canceled if your asset is worth the same as the original deposit price. However, the loss becomes permanent when you decide to withdraw your funds from the pool.
The Risk of DeFi Smart Contracts
Yield farming and Defi are controlled by smart contracts. One bug can cause the price of a token to drop to zero. Hackers can retain or exploit that bug. This could mean losing all of your crypto assets in the pools affected by this problem.
Skyrocketing Gas Fees
Ethereum gas fees are high; that’s the bottom line. This problem is common for Defi yield farming, especially for investors with smaller funds. On the other hand, wealthier investors may not be phased too much by these fees.
When many individuals tap into yield farming and lock in a large amount of crypto into DeFi, gas fees typically skyrocket. This was a nasty issue back in 2020 when gas fees reached 100X more than usual.
The Risk of Unfairness
Unfairness is another problem you’ll have to consider. Yield farming pools can be controlled heavily by the founders and wealthier investors involved in the pool. Therefore, investors with smaller funds are put in a position where much price action is dictated by prominent investors.
If one of these wealthier investors decides to withdraw a chunk of their investments, it can affect the entire platform by causing a crash in the value of tokens. Anyone holding the coin, including yield farmers, would be drastically affected by this.
Risk of Bugs in Code
Most apps contain bugs, and this occurs even when developers go the extra mile to prevent such issues.
Bugs don’t always cause enormous complications for many of the top apps. However, sometimes they can be pretty severe. As we mentioned earlier, bugs can be exploited by hackers and could cause investors in the pool to lose money. Like when hackers managed to loot $30M dollars from the Fantom Blockchain Yield Farming Project.
Liquidation is another issue to be aware of. You risk this problem when you consider pulling your money or crypto assets from the pools. Strategy is key here. For example, if your coins are worth about $1000 in the pool, and the value consistently decreases, you are left with essentially two options. Pull out, or stick with the pool.
Sometimes pulling out is the right decision and could save you from continuous loss by liquidating or swapping your coins and moving on. Although, sometimes, it’s not entirely the right choice. There’s always the possibility of the value soaring an hour after you pull out, making you wish you had stuck with the pool.
This isn’t something you can control, so play your cards right and think about what you’re doing before making any decisions. Liquidation = price risk + strategy risk.
Precautions You Can Take Against the Risks of Yield Farming
Yield farming safely isn’t as complicated as it may seem. One of the most important things you’ll want is to confirm that reputable companies have audited smart contracts to mitigate risks. Audits of new features added as time goes on are a significant bonus. Focus on projects that take security safely if you’re contributing your hard-earned money to the pool.
When investing your money into a pool, make sure the smart contract associated with the pool is audited consistently by trustworthy firms. Yield farming can be pretty profitable, but some risks are involved, including impermanent loss, gas fees, unfairness, bugs in code, and more.