Introduction:
At its most basic level, yield farming involves utilizing inactive cryptocurrency assets to earn cryptocurrency interest. Utilizing smart contracts, owners can lend their cryptocurrency to others and, in return, receive rewards. Within the decentralized finance (DeFi) ecosystem, there are several methods for generating yield from cryptocurrency, with the most common ones including:
1. Lending assets through a crypto lending protocol.
2. Staking cryptocurrency on a protocol.
3. Becoming a liquidity provider (LP) for a DeFi protocol (e.g., decentralized exchange (DEX)) and earning LP rewards (see LP tokens).
Many participants in yield farming employ one or more of these methods to establish a passive income stream. However, like other opportunities in DeFi, yield farming comes with its own set of risks. Whether you're considering becoming a yield farmer or simply interested in understanding its mechanics, conducting thorough research is essential.
The Risks of Yield Farming:
Impermanent Loss:
Arguably the most notable risk in yield farming and the broader DeFi space is impermanent loss. When engaging in yield farming, crypto owners often lock up their assets for a specific period, rendering them relatively illiquid. Impermanent loss occurs when the price of deposited tokens changes from the initial deposit price, with the magnitude of the loss proportional to the price change, irrespective of its direction. While earned yield farming fees may offset losses, this is not always guaranteed, posing a significant risk.
Hacks:
DeFi protocols are governed by smart contracts, and a single flaw in the smart contract code could lead to a token's value plummeting to zero. This risk is exacerbated by the potential exploitation of the bug or security issue by malicious hackers to manipulate the project.
Scams:
Individuals with malicious intent and the requisite skills can create a DeFi platform, presenting it as a legitimate yield farming site. Since DeFi projects are open-source and permissionless, anyone can replicate the underlying code and establish a new project. While early adopters often receive higher rewards, the allure of such gains comes with elevated risks.
Newly launched yield farming platforms may be challenging to research, as user reviews and information may be limited. Caution is advised with such platforms, as difficulties in withdrawing deposited funds or claiming rewards may arise even after committing to the platform.
High Gas Fees:
Congested networks often lead to increased gas fees, affecting yield farmers with smaller funds, as these fees can diminish their earned rewards. Even if assets remain in the pool, additional risks like impermanent loss and liquidation may still impact participants.
Common Due Diligence Measures:
Security:
Ensuring the security of yield farming and DeFi protocols is crucial to prevent malicious attacks. To mitigate this risk, it is imperative to verify that a reputable source has audited the smart contract code. Look for DeFi projects that have undergone comprehensive smart contract audits.
Token:
Different pools offer opportunities for various assets, including stablecoins and blue-chip tokens. Protocols may also distribute their own tokens to stakers and liquidity providers. Understanding how a protocol binds its token to its services is crucial, as tokens may serve marketing purposes or other functions.
Timeline:
New DeFi protocols often offer higher rewards to early adopters, incentivizing them to take risks by investing in and using a new or untested product. While early adoption may yield greater rewards, it also entails high risk, as the protocol's success is uncertain.
Team:
Evaluate the reliability of the yield farming team by checking for errors on the project's website, as mistakes may indicate a careless or fraudulent team. A well-designed website with no typos or broken links suggests professionalism. Additionally, a balanced team comprising entrepreneurs, product managers, developers, marketing professionals, and financial experts enhances credibility. Regular external audits and renowned advisors further strengthen a team's reliability.
Closing Thoughts:
Yield farming can serve as a viable passive income strategy for those proficient in effective risk management. However, given the volatile nature of yield farming and crypto markets, careful planning and vigilance are essential. The aforementioned approaches can serve as a starting point to mitigate risks, but thorough due diligence is imperative before investing in any financial opportunity.