With the growth of Decentralized Finance (DeFi) more projects are trying to attract investors with higher return, and to keep them in as an investor they often provide a liquidity pool so that token holders could lock their assets and provide liquidity to the company. Today we are going to discuss the risks of yield farming and how to mitigate it.
Risk of Impermanent Loss
Liquidity providers may face impermanent loss risk any time the value of a cryptocurrency drops.
When performing yield farming, liquidity providers are often required to add at least two different coins with equivalent value (eg: ABCD and WXYZ). However, the price of both coins are volatile and can affect the fiat value of the coin on the pool at any time.
The impermanent loss ricks take place when the price of token that are involved on the yield farming falls. It is called impermanent because once the price of a token goes back to its original value, the loss is back to zero.
This is also the reason why yield farm pools often offer incentive for their liquidity provider. Profit from farming yields on your cryptocurrency assets sometimes make up for the loss, but it doesn’t always.
To mitigate this risk, provide liquidity for more stable coin pools or token pairs with historically low volatility. DeFiato offers a range of stablecoin yield farming for users who prefer a more stable reward with lower volatility.
DeFi Smart Contract Risk
Malicious hacker could attack the smart contract that hold certain yield farming.
Smart contracts control yield farming and DeFi. If there is a bug or error in the code, a malicious hacker could use that mistake to attack and manipulate the project, allowing them to drain all assets in the liquidity pool, and leave without a trace.
Always confirm that the smart contract has been audited, and if you find the audit paper do spend your time reading through the document to ensure that the project has good code quality, testing and following best practices.
liquidation risk
This is not exactly a risk problem, but a strategy problem.
If the coin value in the liquidity pool keeps going down, liquidity providers would need to liquidate their money to save them from further loss. On the other hand, there is always a chance that the price of the token will bounce back and make the liquidity provider regret their decision to withdraw their money from the pool.
History always repeats itself, these are often more true than not. So, check out the historical pattern of the token as forecasting guidelines. Decide your entry and exit points to ensure that you do not regret your decision.
Unfairness
People with bigger investment capital may be able to impact token price significantly.
A token price relies on the daily transaction volume made by investors, if the order book is filled with people buying the token, the price will rise to match the high demands, vice versa. Therefore, putting wealthier investors in advantage. Because, when they invest a large amount of money, the price will soar, but once they withdraw their money it will cause the price to drop, leaving smaller investors on a loss.
Newer projects usually mitigate this risk by adding locking and vesting periods for both retail and VC investors. Additionally, smaller investors often follow the ‘whale’ on social media and portfolio to monitor their movement.
Risk of Scam
Rug pulls, pump and dumps, and outright fraud also pose a threat to all types of investors.
In yield farming, depositing crypto assets into a protocol often means pairing one stable coin token with a lesser known token – exposing investors to a rug pull risk.
A new yield farming pool often offers the highest yield possible, people would be tempted to invest right away without looking at enough data and reviews regarding the project. This action is very risky as there is always a chance of scammers creating this exact pool.
Make sure that you check all necessary data before investing in a certain project. It would be best if you do a core team background check to ensure their scope of knowledge and reliability.
Gas Fees
This is a problem for DeFi yield farming, especially for investors with smaller funds, whilst wealthier participants might ignore.
To participate and withdraw from a yield farming pool, users often need to complete multiple transactions, which quickly adds up. Smaller investors will soon realize that if they decide to withdraw their earnings they would actually end up losing money. But if they leave their money in the pool they are exposed to other risks such as impermanent loss and liquidity risk.
Many platforms are battling with these issues to ensure that users would not need to worry about gas fees. Ethereum 2.0 with layer two scaling aims to solve this problem. DeFiato is also working towards this matter because we want mainstream users to be able to enter the DeFi ecosystem no matter their initial investment amount.
Price Risks
This risk is not particular to farming yields but on your cryptocurrency assets’ price volatility in general.
This risk will also affect your expected return for your investment in yield farming. Farming platforms usually offer their own native token as rewards for the yield farmers. Meaning if their token price falls, even with the same APY you will receive less reward equivalent to fiat.
Note that as long as you own a cryptocurrency you are expected to face this risk. So, do not put all your money into one basket. Diversify the tokens that you use for yield farming across a variety of blockchains and protocols.
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