What are Yield Farming Risks? How to Fight Them?
Yield farming risks are equally important while studying yield farming as are its benefits. The yield farming process generates attractive, qualitative as well as quantitative profits to the investors. So, it is acting as a magnet for the crypto owners. More and more people are feeling inclined to farm their assets in the liquidity pools. They are looking to earn exciting profits on them as passive income. But only some investors are aware of the potential risks that tag along with the benefits of yield farming. So, in this article, we are discussing each type of risk involved in yield farming. Also, we have highlighted a few ways to prevent these risks from hurting your yield farming rewards and income.
Yield Farming and its Benefits
Yield farming involves locking your existing crypto-assets in liquidity pools to generate passive income. Investors lock their crypto assets in pairs and the protocol rewards them for their ability to put money in the liquidity pool. The investors earn rewards in the form of APY rewards, transaction fees, and native governance tokens of the protocol. Then the investors lend their earned tokens again in the liquidity pool to generate another round of yield and profits. This is known as yield farming where the investor’s farm yields on their pre-earned yields. They do so to generate maximum profits from their crypto-assets.
What are Yield Farming Risks?
Yield farming involves lending a pair of tokens in equivalent quantities. The user’s farm yields according to the proportion contributed by the investor to the protocol. But there are many risks associated with this process. In addition to earning money, the investors suffer from a likelihood of witnessing losses. Let’s understand each type of risk that yield farming can cause to the investors.
Smart Contract Risks
The process of lending and borrowing money in the case of decentralized finance is governed by smart contracts. Smart contracts allow transactions to be exited automatically. But there can be certain errors or bugs in the code of the smart contract. These bugs or errors in the code may be manipulated by hackers. So, these hackers may exploit the smart contracts to extract all the money away. This leaves no capital to the liquidity providers. This is why we advise investors to choose one of the best yield farming platforms to practice the process. It is because the high-end platforms maintain a great team of developers. These developers and scrutinizers analyze and overlook the security of the contract from time to time.
These yield farming risks are especially common when you are going to farm yields on a protocol that uses a token swapping mechanism. Some platforms like Uniswap need investors to supply tokens in pairs. They work on the automated market maker model where the lending and borrowing of funds happen automatically without the need of a third party. Such AMM-driven protocols do not update their prices immediately according to the market sentiments. So, when the price of the token falls in the exchanges, some investors can take advantage of the narrow time gap by selling their tokens off at high prices on the protocol. On the other hand, liquidity providers have to incur these losses. These are impermanent losses.
Liquidation risks occur when the value of the collateral used for taking a loan on a yield farming platform is no longer able to cover the amount of loan that you have taken. This puts up a collateral penalty on the borrower. Applying this as a yield farming risk, the value of tokens locked in the liquidity pool may decrease, resulting in the liquidation of the assets. So, the liquidity providers may suffer losses if the price of the tokens that they have locked in the pool decreases in the market.
Yield Farming Strategy Risks
The strategy with which you enter the yield farming protocol largely determines the number of profits that you will earn. Usually, at the time of launch of a liquidity pool, the rewards are very high as fewer people have invested in it. But as the life of the pool grows, so does the number of investors. But the returns from the liquidity pool are inversely proportional to the number of investors. Therefore, the investors have to monitor their potential returns from the pool continuously and pick out the time to exit the pool and enter the new one.
Gas Fee Risks
The gas fee is the fee that the yield farming protocol charges the investors for participating in the liquidity pool. When more people feel interested in participating in the yield farming protocol, the gas fees become very high. So when the liquidity providers with a smaller share in the liquidity pool tend to withdraw their money, the gas fee can be costly and much more than their share. This may lead to the investors losing their money in yield farming.
How to Combat Yield Farming Risks?
Investors can escape some of these brutal yield farming risks by applying a few strategies. For example, the investors can prevent the occurrence of impermanent loss by locking the less volatile assets in the staking pool. Secondly, to prevent gas fee risks, the investors can lock their assets in alternate blockchains where the gas fee is not that high. Also, the investors may decide on a certain amount that is not too low so that even if the gas fee skyrocket, the investors can easily pull their funds out. Moreover, the investors must familiarize themselves with the yield farming protocol that they have chosen. They must be aware of the way they work and the kind of benefits and risks that may occur in the protocol.
Considering these risks while choosing the yield farming platform for yourself is extremely important for investors, especially the newcomers. Some of these risks are completely out of the hands of the investors or the decentralized finance protocol you are farming on. However, you can easily avoid some of these risks solely by being more aware of the terms and conditions of the protocol, the underlying technology of its working, and the credibility of the protocol. Therefore, the investors must carefully read about the yield farming protocol, its benefits, and risks before locking their money in it.