There's risk in everything, and yield farming is not an exception.
In this post, I will be sharing with you the top 6 risks associated with yield farming, so that you can devise your own strategies for managing and possibly avoiding them.
If you're new to yield farming and have no idea of what it is, read my previous post on the topic.
Top 3 yield farming risks
The risk of Impermanent loss
The risk of bugs, hacks, and exploit
The risk of rug pulls and scams.
Let's discuss each of these risks below.
1. Risk of impermanent loss
Usually, most liquidity pools require you to deposit an equal value of 2 different cryptocurrencies.
Impermanent loss occurs when the price of the tokens changes due to volatility, such that it reduces the value of your original investment.
It is the temporary loss resulting from providing liquidity on decentralized exchanges such as Uniswap and PancakeSwap.
The loss is "temporary" because it is only realised if you remove the liquidity from the pool.
If you leave it there long enough, prices may return to what it was when you first deposited the tokens or higher, thus eliminating the impermanent loss.
To understand impermanent loss better, watch the video explainer below by Finematics.
2. The risk of bugs, hacks and exploits.
Liquidity pools are managed by smart contracts (codes) and even though code may be law, they're subject to bugs and errors.
A bug in the code could make it impossible to withdraw your money from a smart contract as witnessed in the case of YAM Finance sometime in 2020.
That is why you should NEVER put your money into an unaudited smart contract.
However, even an audited smart contract code can still have bugs but the chances are limited. An audit only cuts the risk of a bug down by a reasonable degree.
There could still be unidentified bugs that could cause the smart contracts to malfunction. Or even get hacked or exploited by a superior developer, as was the case with Harvest Finance in late last year, 2020.
3. The risk of rug pulls
In crypto and DeFi, a rug pull means that the developers of a project have removed or drained the liquidity of the token.
They do this by either pulling out the initial liquidity they added for users to be able to buy and sell the token. Or simply create new tokens and dump them on the market which causes the price of the token to fall significantly.
When this happens every other investor, holder, trader, liquidity provider of the token will attempt to cut their losses by selling their tokens all at once.
This further adds to the selling pressure and the pool eventually runs dry. Leaving investors with huge losses.
Scammers have developed and used several strategies to pull the rug on investors in the past. And they will most likely keep innovating and coming up with new and better strategies.
Your job is to learn and become smarter as you grow with the market.
Conclusion
Yield farming is an extremely risky business. Most especially as there's little to zero regulation of the industry.
This lack of regulation gives bad actors to behave in any way they like and leaves you as an investor to watch out for yourself and take personal responsibilities.
That's the nature of crypto anyway, as you're your own bank. Right?
Yes.
Therefore you must understand all the inherent and associated risks involved in yield farming and invest accordingly.
These are all great points. In terms of yield farming, do you prefer centralized or decentralized solutions. Because as far as risks are concerned, they both have an advantage over the other in different areas. I can see centralized being safer if there is a liquidity crisis and decentralized after the first big crash on these models occurs. Cheers