Yield farming, also known as liquidity mining, is gaining popularity in the cryptocurrency industry. It involves receiving reward tokens in exchange for locking or staking cryptocurrencies. The concept of yield farming has come from Decentralized Finance (DeFi) space. As the DeFi space has started gaining popularity, subsequently the concept of yield farming is driving attention in the cryptocurrency industry.
The rising popularity has resulted in the emergence of various projects offering returns of rewards in the form of new cryptocurrency tokens through yield farming. However, although the rewards carry certain benefits, there are risks and dangers of farming. In this article, we examine the basics of yield farming and the risks that it poses to a crypto farmer.
DeFi Yield Farming
Decentralized Finance incorporates an ecosystem of blockchain applications in the banking and finance sector. One of the applications of DeFi rests in lending and borrowing assets. With yield farming, users can lend their cryptocurrency assets in different DeFi projects and in exchange receive rewards in the form of their native cryptocurrency tokens.
Source: DeFi Pulse
A crypto farmer can put their cryptocurrencies like Ethereum in DeFi projects and receive interest, rewards, or bonuses. However, although the concept sounds simple, it subsequently carries a fair amount of risks. Moreover, if a yield farmer is not careful, they can subsequently lose their crypto assets.
Liquidation Risks
Cryptocurrency assets are volatile in nature. A massive and sudden drop in prices of cryptocurrency assets is common in the industry. When borrowing collateralized assets from different platforms like Compound or Aave, it can result in the liquidation of your collateral. Due to the volatile nature of cryptocurrencies, your assets can be liquidated in case if they no longer cover your loan. Alternatively, even if the value of your loan amount increases it can result in the liquidation of the cryptocurrency asset that you have kept as collateral in exchange for borrowing.
To avoid liquidation risks in farm yield, borrow or supply with assets containing lower volatility. Stablecoins like Tether carry lower risks even if they are liquidated.
Composability Risks
The DeFi industry does not work in pieces. Instead, various DeFi applications interact and integrate at various points. The DeFi protocols are permissions and interoperable with each other. However, this carries security threats and vulnerabilities.
In case if any of the DeFi protocols are exploited, it can result in the loss of a farmer’s cryptocurrency assets. With farm yield, you also have to rely on other protocols of DeFi due to interaction with each other.
Impermanent Loss
In liquidity mining, farmers provide liquidity to pools like Uniswap and in turn receive a yield from the fees of the decentralized exchange. Hence, liquidity providers supply liquidity in the form of cryptocurrency assets to DeFi protocols in exchange for a return.
However, in some cases, a yield farmer stands to lose money in comparison to holding the asset. Also deemed as Impermanent loss by Uniswap, this occurs due to price divergence in cryptocurrency assets.
Smart Contract Risk
Another danger of farming is the risk of exploitation in smart contract code. Yield farming involves supplying your funds in a smart contract that automatically operates as per pre-defined factors. However, in case if the smart contract of a DeFi protocol is hacked or exploited, an attacker can manipulate the project. This can result in the loss of your cryptocurrency asset.
As per a recent survey, nearly 40% of DeFi users cannot comprehend the smart contracts used in the protocols. Unaudited smart contract code has even led to attack on various DeFi projects. One of the recent examples of such an attack is Yam Finance.
While the project attracted nearly $400 million in DeFi tokens, the value of its native token crashed to zero when a major flaw was found in its smart contract code. Such security threats and unaudited smart contract code carry risks in yield farming.
Final Words
While it is certain that yield farming carries potential benefits, there are various challenges yet need to be addressed. One of the hampering issues in this space includes the scalability of the Ethereum blockchain. As most of the DeFi applications are built on Ethereum, it has resulted in clogging of transactions and higher gas fees.
The space of yield farming and decentralized finance is relatively new. It certainly enables innovation in the financial ecosystem with different applications. However, it might take trial and time before it is optimized to the best of use.
Good article