4 Main Yield Farming Risks, And Ways To Avoid Them

Yield farming is a strategy in which users allocate their funds in a DeFi protocol and get some extra tokens as a reward. The first platform to introduce yield farming was Compound, and after DeFi skyrocketed in 2020, the strategy remains popular to date. Yield farming has become one of the drivers behind the growth of DeFi as it offered users unprecedented returns that could be accessed in a permissionless way, i.e. by everyone with an internet connection.

Yield farming is very alluring, but there are some risks associated with it. In this article, we will explore them, and you will learn how to stay safe in the yield farming sphere.

How does yield farming work?

These pools allow DeFi users to swap between different tokens. For making this possible, you get a share from all the swaps processed in a pool and some extra CAKE tokens as a reward. APR on PancakeSwap can reach hundreds of percent, but this number constantly changes as the tokens’ prices are very volatile, so your income isn’t guaranteed.

Other DeFi platforms such as borrowing and lending services also enable yield farming. For instance, Compound and Maker reward you for allocating money in these protocols, and the money further serves as loans for other users. This is basically the same liquidity provision, but the funds are used as collateral for loans rather than pool-locked tokens. For your assistance, these protocols reward you with COMP and MKR tokens, respectively. You can sell or reinvest these earnings to maximize your return.

4 critical risks of yield farming — and ways to avoid them

Token price drops

When we invest in liquidity pools of small tokens in search of the best APR, we may forget that these tokens may not have real value and a roadmap, and they are likely to dump. Do profound research and invest only in projects whose teams you fully trust.

Impermanent Loss

Liquidity pools where users allocate their funds are functioning on decentralized exchanges like Uniswap (Ethereum-based) or PancakeSwap (BSC-based). These exchanges don’t have order books like their centralized counterparts. Rather, prices in DEXes are formed not following the BUY and SELL orders’ balance in an order book, but based on the balance of tokens in liquidity pools, which is shaped algorithmically. This is called the Automated Market Maker (AMM) model.

So the price formation mechanisms in CEXes and DEXes vary, and the price of the same assets across them may be different. For instance, 1 ETH that you hold in your wallet or on Binance may be worth more than the same ETH held in an AMM. This difference is called impermanent loss. Whenever the token balance in your pool recovers, there is no loss. If you withdraw before it does, the loss becomes permanent — so it’s recommended not to withdraw before the price goes in your favor.

Smart Contract Risk

Yam Finance was quite a big incident last year. The protocol attracted $600 million of liquidity before even having been audited. Soon, it came out that there was a bug in Yam’s smart contract that made it impossible for the users to control the project. The community started to panic sell, and YAM price dropped by 99%.

One of the latest examples is the Polygon-based YELD token from the PolyYeld Finance protocol. This time, the price collapsed not because the users lost their faith in the project, but because there was a bug and it was exploited by hackers. The attackers minted 4.9 trillion YELD, and as supply boosted, the price immediately collapsed. Hackers managed to withdraw 123 ETH.

The lesson here is simple — invest only in audited protocols whose security has been validated by the community.

High gas price

Bottom line

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