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Yield farming is the practice of using one's crypto assets to generate passive income or yield. This typically involves providing liquidity to DeFi or lending protocols, as well as staking crypto assets for rewards. Some farmers even implement all methods at the same time. However, like other ways to earn cryptocurrency, yield farming is associated with certain risks. Intermittent losses, bugs in smart contracts or protocols, and high gas fees are just a few of them.
Therefore, yield farmers must conduct thorough research before investing their funds in yield farming. First of all, it is necessary to study the composition of the team, the security level of the project, the type of token used and the timing of the investment. Although your own research cannot completely protect you from losses, it can help significantly reduce your risks.
Introduction
The essence of yield farming is that free crypto assets are used to earn interest. With the help of smart contracts, owners can lend their cryptocurrency to other users and receive rewards for it. In the decentralized finance (DeFi) ecosystem, there are several ways to profit from cryptocurrency. Among the most common are the following:
Lending assets through crypto lending protocols.
Staking cryptocurrency in the protocol.
Providing liquidity (LP) to DeFi protocols (such as decentralized exchanges (DEX)) and receiving LP rewards (more in the article on LP tokens).
Many income farmers use one or more of the above methods to generate passive income. However, like other DeFi opportunities, yield farming comes with certain risks. Whether you're looking to become a farmer or are simply interested in the mechanics of yield farming, doing your due diligence is essential.
Risks of profitable farming
Impermanent losses
Impermanent losses are one of the most common risks in yield farming in DeFi. When cryptocurrency holders engage in yield farming, they lock up their cryptocurrency for a certain period, making these assets relatively illiquid.
Impermanent losses occur when the value of tokens deviates from their own price at the time of deposit into the pool. The more significant this deviation is, the greater the loss will be (regardless of the price direction).
Although commission returns earned through farming can theoretically compensate for losses, nothing guarantees complete protection against risks. More information can be found in our detailed article on non-permanent losses.
Hacks
DeFi protocols are controlled by smart contracts, and one mistake in their code can lead to the complete devaluation of the token. This risk is compounded by the fact that a malicious hacker could exploit bugs and attack the project.
Fraud
An attacker with a certain skill set could create a fake DeFi platform and pass it off as an official yield farming project. After all, DeFi projects are open source, transparent and publicly available, meaning anyone can copy the underlying code and create a new project based on it. Although early investors in new projects receive larger rewards, carefully consider whether you are willing to take such risks for high rewards.
Newly launched yield farming platforms are more difficult to analyze as they usually have quite a few reviews and information publicly available. Be especially careful as you may not be able to withdraw deposited funds or your rewards if you decide to leave such a platform.
High commissions
Network congestion leads to increased gas prices. Such price spikes affect profitability farming with small amounts of funds, since increased commissions can offset all profits. Even if farmers decide to leave their assets in the pool, they may still face other risks such as variable losses and liquidation.
Common research methods
Security tokens
Ensuring the security of yield farming and DeFi protocols is critical to preventing malicious attacks. To reduce risk, be sure to have your smart contract code audited by a reputable source. Try to choose DeFi projects whose smart contracts have passed strict audits.
Many DeFi projects, such as UniSwap, originated from forks of successful DeFi protocols. However, many projects fail due to network effects or lack of liquidity, as well as many other reasons. Moreover, some of them are created for fraudulent purposes. For example, a team of attackers could create a fork, try to attract liquidity to it, and then steal the invested tokens.
It is also important to consider the total value locked (TVL) of a project (the total amount of assets locked in the protocol to date). A suspiciously low TVL indicates that even less capital is locked up in the protocol, which means farmers will not be able to earn a high enough return.
Token
Many pools offer a variety of earning opportunities with different types of assets, including stablecoins and blue chips (popular tokens from large blockchain projects such as Bitcoin and Ethereum). Protocols can also distribute their native tokens to stakers and liquidity providers.
It is important to remember that a protocol can bind a native token to its services in several ways. For example, a token can be used for marketing purposes to attract more users. Always check carefully which token you will receive as a result of yield farming.
Timeline
Often, new DeFi protocols offer higher rewards to their early investors in order to attract liquidity. This encourages farmers to take risks by investing in and using a new or untested product or service.
Although investing in new projects at an early stage can bring significant profits, it also comes with high risks, which can make profit farming unprofitable. As a result, your time and money will be wasted.
Yield farmers must carefully consider their decisions and consider all risk factors as well as other earning opportunities. Due to possible token inflation and resulting price declines, new DeFi protocols will not be able to offer high rewards for a long period of time, especially if they reward farmers in their native tokens.
Team
When studying information about the project, pay attention to errors on the official website of the project: errors and typos may indicate an indifferent attitude or even fraudulent intentions of the development team. The website of a reliable project should have a user-friendly design without any typos and with working links. Another way to assess the reliability of a team is to check whether it undergoes regular audits by an external independent expert.
The development team should include entrepreneurs, product managers, developers, software engineers, marketing specialists and financial experts. If well-known advisors are also involved in the project, this is a good sign.
If possible, it is worth learning more about individual team members. Start by checking out their social media accounts to see their past performance as well as their activity on platforms like LinkedIn, GitHub, Reddit, TradingView, and YouTube.
Based on the activity and positioning of developers on social networks, one can judge their skills, experience and influence. An established team with a good reputation is less likely to engage in fraud.
In conclusion
Yield farming is a viable passive income strategy for people with experience managing risk effectively. However, given the volatile nature of yield farming and the crypto markets in general, farmers must remain vigilant and put a lot of effort and time into carefully planning a strategy.
If you plan to farm profitability, then use the above-mentioned approaches to reduce risks. Always do your research and due diligence before investing in any project.
Recommended reading
What is yield farming in decentralized finance (DeFi)?
Decentralized finance (DeFi). The Complete Beginner's Guide
Receiving passive income in cryptocurrency. Beginner's Guide
Why and How to Do Your Own Research (DYOR) Before Investing in Cryptocurrencies
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