TL;DR
Yield farming is the use of cryptoassets to generate passive income or yields. Typically, it involves providing liquidity to DeFi protocols or lending or staking crypto assets in exchange for rewards. Some investors in this category, yield farmers, use all of these options simultaneously. As with all crypto opportunities, yield farming is not without risk. Impermanent loss, bugs in smart contracts or exorbitant Gas protocols and fees are some of the risks that farmers face.
Therefore, yield farmers should do thorough research before committing their funds to a yield farm. Some common ways to do this include investigating the team, security, token type, and timeline associated with the investment. While the DYOR (do your own research) philosophy cannot completely prevent losses in the crypto sector, it does help mitigate risks.
Introduction
In its most basic form, yield farming uses idle crypto assets to generate crypto interest. Through smart contracts, token owners can lend their cryptocurrencies to others and receive rewards in return. Within the decentralized finance (DeFi) ecosystem, there are some ways to generate crypto income. The most common are:
Lending assets using a crypto lending protocol.
Staking cryptocurrencies in a protocol.
Become a liquidity provider (LP) on a DeFi protocol (e.g. on a decentralized exchange (DEX) to receive LP rewards (LP tokens).
Many yield farmers use the above methods to build a passive income stream. As with other DeFi opportunities, however, yield farming is not without its risks. If you intend to become a farmer or are interested in this mechanic, it is good to do your due diligence.
The risks of yield farming
impermanent loss
Probably the most prominent risk in yield farming and the DeFi sector in general is impermanent loss. When cryptocurrency holders participate in yield farming, they often lock up their cryptocurrencies for a specific period of time, making these assets relatively illiquid.
Variation in token prices after deposit into the pool generates impermanent loss. The greater the change, the greater the loss, regardless of the price direction.
While the yield farming rates earned can help offset losses, this is not always the case. It is an operation that can pose great risks. If you want to know more, read our guide on impermanent loss.
Hacker attacks
Smart contracts control DeFi protocols, and a single bug in the smart contract code can cause the value of a token to reduce to zero. This risk is even greater considering that a malicious hacker could exploit the bug or security flaw to manipulate the project.
Fraud
Someone with bad intentions and the necessary skills can create a DeFi platform and advertise it as a legitimate yield farming site. After all, DeFi projects are open-source, transparent and permissionless, which means anyone can copy the underlying code and create a new project. Generally, early adopters of a project receive more generous rewards, but it is important to evaluate with caution as large rewards come with greater risks.
Newly launched yield farming platforms can be more difficult to research as user reviews and information about them tend to be limited. Be especially cautious with these platforms, as you may not be able to withdraw your deposited funds or redeem your rewards if you change your mind.
High Gas Rates
When a network is congested, there is usually an increase in Gas rates. These increases affect yield farmers with fewer funds, as Gas fees can eat into their earned fees. Even if they choose to leave their assets in the pool, they may still be affected by other risks such as impermanent loss and liquidation.
Common ways to do your research (DYOR)
Security
It is essential to ensure the security of yield farming and DeFi protocols to prevent malicious attacks. To reduce the risk of these attacks, it is important to verify that a trusted source has audited the smart contract code. Look for DeFi projects that have had their smart contracts fully audited.
Many DeFi projects start with a fork of successful DeFi protocols such as UniSwap. However, many fail due to network effects or lack of liquidity, among other reasons. Worse still, some are deliberately created as scams. For example, a team of scammers could create a fork, try to attract liquidity to it, and then disappear with the newly acquired tokens.
It is also important to know the Total Value Locked (TVL) in the project, which is the total funds currently locked in the protocol. If the TVL appears suspiciously low, it is an indicator that there is even less capital locked in the protocol, which in turn means less returns for yield farmers.
Token
Different pools offer different opportunities for various assets, including stablecoins and blue-chip tokens (i.e. tokens from established blockchain projects such as Bitcoin and Ethereum). Protocols can also distribute their own tokens to stakers and liquidity providers.
It is essential to remember that a protocol can link its token to its services in several ways. For example, the token can be used as a marketing tactic to attract more users. Therefore, always be sure which token you will receive from yield farming.
Timeline
Aiming to increase liquidity, new DeFi protocols often offer higher rewards to their early users. This also acts as an incentive for the user to be willing to take risks by investing in and using a new or untested product or service.
However, while early adoption can offer good rewards, it is also a high-risk venture — the yield farming protocol may not be successful. Therefore, you may not recover the money and time invested.
Yield farmers must carefully evaluate their options and consider all factors as well as other opportunities. Due to the possibility of token inflation and subsequent price declines, offering high rewards for long periods is not a sustainable practice for new DeFi protocols, especially if they reward farmers using their native tokens.
Team
When searching for information, look for errors on the main yield farming website – errors could indicate a sloppy team or worse, a scammer. Ideally, the website should be well-designed, free of typos or broken links, and professional-looking. Another way to assess the reliability of a team is to check whether it is regularly audited by an external and independent auditor.
A team should be well-balanced and include a healthy mix of entrepreneurs, product managers, developers, software engineers, marketers, and financial experts. If the project also has renowned advisors, it is a bonus.
If possible, also research individual team members. Check their social media accounts to learn about their past achievements, as well as their activities on platforms like LinkedIn, GitHub, Reddit, TradingView, and YouTube.
The way they interact on social media can show a glimpse of their skills, experience and influence. Generally speaking, an established team with a good reputation is less likely to be part of a scam or fraud.
Final considerations
Yield farming can be a viable passive income strategy for users with experience in effective risk management. However, given the volatile nature of yield farming and crypto markets in general, it takes care, effort and time to plan a solid strategy.
If you are considering yield farming, the approaches mentioned can be used as a starting point to mitigate risks. Additionally, you should dig deeper and do your due diligence before investing in any financial opportunity.
Further reading
What is Yield Farming in Decentralized Finance (DeFi)?
Beginner’s Guide to Decentralized Finance (DeFi)
Passive Earnings with Cryptocurrencies – A Beginner’s Guide
Why and How to Do Your Own Research (DYOR) When Investing in Cryptocurrencies
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