Summary
Yield farming is the practice of using crypto assets to generate passive income or yield. These activities typically include providing liquidity to DeFi protocols, or lending or staking crypto assets to earn rewards. Some yield farmers use them all at the same time. As with all crypto opportunities, yield farming is not risk-free. Impermanent losses, bugs in smart contracts or protocols, and exorbitant gas fees are some of the risks faced by yield farmers.
Therefore, yield farmers must conduct thorough research before allocating their funds to a yield farm. One way to do this is to investigate the team, security, token type, and timeline regarding the investment. Although it cannot completely prevent crypto losses, carrying out DYOR (do your own research) can help mitigate risks.
Introduction
Simply put, yield farming uses unused crypto assets to generate crypto interest. Through smart contracts, owners can provide crypto loans to others and receive rewards in return. Within the decentralized finance (DeFi) ecosystem, there are a number of ways to generate yield from crypto, and some of the most common are:
Lending assets using a crypto lending protocol.
Staking cryptocurrency on a protocol.
Become a liquidity provider (LP) for a DeFi protocol (e.g. decentralized exchange (DEX)) and receive LP rewards (see LP token).
Most yield farmers use one or more of the above methods to create passive income streams. However, just like other DeFi opportunities, yield farming has risks. If you want to become a yield farmer or are simply interested in the mechanics, you should do your due diligence.
Risk of Yield Farming
Loss is not permanent
Perhaps the most prominent risk in yield farming and the DeFi field in general is impermanent loss. When participating in yield farming, crypto owners often lock crypto for a certain period so that the asset is relatively liquid.
Impermanent loss occurs when the price of your token changes from the price when you deposited it into the pool. The bigger the change, the bigger the loss, regardless of price direction.
Although the yield farming fees charged can help offset losses, this is not always the case and can pose significant risks. If you want to learn more, read our in-depth explanation of impermanent loss.
Hacking
Smart contracts control DeFi protocols and a single bug in the smart contract code can cause the token value to drop to zero. This risk is magnified by the fact that malicious hackers can exploit such bugs or security issues to manipulate the project.
Fraud
Someone with bad intentions and the right skills can create a DeFi platform and make it a legitimate yield farming site. After all, DeFi projects are open-source, transparent, and permissionless. This means anyone can copy the underlying code and create a new project. Although early adopters are usually rewarded with greater rewards, think twice before doing so, as high rewards come with high risks.
Newly launched yield farming platforms can be more difficult to research, as user reviews and information about them tend to be limited. Be careful with such platforms, as you may not be able to withdraw deposited funds or claim rewards even if you change your mind after allocating funds to them.
High gas costs
Network congestion usually causes gas costs to rise. This extraordinary spike affects yield farmers with less funds, because gas costs can erode the fees charged. Even if they choose to leave their assets in the pool, other risks such as impermanent loss and liquidation can still impact them.
General Ways to Perform DYOR
Security
Ensuring the security of yield farming and DeFi protocols is important to prevent malicious attacks. To reduce the risk of such attacks, you should ensure that trusted sources have audited the smart contract code. Look for DeFi projects with smart contracts that have been thoroughly audited.
Various DeFi projects started by forking successful DeFi protocols, such as UniSwap. However, most projects fail due to network impacts or lack of liquidity, among other things. What's worse, some of them are deliberately created as scams. For example, a fraud team could create a fork, try to attract liquidity to it, and then disappear with the newly acquired tokens.
You should also know the Total Value Locked (TVL) in the project, which is the total amount currently locked in the protocol. A very low TVL is an indicator that there is little capital locked in the protocol, thus providing lower yields for farmers.
Token
Different pools offer different opportunities for different assets, including stablecoins and blue-chip tokens (that is, tokens from established blockchain projects such as Bitcoin and Ethereum). The protocol can also distribute its own tokens to stakers and liquidity providers.
You should keep in mind that a protocol can tie its tokens to its services in various ways. For example, a protocol may use tokens as a marketing tactic to attract more users. Therefore, always ensure that the tokens you will receive are from yield farming.
Timeline
New DeFi protocols often offer higher rewards to early adopters to increase liquidity. These rewards also serve as incentives for daring to take risks by investing in them and using new or untested products or services.
However, while early adopters can generate greater rewards, they also face high risks — yield farming protocols may not be successful. Therefore, the money and time invested may not be recouped.
Yield farmers must weigh their options carefully and consider all other factors and opportunities. Due to the potential for token inflation and resulting price drops, new DeFi protocols that offer high rewards over long periods of time will not be sustainable, especially if they reward farmers using their native tokens.
Tim
When searching for information, look for errors from major yield farming websites – errors may indicate that the team is careless or, worse, fraudulent. Ideally, a website should be well designed, have no salt or broken links, and look professional. Another way to assess a team's reliability is to find out whether regular audits are performed on it by independent external auditors.
A team should be balanced and consist of entrepreneurs, product managers, developers, software engineers, marketing professionals, and financial experts. It would be even better if the project also had a renowned advisor on its board.
If possible, also do research on each team member. As a first step, check their social media accounts to learn about their past accomplishments as well as activity on platforms such as LinkedIn, GitHub, Reddit, TradingView, and YouTube.
The way they interact on social media can indicate their skills, experience and influence. Generally, established and reputable teams are less likely to commit fraud.
Closing
Yield farming can be a viable passive income strategy for people experienced in effective risk management. However, given the volatile nature of yield farming and the crypto market in general, you need vigilance, effort and time to plan a strong yield farming strategy.
If you want to do yield farming, the approaches mentioned can be used as a first step to mitigate risk. 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)?
A Beginner's Guide to Decentralized Finance (DeFi)
A Beginner's Guide to Generating Passive Income with Crypto
Reasons and How to Do Your Own Research (DYOR) When Investing in Crypto
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