TL;DR
Yield farming is the practice of using one’s crypto assets to generate passive income or yield. It typically involves providing liquidity to DeFi protocols or lending or staking crypto assets for rewards. Some yield farmers use them all at the same time. As with all crypto opportunities, yield farming is not without its risks. Volatile losses, errors in smart contracts or protocols, and exorbitant gas charges are some of the risks farmers face.
Therefore, yield farmers must do thorough research before allocating their funds to a yield farm. Some common methods include investigating the team, security, type of token and timing related to the investment. While DYOR (own research) cannot completely prevent crypto losses, it can help mitigate risks.
introduction
In its simplest form, yield farming uses idle crypto assets to earn crypto interest. Smart contracts allow owners to lend their cryptos to others and receive rewards in return. Within decentralized financing (DeFi) ecosystem there are some possibilities generate income of crypto, the most common are:
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lending of assets with a Crypto Loans Protocol.
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Cryptocurrency staking on a protocol.
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A… become Liquidity Provider (LP) for a DeFi protocol (eg decentralized exchange (DEX)) and receive LP rewards (see LP Token).
Many yield farmers use one or more of the above methods to build one passive source of income. However, like other DeFi opportunities, yield farming has its drawbacks risks. Whether you intend to become a yield farmer or are just interested in its mechanics, it’s good to do your due diligence.
The Risks of Yield Farming
Ephemeral Loss
Probably the most prominent risk in yield farming, and the DeFi space in general, is fickle loss. When crypto owners engage in yield farming, they often lock up their crypto for a period of time, making those assets relatively illiquid.
A temporary loss occurs when the price of your tokens changes from the price at which you deposited them into the pool. The greater the change, the greater the loss, regardless of price direction.
Although yield farming fees earned can help offset the loss, this is not always the case and can be a major risk. If you want to learn more, read our detailed explanation of impermanent loss.
Chop
Smart Contracts Control of DeFi protocols and a single mistake in smart contract code could cause a token’s value to drop to zero. This risk is compounded by the fact that a malicious hacker could exploit the bug or security issue to manipulate the project.
Fraud
Someone with bad intentions and the right skills can create a DeFi platform and pose as a legitimate yield farming site. DeFi projects are, after all open-sourcetransparent and without permission, which means anyone can copy the underlying code and create a new project. While early adopters tend to get handsomer rewards, you should 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 are usually limited. Be extra careful with such platforms as you may not be able to withdraw your deposited funds or claim your rewards even if you change your mind after opting for such a platform.
High gas fees
When a network is congested, it usually causes an increase in gas Fees. Such unprecedented spikes hit yield farmers with fewer resources as gas fees can eat away at their earned fees. Even if you choose to keep your assets in the pool, there are other risks such as temporary loss and the like liquidation can still influence it.
Common paths to DYOR
Security
Ensuring the security of yield farming and DeFi protocols is crucial to prevent malicious attacks. To mitigate the risk of such attacks, it’s important to ensure that a reputable source has reviewed the smart contract code. Look for DeFi projects whose smart contracts have been thoroughly vetted.
Countless DeFi projects start with forks of successful DeFi protocols such as UniSwap. However, many fail due to network effects or a lack of liquidity, among other things. Worse, some are even intentionally created as a scam. For example, a fraudulent team can create one Forktry to attract liquidity and then disappear with the newly acquired tokens.
It is also important to know the total value locked in the project (TVL), which is the total amount currently locked in the log. If the TVL seems suspiciously low, it’s on indicator that even less capital is tied up in the log, which in turn means less yield for farmers.
Sign
Different pools offer different opportunities for different assets, including stablecoins and Blue chip token (i.e. tokens from established blockchain projects such as Bitcoin and Ethereum). Protocols can also distribute their own tokens to players and liquidity providers.
It’s important to remember that a protocol can bind its token to its services in a number of ways. For example, it can use the token as a marketing tactic to attract more users. Therefore, always be sure of the token you receive from yield farming.
timeline
New DeFi protocols often offer higher rewards to early adopters in efforts to increase liquidity. It also acts as an incentive to be willing to take a risk by investing in and using a new or untested product or service.
While early adoption can result in greater rewards, it is also a risky endeavor – the yield farming protocol may not be successful. Therefore, the money and time invested may not be recouped.
Yield farmers should carefully consider their options, considering all factors and other possibilities. Due to a possible token inflation and the resulting price drop, it is not sustainable for new DeFi protocols to offer high rewards over long periods of time, especially if they reward farmers with their native tokens.
team
As you search for information, watch out for errors on the main Yield Farming website – errors can indicate a careless or worse, fraudulent team. Ideally, the website should be well designed, free of typos or broken links, and look professional. Another way of assessing the reliability of a team is whether or not it is subject to regular audits by an external and independent auditor.
A team should be balanced, with a healthy mix of entrepreneurs, product managers, developers, software engineers, marketers, and finance professionals. It’s a bonus if the project also has renowned consultants on the board.
If possible, also conduct research on individual team members. First, check out their social media accounts to learn more about their past achievements as well as their activity on platforms like LinkedIn, GitHub, Reddit, TradingView, and YouTube.
How they interact on social media can be indicative of their skills, experience and influence. In general, an established team with a good reputation is less likely to run a scam.
Final Thoughts
Yield farming can be feasible Passive Income Strategy for those experienced in effective risk management. However, given the volatility of yield farming and the crypto markets in general, planning a robust yield farming strategy takes vigilance, effort, and time.
If you are considering yield farming, the above approaches can be used as a starting point to mitigate risk. Additionally, you should dig deeper and do your due diligence before investing in any financial opportunity.
Further reading
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What is Yield Farming in Decentralized Finance (DeFi)?
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A Beginner’s Guide to Decentralized Finance (DeFi)
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A Beginner’s Guide to Earning Passive Income with Crypto
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Why and how to do your own research (DYOR) when investing in crypto
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