COINCU on Binance Feed: Crypto 101: What is Yield Farming in Decentralized Finance? (Part 2)

In the previous article, we learned about the concept of yield farming, how it works, and the ways of farming today. In this article, you will learn how to calculate the profit and risk involved. How to calculate yields from yield farming?

Expected returns are commonly used. Expected returns are estimated over the course of a year.

Annual Percentage (APR) And Annual Percentage Return (APY) are two commonly used measures. The difference is there The APR doesn’t account for the effect of compounding, but the APY does. In this context, compounding means reinvesting profits to generate further returns. Note, however, that the terms APR and APY can be used interchangeably.

Keep in mind that the two measures are only forecasts and estimates. Even short-term benefits are difficult to predict accurately. Yield farming is a highly competitive, fast-moving sector with ever-changing incentives.

If a yield farming approach works for a while, other farmers will use it, and eventually big profits won’t be made.

DeFi must therefore develop its own earnings estimates APR And APY are outdated market measures. Due to the high speed of DeFi, weekly or even daily return forecasts might make more sense.

The risks of yield farming

Profit-oriented agriculture is not easy. The most successful yield farming tactics are extremely sophisticated and should only be used by experienced farmers. In addition, yield farming is often better suited to individuals who have a lot of money to invest (e.g. whales).

Yield farming has enabled a variety of decentralized applications, each offering its own value proposition and variation on the original architecture. Greater benefits than consumers might expect from traditional finance come with a number of risks, however.

Hazards associated with yield farming include, but are not limited to:

Smart Contract Risk

Blockchains are often considered to be very secure platforms for conducting financial transactions. However, the underlying business logic of smart contracts depends on code quality and the expertise and experience of specific development teams.

Smart contract vulnerabilities, hackers and protocol exploits can appear in the DeFi ecosystem, exposing depositors to loss of funds. Peer-reviewed open-source code, security reviews, and excellent testing practices help developers mitigate this risk, but caution is always advised.

liquidation risk

Some yield farming tactics use leverage to maximize the risk of a liquidity mining opportunity, exposing the user to liquidation risk (funds being sold to pay off the debt).

In addition, during times of extreme market volatility and network congestion, the risk of liquidation increases as collateral build-up to avoid liquidation can become prohibitively expensive. If a user chooses a strategy that involves leverage, he should consider this danger; otherwise, they should opt for non-leveraged alternatives.

systemic risk

Due to the modularity of the smart contract ecosystem, a given DeFi application can be based on numerous DeFi protocols, increasing the potential risk of a smart contract failure in just one of them. Additionally, even if a smart contract is secure on its own, it may not be if improperly stacked with other contracts. Understanding the procedural vulnerability of a position is critical to mitigating excessive risk.

Ephemeral Loss

The difference in value over time between inserting tokens into a multi-token pool in a Automated Market Maker (AMM) For yield farming, simply storing those tokens in a wallet is called a temporary loss. If the price of the tokens in the liquidity pool deviates in one direction or another, this loss occurs.

The ‘Loss’ is synchronized ‘unstable’ because it disappears as soon as the price ratio between the token pairs in the pool returns to its value at the time of deposit. However, such a condition is rare, and losses in other situations are permanent. Various protocols offer mitigation strategies for transient losses, while other protocols are unaffected by this risk.

“Rugpull” hazard

A “rug pull” is a circumstance where enemy players start a token to get as much value as possible before ending the project. Rug pulls can be done in a number of ways, including eliminating a large portion of the liquidity from a market AMMBlocking sales in the token contract, minting a large number of new tokens and more.

Before committing to any newly launched project, DeFi users should assess the dangers associated with early-stage initiatives and conduct their own due diligence.

To learn more about this topic, you can continue here.

DISCLAIMER: The information on this website is intended as general market commentary and does not constitute investment advice. We encourage you to do your own research before investing.

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