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 in exchange for rewards. Some yield farmers use all of them simultaneously. As with all crypto opportunities, yield farming is not without its risks. Impermanent loss, bugs in smart contracts or protocols, and exorbitant gas fees are some risks yield farmers face.
Hence, yield farmers must do thorough research before committing their funds to a yield farm. Some common ways to do so include investigating the team, security, type of token, and timeline associated with the investment. While DYOR (doing your own research) cannot entirely prevent crypto losses, it can help to mitigate risks.
In its simplest form, yield farming uses idle crypto assets to earn crypto interest. Through smart contracts, owners can lend their crypto to others and receive rewards in return. Within the decentralized finance (DeFi) ecosystem, there are a few ways to generate yield from crypto, the most common ones being:
Lending assets using a crypto lending protocol.
Staking cryptocurrency on a protocol.
Many yield farmers use one or more of the above methods to build a passive income stream. Like other DeFi opportunities, however, yield farming has its 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
Probably the most prominent risk in yield farming and the DeFi space in general is impermanent loss. When crypto owners participate in yield farming, they often lock up their crypto for a specified period, making those assets relatively illiquid.
Impermanent loss occurs when the price of your tokens changes from the price at which you deposited them into the pool. The bigger the change, the bigger the loss, regardless of the price's direction.
Although yield farming fees earned may help offset the loss, this is not always the case and can present a major risk. If you want to learn more, read our in-depth explanation of impermanent loss.
Smart contracts control DeFi protocols and a single bug in the smart contract code could cause the value of a token to plummet to zero. This risk is compounded by the fact that a malicious hacker could exploit the bug or security issue to manipulate the project.
Someone with bad intentions and the right skillset can create a DeFi platform and pass it off as a legitimate yield farming site. After all, DeFi projects are open-source, transparent, and permissionless, meaning anyone can copy the underlying code and create a new project. While early adopters are typically rewarded more handsomely, think twice before doing so, as high rewards come with high risks.
Newly launched yield farming platforms may be harder to research as user reviews and information on them tend to be limited. Be especially cautious with such platforms as you may be unable to withdraw your deposited funds or claim your rewards even if you change your mind after committing to such a platform.
High gas fees
When a network is congested, it usually leads to a rise in gas fees. Such unprecedented spikes affect yield farmers with less funds, as gas fees can eat into their earned fees. Even if they choose to leave their assets in the pool, other risks like impermanent loss and liquidation may still affect them.
Common Ways to DYOR
Ensuring the security of yield farming and DeFi protocols is critical in preventing malicious attacks. To reduce the risk of such attacks, it is essential to ascertain that a reputable source has audited the smart contract code. Look for DeFi projects that have had their smart contracts thoroughly audited.
Countless DeFi projects start by forking from successful DeFi protocols such as UniSwap. However, many fail due to network effects or a lack of liquidity, among other reasons. Worse, some are even deliberately created as scams. For example, a fraudulent team may create a fork, try to attract liquidity to it, 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 amount currently locked in the protocol. If the TVL seems suspiciously low, it's an indicator that even less capital is locked up in the protocol, which in turn means less yield for farmers.
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's essential to remember that a protocol can bind its token to its services in several ways. For instance, it may use the token as a marketing tactic to attract more users. Therefore, always be sure of what token you’ll receive from yield farming.
New DeFi protocols often offer higher rewards to early adopters in efforts to increase liquidity. It works also as an incentive for being willing to take a risk by investing in and using a new or untested product or service.
However, while early adoption may lead to greater rewards, it is also a high-risk venture — the yield farming protocol may not be successful. As such, the money and time invested may not be recouped.
Yield farmers should weigh their options carefully and consider all the factors, as well as other opportunities. Due to possible token inflation and the resulting price decline, it's not sustainable for new DeFi protocols to offer high rewards for long periods, especially if they reward farmers using their native tokens.
When browsing for information, look out for errors from the main yield farming website – mistakes can indicate a sloppy or worse, fraudulent team. Ideally, the website should be well-designed, have no typos or broken links, and look professional. Another way to assess a team's reliability is whether or not it is subject to regular audits conducted by an external and independent auditor.
A team should be well-balanced and comprise a healthy mix of entrepreneurs, product managers, developers, software engineers, marketing professionals, and financial experts. It’s a bonus if the project also has renowned advisors on its board.
If you can, conduct research on individual team members as well. For starters, check their social media accounts to learn 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 indicate their skillset, experience, and influence. Generally speaking, an established team with a good reputation is less likely to be running a scam.
Yield farming can be a viable passive income strategy for those experienced at effective risk management. However, given the volatile nature of yield farming and crypto markets in general, it requires vigilance, effort, and time to plan a robust yield farming strategy.
If you're considering yield farming, the aforementioned approaches can be used as a starting point to mitigate risks. In addition, you should dive deeper and do your due diligence before investing in any financial opportunity.