In several of our recent articles, we have discussed yield farming. I published the yield farming guide and then created a tutorial on how to do yield farming on Ubeswap. As explained in those articles, it is quite profitable. However, there are several risks of yield farming.
Any investment that offers medium to high rewards has risks, and yield farming is no different. That is why in this article, I will show you the risks of yield farming and liquidity mining so you are clear on what you’re going into before you proceed.
If you don’t know what yield farming is, click on any of the two links above to find out. I recommend you click on the first one and read through it before proceeding to the second.
What are the Risks of DeFi Yield Farming?
Here are the risks associated with yield farming:
- Risk of Impermanent Loss
- DeFi Smart Contract Risk
- Risk of Scam
- Gas Fees
- Bugs in the Code
- Price Risks
- Strategy Risk
Risk of Impermanent Loss
Impermanent loss is one of the biggest risks of yield farming.
When farming yields on your assets, you add liquidity in pairs of equivalent value; if you add one ETH in an ETH/USDC pair and 1ETH is 2000 USDC, you must add 1ETH and 2000 USDC.
Suppose the value of ETH falls to 1000 USDC, the coins in the entire liquidity pool shifts to make up for that. When you have a huge loss in any of the coins in the pool in such situations, you can end up with an impermanent loss where you get a lower value than what you put in when you withdraw your liquidity.
The profit from farming yields on your cryptocurrency assets sometimes make up for the loss, but it doesn’t always. Given the volatility of cryptocurrencies, you can be faced with this risk any time the value of a cryptocurrency drops. However, it only happens when the difference in value drops a lot.
DeFi Smart Contract Risk
Smart contracts control yield farming and DeFi. One bug in the smart contracts can cause the price of a token to drop to zero. A malicious hacker can exploit that bug to manipulate the project for any possibility, including losing all your cryptocurrency assets in the pools affected. To mitigate this risk, confirm that the smart contract has been audited.
Yield farming pools are controlled to a large extent by the founders and wealthier investors. That puts yield farmers with small funds at risk because if a wealthier investor takes out a large chunk of their investments, it can affect the platform.
One good example of this is what happened with Sushiswap. It fell quickly because the founder, Chef Nomi, removed his liquidity which ran in millions from the SUSHI/ETH pool. That caused a 73% crash in the price of SUSHI tokens which, of course, affected anyone holding the coin, including yield farmers.
Risk of Scam
When considering yield farming pools and applications to use, you need to be careful. Anyone can create an app for yield farming if they have the necessary skills. You must ensure that you are not using an app that isn’t properly vetted or the owners aren’t known.
Even then, you might still fall to this risk. The reason is that you get higher rewards from new protocols and applications; anyone that jumps on such in the first few weeks of launch can make a lot. When such things are new, you can’t get reviews or comments from actual users.
You can still check online for comments because, in most cases, there would be some publicity about the app before they launch any liquidity pool. So, check GitHub, Twitter, and Reddit to see if there are negative comments.
Gas fees on Ethereum are high – this is one fact that no one can debate. This is a problem for DeFi yield farming, especially for investors with smaller funds; wealthier participants might not mind.
When a lot of people take advantage of a yield farming opportunity and lock a lot of cryptocurrency in DeFi, gas fees skyrocket. In 2020, this was a big issue where gas fees reached over 100x more than usual due to yield farming activities on Uniswap.
When such happens, those with fewer funds would realize it’s costly to withdraw their earnings and might end up losing money if they try. If they choose to leave the cryptocurrency in the pool, any other risks, such as impermanent loss and liquidation risks, can lead to a loss. Ethereum 2.0 with layer two scaling aims to solve this problem.
Bugs in the Code
Every app has bugs. Even when the developers do their best to ensure they don’t, they can miss some of these things. For most top applications, such bugs don’t cause much impact most of the time, but sometimes they can be serious. A malicious actor can exploit such issues to their advantage, making all investors in the yield farming pool lose their money.
This risk is not particular to farming yields on your cryptocurrency assets; it can happen to any crypto investor. As long as you hold crypto, you are liable to the risk of losing your money. Price changes happen a lot in the market. If the value of the coins in the pair you provide liquidity for lose value, you would lose some of your money,
There is also the aspect of the token. Some yield farming platforms offer their token as part of the rewards to yield farmers. If the value of the token falls, what you expect as returns for your investment reduces.
To give a clear picture of the above, here’s this example. When farming yields on your assets in Ubeswap, you get UBE. If UBE was $5 when you invested but a few weeks later, it is $1, what you get in fiat is way different from what you expected at the time of your investment.
When doing yield farming, your strategy matters. You have to decide on what kind of pair to invest in. A hot pool today wouldn’t be hot in a few weeks from now.
Here’s the thing: if a pool provides 2000% returns which usually happens at launch, in a few weeks, that can drop to 300% because more money would have been pooled in by then. People would find out about that pool and invest, and as more people invest, the returns would reduce.
Although yield farming can be passive, you need to monitor your investment periodically, follow crypto news and us (subscribe for email updates), so you can pool out of a pool and invest in a better one when you need to.
You also look at the market’s volatility as that can affect your capital and returns. If you weren’t sure about a coin but invested only because of the high returns and the value is falling fast, you might decide to pool your investments in another pool.
Yield farming can be long term, so you shouldn’t have to jump from pool to pool. Strategize wisely, and you will enjoy the returns from your crypto assets.
That is it for the risks associated with pulling your cryptocurrency in a yield farm. You can grow your cryptocurrency assets, whether Bitcoin, ethereum, Celo, and other cryptocurrencies in the blockchain. It’s a great way to grow your cryptocurrency rather than leaving it to sit in an exchange or wallet.
I hope you take the suggestions in this article to mitigate your risks, so you earn more than you lose most of the time. Bear in mind that every good investment has risks; you just need to know how to mitigate them to reduce their impact.
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