What are the risks of yield farming? Good, Bad And The Ugly
DeFi is one of the hottest topics in the cryptocurrency space in recent months. DeFi projects promised to take away the power from the government and give it to the people. For example, loans can be obtained within seconds through DeFi platforms. It takes several days of filling tons of paperwork to be obtained through traditional financial institutions.
The DeFi space is growing, and many believers are staking on various DeFi projects. The major problem with participants of DeFi projects is that many of them don’t understand the risks associated with DeFi projects. Many scandals have happened in recent months related to various DeFi projects; the fear has grown in recent months.
Yield farming is one of the ways to benefit from DeFi. Yield farming is also a high-risk adventure. For DeFi to grow and for big institutions to participate, people need to understand the various risks associated with yield farming and how they can be managed.
Liquidation Risk: the possibility of zero balance
In the traditional finance system, liquidity is provided by financial institutions. Banks receive tons of cash through deposits from customers. Banks make a profit by lending loans with interest rates or by investing in assets. DeFi yield farming makes it easier for investors to manage liquidity transparently. Liquidation risk happens when the price of your collateral price has dropped beyond the price of your loan which causes a liquidation penalty to your collateral. Liquidation can happen when the value of your collateral drops or the price of your loan increases.
Smart Contract Risk
DeFi runs on smart contracts; smart contracts are codes stored on the blockchain that execute if certain conditions are met. Yield farming is controlled by smart contracts that remove the middlemen in traditional finance. Smart contact risk is high because a malicious hacker can explore bugs in the codes.
Ethereum co-founder Vitalik Buterin spoke about smart contract risk on Laura’s Unchained podcast.
“I think one big one is just that a lot of people are underestimating smart contract risk.”
Developers of DeFi projects are facing a lot of challenges in developing foolproof smart contracts. The cost of executing the codes is high, scalability and speed are other problems developers face in creating smart contracts. Slow consensus times and transaction speeds are limiting developers.
The greatest example of smart contract risk in DeFi happened in August this year when the Yam token price dropped from an all-time high of $167.66 to around $0.97. This drop in the token was caused by a bug that was found on the smart contract.
Yam finance co-founder Brock Elmore tweeted,
“I’m sorry, everyone. I’ve failed. Thank you for the insane support today. I’m sick with grief.”
“Fairness” amongst pool participants
Yield farming gives cryptocurrency investors the ability to participate in a liquidity pool. Borrowers and lenders can participate without any restrictions. But the question of fairness of the liquidity pools raised by the crypto community when the Suchiswap scandal happened.
An anonymous developer Chef Nomi forked Uniswap and created his own project called Sushiswap. It was almost the same concept as UniSwap is pretty the same except that liquidity providers and token holders are rewarded. A week later, Chef Nomi sold US$ Sushi tokens out of his founder’s reward for Ethereum, leaving 13 million worth of the token worthless for investors. He received a backlash from the crypto world because of his actions, with many calling his action an exit scam. He returned US$ 14 million and apologized in his tweet,
“I have returned all the $14M worth of ETH back to the treasury. And I will let the community decide how much I deserve as the original creator of SushiSwap.”
The problem with yield farming is that participants with small funds might be at risk because founders and investors with large funds have more control over the protocol than investors with little funds.
Price risk is a great challenge as far as yield farming is concerned. We gave an example of Yam token falling rapidly overnight. Let’s assume that a participant has gained significantly on the platform through his yield farming strategies. Let’s say 213%. He will surely be at a loss because the price of the token has dropped in the market. Another example of price risk is a loan. Suppose the price of the collateral falls below a specific price. The platform will liquidate the borrower before he gets the chance to return the loan.
Increased gas fees are one of the risks associated with yield farming. The increase in the amount locked in DeFi increased the number of transactions performed on the Ethereum network. More people we’re using the decentralized exchange Uniswap for exchanging their tokens using the Ethereum network. It was reported that gas fees reached around 100x during the highest peak of the DeFi season. If gas fees go higher, it means that yield farming might not be realistic for average investors. Ethereum has unveiled Ethereum 2.0 with layer 2 scaling which promises to solve the high gas fee problem on the Ethereum network. NEO, TRON, BNB also have lower gas fees.
Yield farming strategies include lending, arbitrage trading, or participating in loan pools. Yield farming strategies change over time. The methods which are the hottest today may not work tomorrow because of certain conditions. For example, loan pools might be saturated because of low liquidity on the platform. Arbitrage trading involves scanning multiple exchanges to take advantage of price inefficiencies. Arbitrage trading may no longer be profitable if volatility decreases.
Yield farming is a powerful way of earning profit from DeFi platforms. Yield farming risk can be managed when an investor is aware of the various risks associated with yield farming. You have learned about the risk associated with yield farming from this article. You can easily decide if yield farming is right for you.
The views, thoughts and opinions expressed here are the authors alone and do not necessarily reflect or represent the views and opinions of BlockGeeks.
This article was authored by Aly Madhavji.
Aly Madhavji is the managing partner at Blockchain Founders Fund which invests in and venture builds top-tier startups. He is a limited partner on Loyal VC and Draper Goren Holm. Aly consults organizations on emerging technologies such as INSEAD and the UN on solutions to help alleviate poverty. He is a Senior Blockchain Fellow at INSEAD and was recognized as a “Blockchain 100” Global Leader by Lattice80. Aly serves as a board member of CryptoStar Corp. (TSXV: CSTR) and has served on various advisory boards including the University of Toronto’s Governing Council.