“There’s no such thing as a free lunch.”
Many newbies fall into the trap of depositing into the highest return pools with APY rates that go into the hundreds or thousands.
It is advisable to ask the following questions before depositing a single cent with the protocol:
- Have you done basic research about the protocol?
- Is the protocol audited? If so, by who? Can it be trusted?
- Is the website legitimate? Is it a simple fork and copy-pasta?
- How long has the liquidity pool been live? How much liquidity is there? How much is owned by the team?
- Can the team pull liquidity instantly to rug the project? Is the farming smart contract safe? Is there a timelock?
- How many users have deposited with the protocol? Are they genuine users?
- Is there utility for the rewards token? Is it a ponzi play?
Most high yielding farms would not have high APYs for a long-time as the market is efficient and would instantly price the risk of the farm. If the farm is less risky than the market but it is giving a higher return, net deposits will flow into the farm, bringing the yield down until equilibrium.
Yield Farming Risks
Yield farming is not risk free.
While it may be lucrative on the surface, it is important to understand their mechanics and how they work. The main risks towards yield farming are smart contract risk and impermanent loss risk.
Smart contract risk
Most of DeFi and staking run on smart contracts - programmable code stored on the blockchain that execute transactions autonomously.
If there are any bugs in the protocol’s smart contracts, it can lead to severe loss of funds. There are dozens of similar case studies of projects getting hacked and users losing all their deposited funds. For example, a bug in Revest Finance's smart contract caused a US$2m loss for the protocol.
Impermanent loss risk
Impermanent loss risk is a key risk when yield farming but often misunderstood.
It refers to the temporary (i.e. impermanent) loss of value due to price volatility leading to a divergence in price between token pairs provided into a liquidity pool.
Assuming a liquidity pool of ETH/USDC in a 50/50 ratio. The liquidity provider has to provide the two assets in the correct ratio. However, after deposit, the price of the volatile asset (i.e. ETH) might change, and arbitrage bots would remove ETH and deposit USDC into the pool. The profit from the liquidity provider has been removed by the bot.
Impermanent losses are extremely brutal if the percentage change in the price is very huge compared to when you first deposit. In the graph below, if the price of the asset in the pool changes by 400%, the liquidity provider would have experienced an impermanent loss of close to 22%.
Since most liquidity providers are compensated by token rewards and a small percentage of swap fees going through the liquidity pool, the actual loss is often smaller; but it's still something to take note.
The price of the asset that you're farming on can change dramatically in minutes. Even if you're farming an asset at a 900% APR yield, the price of the asset can fall 90% in days. This may still result in a net loss for the yield farmer if the price of the asset falls faster than the rate of earning rewards.
When liquidity pooling and adding funds into liquidity pool, you are betting that at the end of the day there is sufficient liquidity for you to withdraw your funds fromt the pool. However, this is not always the case as exploits can drain the pool's liquidity through various means like an oracle price manipulation in combination with a flash loan. When this happens, the resulting pool liquidity might be worthless (i.e. held fully in the worthless token).
While yield farming is a fantastic way of earning yield in DeFi, there are many risks associated with the sky-high projected yields that you come across. However, just like any investment opportunity, there are always risks.
As long as you are aware and fully understand the risks associated with yield farming, you can make a more informed choice about whether the farm is risky or not, and decide whether it is worth risking 100% of your funds for the projected yield.