In Part 1 of our article series on yield farming, we explained a few things. Among others, we talked about what yield farming is. Furthermore, we looked into TVL and how to calculate APR or APY.
In this second part, we look into some potential risks. We will also have a closer look at some popular yield farming protocols. Let’s dive straight into it.
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What Are Potential Risks With Yield Farming?
The higher the yield, the more complex and riskier DeFi strategies become. Let’s have a look at these risks with some explanations.
Yield Farming Risks
- Smart contract risk or bugs — DeFi is a competitive space. As a result, protocols don’t always have their new smart contracts audited. In other words, they want to get their new smart contract out asap. These smart contract hacks are the most common hacks in the DeFi space.
- Rug pulls — This is when the team or developers behind the platform drain all the liquidity. Thereafter, they do a runner with all the funds.
- Regulation — DeFi is set up in a decentralized way. This means that there are no middlemen or third parties involved. Also excluding any regulatory bodies, like government departments. However, the SEC is already looking at DeFi since some assets may be securities. This is an interesting development to follow and see how this will pan out.
- Volatility — Crypto is a very volatile space. Token prices can change swiftly, either up or down. Since you locked your tokens in a smart contract, you can’t get them out. This is risky when the price of a token drops.
- Impermanent loss (IL) — This is when the price of a token in a liquidity pool changes. The ratio of the available tokens in the pool now also changes. The value of your token in the pool is now less compared to if you hadn’t deposited that token into a pool. You would have been better off not investing in a liquidity pool. CoinGecko has an impermanent loss calculator. There are other apps that offer IL calculators for when there are more than two tokens in a pool.
- Liquidation — This is when your collateral drops below a certain threshold. This threshold no longer covers the collateral. You can either increase your collateral or get liquidated. As a result, you lose your collateral.
What Are Some Popular Yield Farming Platforms?
Here’s a list of some popular yield farming platforms with a short explanation.
- Uniswap — This is a DEX on Ethereum that uses P2P trading. The protocol works with liquidity pools. You create a market by investing two tokens in a 50/50 ratio. The reward is a percentage of the trading fees and their governance token, UNI. Similar DEXs are PancakeSwap on the BNB chain or Trader Joe on Avalanche. Many L1 chains have their own DEX.
- Aave — A lending and borrowing protocol for stablecoins. It’s noncustodial and decentralized. You can borrow assets and receive a compounding interest for lending. This is in the form of the Aave token. Similar protocols are Compound, Benqi on Avalanche, or Solend on Solana.
- Curve — This DEX allows for pegged assets, like stablecoins. Their APY is around 10% with rewards as high as 40%. Impermanent loss is usually no issue with stablecoins. As long as the stablecoins remain pegged, these pools are low risk. Their largest pool is the 3-pool with DAI, USDT, and USDC. They just started a 4-pool, which included UST, that was at the base of the UST crash. Read about this in our article.
- Yearn — This is a liquidity aggregator. You can join automated yield farming strategies. These cover a variety of loan pools. Their best-known pool, Yearn.finance, moves tokens around various DeFi protocols. This way you get the highest yield possible. You can earn the YFI token as a reward. Other aggregators are Beefy or Barnbridge.
- JustLend — This Tron-based protocol offers 30% APY on their newly launched USDD stablecoin. Like the Anchor Protocol did with the now almost defunct UST.
Some Tips on Yield Farming
Before you take part in any yield farming, make sure to do your own research. You can also ask yourself a few questions before you start.
- Is the protocol established?
- How do they generate the yield?
- Did the protocol have an audit?
- Does the protocol have enough liquidity?
- How high is the risk for impermanent loss?
- Is the blockchain on which this protocol runs trustworthy?
This is it for the second part on the yield farming topic. Yield farming has benefits, since staking or lending is low risk. It also generates a revenue of passive income. However, a greater yield may lead to more complex strategies. In turn, this may lead to a higher risk.
We explained some risks involved with yield farming. Make sure that you understand these risks before you start yield farming. Furthermore, we showed you a variety of yield farming protocols.
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