Just like any other crypto investment, yield farming is never risk-free. In the same way, droughts, floods, and pests can wreak havoc on a farmer’s harvest; some DeFi elements can reduce farmers’ yield. The primary risks come from smart contracts, exchange rates, price oracles, platform risks, and black swan events.
From Part I of this DeFi series, we have highlighted the benefits of yield farming in detail. Generally, we have learned that yield farming credit markets provide new ways for crypto investors to earn unbelievably good returns on their digital assets, almost 100 times better than the traditional finance system would offer. Besides, yield farming provides better returns than virtually any other conventional investment channel, from property to stocks to bonds.
Yield farmers can also turbo-charge their profits with liquidity mining. They obtain tokens from the companies borrowing their investments, on top of the high interest on their loan.
The Risks of Yield Farming
Yield farming is not as easy as some think. The most profitable yield farming tactics are too complicated and only recommended for experienced investors. Besides, yield farming is more advantageous to investors with adequate capital, such as whales.
Yield farming is not simple as it appears, and if you do not understand its ins and outs, you will probably lose your investment. If your collateral’s value dips below the threshold needed by the protocol, it may be liquidated on the open market. To avoid such a scenario, you will be required to add more collateral.
The other major threat of yield farming is smart contracts. Because of the DeFi space’s delicate nature, most protocols are designed and developed by small teams with constrained resources. Most teams avoid the debugging process; hence, the risk of smart contract bugs is high.
Even in the case of massive protocols that are audited by reputable companies, vulnerabilities and bugs are revealed most of the time. Because of the immutable nature of blockchain technology, user funds can easily be lost. You should consider this point when locking your funds in a smart contract.
Additionally, one of the primary benefits of DeFi is also its major threat. It is a concept of composability. Now, how does this affect yield farming?
Well, as we discussed earlier, DeFi protocols are permissionless and can flawlessly integrate. This implies that the whole DeFi ecosystem is heavily dependent on each of its building blocks. This is what people refer to when they say that these apps are composable- they can efficiently work together.
Then how is this a risk? Well, if one of the building blocks fails to work, the whole ecosystem will be affected. This poses one of the major threats to yield farmers and liquidity pools. Apart from trusting the protocol, you lock your assets in; you must also trust all the entire ecosystem it depends on.
Lastly, there is the risk of joining DeFi platforms with tender, unproven tokens that can quickly decline in value, making the whole ecosystem crash.
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