Yield farming is a term that’s on the rise in the cryptocurrency market. Whether you are an avid trader or a newbie in the crypto world, I’m sure you’ve come across the word yield farming at least once or twice. In simple terms, users are getting paid for using their favorite DeFi projects.
In today’s topic, however, we’ll focus on the risks and rewards of yield farming. But before we get started, do you know what yield farming is? If not, then let me break it down for you in a short section. But if you already know what this term means, then skip this section.
Yield Farming Guide: Brief definition
Yield farming is the general practice of staking and lending your crypto assets to generate high returns in the form of additional cryptocurrencies. More importantly, yield farming protocols are designed to incentivize liquidity providers to stake or lock their crypto assets in smart contracts. These incentives can be in a small percentage of the transaction fees or interests from the governance token. Generally, the returns are expressed in the form of an annual percentage yield (APY).
When investors add more funds into the yield, the value of the issued returns rises in value. Most farmers will stake stable coins such as DAI, USDT, and USDC. But today, most of the DeFi projects that are profitable are based on the Ethereum blockchain. The governance token on Ethereum offers what is known as liquidity mining.
To be more specific, liquidity mining only happens when a yield farming participant earns rewards with additional compensation. Additionally, most yield farmers are rewarded with governance tokens that can be traded on a centralized exchange such as Binance. Now that you understand yield farming, let’s take a look at the risks and rewards of this technique.
The Risks and Rewards of Yield Farming
1. Zero Balance
In the fiat industry, liquidity is provided by banks and other financial institutions. Banks receive a ton of cash via customer deposits. Then the bank will make a profit by lending the loans with interest rates or investing in assets. The DeFi technology makes it easy to manage liquidity transparently.
However, what you need to understand are the liquidation risks. The liquidation risks happen when the price of the collateral drops beyond the cost of your loan hence causing a collateral penalty. The liquidation will happen whenever the value of the collateral drops or the loan price increases.
2. The Smart Contract Risk
We all know that DeFi and yield farming runs on the smart contracts where the code is stored. More importantly, these processes happen on the blockchain you’ve executed the command and when certain conditions are met. Yield farming is controlled by smart contracts, which remove the middlemen compared to traditional finance methods.
Unfortunately, smart contracts are vulnerable to hackers who can explore bugs in the code. The tech team behind DeFi projects is now facing challenges to make the smart contracts impenetrable. The cost of executing smart contracts is incredibly high, with scalability and speed issues. Above all, smart contracts are also relatively slow at consensus times and transaction speeds. The biggest challenge with yield farming is that participants with small funds are at risk since the founders with significant investments have more control.
3. Gas Fees
Another significant challenge of yield farming is the increased gas fees. When the amount locked in the DeFi increases, it translates to a rise in the number of transactions. Most people used Uniswap to exchange their funds on the Ethereum network.
Within a short time, the gas fees reached a peak of 100X. And when the gas fees are high, the yield rewards will not be realistic for an average investor. Thankfully, Ethereum 2.0 promises to solve the high gas fee problem. Additionally, platforms such as Tron, BNB, and NEO have low gas fees.
4. Price Risk
Pricing is also another factor that you need to consider when you want to invest in yield farming. If you made a significant reward in the yield farming and the price of the tokens drop, so will your investment. Let’s say it drops by 200%, and you made a 100% reward. That technically means you are at a loss of 100%.
That’s, unfortunately, the fate of the cryptocurrency market. Therefore, only invest funds that you can spare. Otherwise, such drops could have a profound effect on your portfolio.
5. Strategy Risk
Some of the strategies involved in yielding include lending, loan pools, or arbitrage trading. The strategy will likely change over time depending on the platform. That’s because the best strategy today might not work tomorrow and so on. For instance, the loan pools might be saturated because of low liquidity within the network. That could potentially push the administrator to change their yielding strategies.
6. Rewards
With all the risks involved, yield farming still offers high returns to the investors. More importantly, yielding farming provides 100% better solutions compared to the banking systems. Above all, yielding farming also offers higher profit returns by turbo-charging your investment through liquidity mining.
Take Away Message
Without a doubt, yielding farming carries its set of risks and rewards, and it’s always advisable to understand both aspects of the investment. Today, all investment opportunities have both risks and rewards. It’s up to you to decide which option best works for you. If you are planning to use the traditional financial investment, you should consider trying the yield farming plan. That’s because, from what we’ve seen above, it offers better returns within a short period. Therefore, you will get returns soon, and you can use your profits to invest in other trades that carry fewer risks. Banks act as intermediaries, and sometimes, you’ll not get any returns from simply depositing your money in a bank account. Yet, the bank uses your cash as bank loans to potential investors and earn interest. So, would you rather have a transparent system of making a few passive coins on the side or deposit your money in a bank account? You choose!
