Yield farming has become hugely popular since the growth of DeFi with over $50bn worth of assets engaged according to Defi Llama.
Farming is great because it can provide you with an additional revenue stream and help with things like combating inflation. However, as with any experimental technology, there are risks to consider and manage carefully. There have been a number of losses and exploits throughout the last few years.
Here is our guide on how to prepare and manage risk within yield farming:
Defining Yield
Yield farming is a blanket term for investment opportunities that generate returns in crypto. Not all yield farming opportunities are built equal and have their own risk.
These are the main types of yield opportunities in crypto:
Lending protocols
The most successful Lending protocols in crypto are collateralized, that means when someone borrows money, they are putting up another asset of at least equal value. This means reduced risk for a lender compared to traditional markets. Protocols like Aave are a good example here.As long as there is demand for the asset, you can generate consistent returns here, not many assets are heavily desired though only Stablecoins, big currencies like BTC, ETH & SOL and some others.
Liquidity Provision for AMM’s
AMM’s like Uniswap, Orca and Raydium are really powerful because they let you automatically swap assets without a direct buyer on the other end. In order to do that though, they need liquidity stored. Thats where the farming opportunity comes in as AMM’s will often give the fee’s and additional tokens as rewards and incentive for people to participate.
Liquidity provision programs are popular for bootstrapping new tokens and while they might have huge APY, because they are at their early stage, there hasn’t been sufficient market discovery and its likely that most of their supply is not circulating which means that there can be huge risk of sell pressure long into the future. With more mature assets, this is less of a risk but they can still fluctuate in value which can impact your total capital value.
Impermanent loss is a risk though, the maths of the algorithm can mean that big price fluctuations can short change a user as arbitrage opportunities become available. Stablecoin AMM’s are safer though because the assets can’t move much between each other 1 USDT should equal 1 USDC for example (unless a depeg event happens)
Staking
Staking like Lido and Marinade which tap into the network to obtain assets are a slightly different from others because they are designed to help secure the network and ensure they run properly and have direct rewards from the protocols.
It means there is some form of intrinsic value and purpose that you sometimes don’t get with an early stage token, it gives them better chance of being a sustainable long term yield opportunity as long as the network continues to draw interest from other users.
Sometimes these can be subject to lockup periods and penalty's for early withdrawal, so make sure to check before committing.
One extra note: the type of asset you have will impact which of these opportunities are available. Low cap coins won’t have as many opportunities and likely to be more volatile. For example, a new currency might only have LP on AMM’s which is one of the riskier forms.
Researching Risks
Risks are everywhere in crypto. Here's an attempt to summarize the major types of risks but we'd encourage you to still conduct your own research into and beyond these:
Functionality risks
Activities such as borrowing and using options all have liquidation risks which means that you and/or the protocol generating yield has a chance of of losing the actual assets you own. These techniques are often fine but can open up the risks of attack. Be careful with experimental mechanisms. For example, redemption rules like Terra's 1:1 LUNA/UST created a tragic death spiral where over $15bn was lost virtually overnight. Sometimes going with more established protocols for certain yield generations are the best even if they do have slightly less returns because they have the most tried and tested methods.
Technological risk
1. Hacks: Audits, past stress tests and protocols running successfully for long periods of time are good indicators but not confirmations that a protocol is secure.
2. Custodial Risk: Does anyone else have control over the funds aside from smart contracts?
3. Liquidity risk: Are there lockup terms that mean you can’t get assets out instantly? Is the protocol itself engaging in lockups? Celcius has encountered its issues because it locked away large amounts of its users funds in ETH.
Governance structures
Understanding who has control and influence within the protocol is also valuable. Most governance systems prioritize those who own the most tokens. In times of crisis, these people can look out for their own backs first. For example, MakerDAO governance decided not to compensate users for the liquidation crisis that happened in march 2020. There will always be risks in this area because people are unpredictable but its worth taking the time to understand how a protocol makes decisions and might behave so that you can protect yourself most effectively.
Structuring your yield farming opportunities
Even when you’ve found an ideal strategy, you shouldn’t go all in. Diversification is one of the simplest and most effective techniques you can use. Its worth considering diversification on these levels:
- Asset Class Diversification: A lot of crypto moves very similarly over time. It might actually be best to consider allocating some money to slightly more traditional investments, even if they do have lower returns.
- Asset diversification: Many assets can generate some form of yield within crypto with different pro’s and con’s. Splitting up this way reduces risk around specific currencies (i hate to keep bashing luna but like luna for example)
- Yield diversification: Splitting an asset across multiple yield opportunities further reduces the chance of you being caught out and losing significant portions of your capital.
Management of funds
Very few crypto protocols have experienced any kind of longevity. Aave & Curve are some of the only ones who’ve produced consistent gains over the last few years with hundreds falling by the wayside over the same period of time. Here are things you should consider doing to maintain your funds well into the future:
- Monitoring/Alerts for hacks and upgrades to the protocols you are using. Discord best for instant news but is likely to be unverified. Twitter will provide more official alerts by protocols and you can also set notifications.
- Keeping on top of the latest yield opportunities.
- Taking returns out of the yield protocol you are using and deploying the profits elsewhere. It might be best just take out profits completely as a Stablecoin reserve regardless of how confident you feel about the yield positions.
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