Yield Farming, a new way of making money out of thin air, has become trendy this year. Users are offered high returns for participating in DeFi projects and staking their assets to provide liquidity.
Unsuspecting users are led to believe that yield farming is free money and a lucrative way of having a passive income. This is not entirely accurate because high returns are oftentimes accompanied by high risks.
Impermanent loss risks, smart contract risks, scam risks are just a few examples of risks that yield farmers should be aware of before investing their coins into a new hot thing.
Citing recent examples where huge losses of crypto assets have been lost, this article will discuss the risks arising from yield farming.
How do crypto holders experience losses with yield farming?
Yield farming can be incredibly complex and carries significant financial risk for borrowers and lenders. Cybercriminals use loopholes to outsmart algorithms and steal money. This threat is real, as DeFi protocols lose billions of dollars to hack attacks.
Last year, FXStreet reported that hackers stole over $100 million from the DeFi sector, and the losses are mounting. The risks which lead to losses of investor funds include;
When farming yields on your assets, you add liquidity in pairs of equivalent value; if you add one ETH in an ETH/USDC pair and 1ETH is 2000 USDC, you must add 1ETH and 2000 USDC. However, crypto is volatile and can affect the fiat value of your coins at the end of the day.
Suppose the value of ETH falls to 1000 USDC, the coins in the entire liquidity pool shift to make up for that. When you have a huge loss in any of the coins in the pool in such situations, you can end up with an impermanent loss where you get a lower value than what you put in when you withdraw your liquidity. This is known as impermanent loss. It is one of the biggest risks of yield farming.
Yield farming is susceptible to rug pulling, where the developers withdraw all liquidity from the pool and abscond with funds.
In April this year, the CEO of the popular Turkish cryptocurrency exchange Thodex disappeared, allegedly committing a fraud of $2 billion. According to Bitcoin.com, 30,000 of the 390,000 active users of the platform were affected by this rug pull.
Hacks and fraud due to possible vulnerabilities in the protocols’ smart contracts
New smart contracts and features are often unaudited, leading to code bugs that could encourage hackers and exploit vulnerabilities, leading to the loss of investors’ funds.
In early October, Compound (COMP) users were mistakenly awarded $90 million worth of COMP tokens due to a faulty code. This was after a code upgrade went wrong. The price of Compound’s native token, COMP, plunged nearly 13% after the news of the bug.
DeFi protocols are permissionless and dependent on several applications in order to function seamlessly
Smart contracts control yield farming and DeFi. One bug in the smart contracts can cause the price of a token to drop to zero. A malicious hacker can exploit that bug or security issue to manipulate the project for any possibility, including losing all your cryptocurrency assets in the pools affected. If any of the underlying applications are exploited or don’t work as intended, it may impact this whole ecosystem of applications and result in the permanent loss of investor funds.