The ascent of DeFi (Decentralized Finance) has introduced a new component into cryptocurrency markets: The ability to obtain an interest rate through depositing tokens in a decentralized protocol. This is commonly referred to as yield farming by the community.
Yield farming is attracting the interest of the investors particularly because of the disproportionately high interest rates that investors can obtain especially when compared to the traditional financial system.
However, these high interest rates come with their own set of risks that are frequently overlooked by enthusiastic newcomers. In the following we are going to analyze the most relevant risks that should be considered when constructing yield farming based portfolios.
The following types of risks can be identified when engaging in yield farming opportunities:
|Type of Risk||Description|
|Price Volatility||The risk that the value of the deposited token decreases.|
|Smart Contract Vulnerability||The risk that a security vulnerability in the smart contract protocol where the token is deposited is discovered. In the worst case this can result in the loss of deposited funds.|
|Compliance||The risk that exploiting the yield farming opportunity is illegal in the jurisdiction of the investor. The risk that you do not pay your taxes according to the laws of the jurisdiction you are operating in. Behaviour that is not compliant may result in significant penalties.|
|Security||The risk that the wallet which is used for yield farming purposes is compromised which may result in the loss of your funds.|
The volatility risk is certainly by far the biggest risk and therefore it makes sense to look into it in more detail. Several components are driving the volatility risk of the tokens used for yield farming.
|Types of Volatility Risk||Description|
|Market Risk||The risk that the overall cryptocurrency market decreases in value and therefore the tokens deposited in yield farming contracts are decreasing.|
|Ecosystem Risk||The risk that the ecosystem which you are using for yield farming experiences a loss of confidence from the market or a severe security incident.|
|Token Price Risk||The risk that the token which you are using for yield farming decreases in value in relation to other cryptocurrencies even in the same ecosystem.|
|Impermanent Loss Risk||This risk applies particularly in the case of liquidity providing: The risk that the price fluctuations of the token pair for which you are providing liquidity are high and you end up with a relatively higher allocation of the token that is decreasing in price.|
Risk Mitigation Strategies
For almost all risks mentioned above it is possible to develop strategies that help to control and reduce the risk. In the following we present the most widely used strategies for reducing the previously identified risks:
|Type of Risk||Risk Mitigation Strategies|
|Smart Contract Vulnerability||– Give preference to protocols that have been audited by independent third parties.|
– Give preference to protocols which have passed the test of time (track record without security incident).
– Diversify the tokens that you use for yield farming across a number of ecosystems and protocols.
– Acquire an insurance against a smart contract exploitation (e.g. through Nexus Mutual).
|Compliance||Investigate and adhere to the applicable laws for yield farming and taxation in the jurisdiction you are operating.|
|Security||Use hardware wallets (such as Ledger or Trezor) when interacting with protocols to add an additional layer of security.|
|Market Risk||– Give priority to stable coin based yield farming pools.|
– Hedge the market risk through short positions.
|Ecosystem Risk||Allocate yield farming deposits across a number of blockchain ecosystems. Allocate higher amounts to more trusted and established ecosystems (e.g. allocate significantly larger amounts to Ethereum mainnet in comparison to Polygon Network).|
|Token Price Risk||– Diversify the tokens that you use for yield farming across a number of ecosystems and protocols.|
– Use trusted stable coins for yield farming. (Note that some stable coins such as USDC are more trustworthy than others such as USDT).
– Use cryptocurrencies that have historically low volatility in relation to others (e.g. WBTC).
|Impermanent Loss Risk||Provide liquidity for stable coin pools or token pairs with historically low volatility.|
When analyzing risk mitigation strategies you realize that certain behaviours such as diversifying your yield farming activities across a number of ecosystems and protocols is something that helps you reduce a number of risks. In particular it reduces risks from smart contract vulnerabilities, ecosystem specific risks and token price risks.
It is certainly advisable to apply diversification to your yield farming portfolio. When determining how to diversify your portfolio take into account the maturity and size (TVL) of the respective ecosystems. As a result you may end up allocating significantly higher amounts to yield farming on Ethereum as opposed to Polygon Network.
Risk Tolerance and Acceptance
Strategies to reduce risks might not always be the preferred strategy for investors. In certain circumstances the interest rate of a protocol might be so high that an investor might be willing to accept all the underlying risks and nevertheless allocate a certain share of the portfolio towards that opportunity.
Furthermore, the acquisition of an insurance might decrease the interest rate obtained from yield farming so that it is no longer attractive.
In such situations investors are comfortable accepting risks without engaging in any strategy to reduce the risks. This behaviour is called risk acceptance meaning the investor is aware of the risk and accepts it. The level of risk tolerance is different for every single investor. Risk should ideally be measured in relation to the total portfolio.
In any case it is recommended that investors are understanding inherent risks and have carefully analyzed them before deciding if they want to accept the risks or mitigate them.