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Risk Management in DeFi: Yield Farming

zildfinance profile image ZILD ・3 min read

Yield farming, also known as liquidity mining, is gaining popularity in the cryptocurrency industry. It includes receiving reward tokens in exchange for blocking or placing cryptocurrency. The concept of growing crops came from the decentralized finance (DeFi) space. As the DeFi space began to gain traction, the concept of growing crops is gaining attention in the cryptocurrency industry.

The growing popularity has led to the emergence of various projects offering the return of rewards in the form of new cryptocurrency tokens by growing crops. However, while there are certain benefits to rewards, farming carries risks and dangers. In this article, we explore the basics of growing a crop and the risks it poses for crypto farmers.

How is that related to DeFi?

Decentralized finance includes an ecosystem of blockchain applications in the banking and financial sector. One of the DeFi applications is lending and asset borrowing. Using a profitable farm, users can lend their crypto assets to various DeFi projects and in return receive rewards in the form of their own cryptocurrency tokens.

A crypto farmer can invest their cryptocurrencies such as Ethereum in DeFi projects and receive interest, rewards or bonuses. However, while the concept seems simple, it carries a fair amount of risk later on. Moreover, if the farmer growing the crop is not careful, he could subsequently lose his crypto assets.

Liquidation Risks

Cryptocurrency assets are inherently volatile. Massive and sudden drops in crypto asset prices are common in the industry. Borrowing secured assets from different platforms such as Compound or Aave could void your collateral. Due to the volatility of cryptocurrencies, your assets can be liquidated in case they no longer cover your loan.

Alternatively, even if your loan amount increases, it could lead to the liquidation of the cryptocurrency asset that you have held as collateral in exchange for borrowing.
To avoid liquidation risks in relation to farm yields, borrow or supply assets with lower volatility. Stablecoins like Tether carry less risk even if liquidated.

Impermanent Loss

In liquidity mining, farmers provide liquidity to pools like Uniswap and in turn receive income from decentralized exchange fees. Hence, liquidity providers provide liquidity in the form of crypto assets to the DeFi protocols in exchange for a return.

However, in some cases, the farmer growing the crop may lose money compared to owning the asset. Uniswap also considers this to be a volatile loss due to the divergence of prices for cryptocurrency assets.

Smart contract risks

Another danger of farming is the risk of exploitation in the code of smart contracts. Crop farming involves the provision of your funds in the form of a smart contract that automatically works in accordance with predetermined factors. However, if a DeFi protocol smart contract is hacked or used, an attacker can manipulate the project. This can lead to the loss of your cryptocurrency asset.

According to a recent survey, almost 40% of DeFi users fail to understand smart contracts used in protocols. The unaudited smart contract code has even led to attacks on various DeFi projects. One recent example of such an attack is Yam Finance.
While the project raised nearly $400 million in DeFi tokens, the value of its own token dropped to zero when a major flaw was discovered in its smart contract code. Such security threats and unaudited smart contract code carry risks when growing crops.

Conclusion

While there is no doubt that there are potential benefits from productive agriculture, there are a number of challenges that remain to be addressed. One of the challenges in this area is the scalability of the Ethereum blockchain. Since most DeFi apps are built on Ethereum, this has resulted in transaction clogging and gas charges.

The field of profitable farming and decentralized finance is relatively new. It certainly fosters innovation in the financial ecosystem with a variety of applications. However, it may take testing and time before it is optimized for the best use.

That’s why it is of high importance to rely on securely designed, incentive-tailoved and transparent protocols, as Zild Finance. Check out our website.

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