Cryptocurrency holders can make a decent profit, for example, by farming, if they take the time to get acquainted with the chosen platform and invest a couple of tokens in the liquidity pool. Earnings on some DeFi-applications can reach 1000% per annum. Cool, isn’t it? And what are the risks in this case?
The main risks of farming
First, let’s list the main risks of farming, in which case you can lose part or all of your money:
- An error in the smart contract. When the 1000% annual yield was mentioned, it was referring to new decentralized applications that want to attract users and their funds. Their main method of attraction is a high interest rate. But you have to understand that since the application itself, offering to trust it with your tokens, is new, there is a high probability of accidental or intentional error in its smart contracts. Your funds can be lost forever, not to mention high potential income.
- The risk of hacking the smart contracts of the application. In this case, as in the previous one, the probability of a successful hacker attack on new decentralized applications is higher. And in DeFi services that have been working steadily for a long time, such risks are minimized.
- High volatility of cryptocurrencies. By investing your funds in farming, you freeze them temporarily and lose access to them. During this period, the rate of the cryptocurrency that you sent to the liquidity pool can change significantly, and not to your advantage. That way, you will earn farming interest, but you will lose on the depreciation in the rate of your tokens. You can decrease this risk by adding stablecoin to the pair.
- Impermanent loss is the loss of income in dollars on farming compared to the HODL investment in the same period due to the forced sale of your tokens by the exchange.
Impermanent Loss — in more detail
Unlike the first two risks listed in the previous section, which can occur on the rarest of occasions, cryptocurrency volatility and Impermanent loss are constant risks for those who earn from farming.
Let’s take a closer look at such a concept as Impermanent loss.
Impermanent loss is not necessarily your actual loss, but rather the loss of potential profit you would have made on a token deposit compared to farming.
Impermanent loss occurs when one of the token pairs invested in the liquidity pool becomes significantly cheaper than the other. Then an arbitration mechanism or other mechanisms related to the sale of your tokens will come into effect on a decentralized exchange. In this case, the ratio of tokens in the pair changes greatly and when you withdraw them you receive not what you invested.
That is, at a rate lower than the market rate will be exchanged the token, which went up significantly, for the second of the pair. For example, by depositing 5000 WTON and 2 ETH when the price of ETH rises significantly relative to WTON, you can withdraw 10000 WTON and 1 ETH.
In this case, you can win in dollar terms by withdrawing tokens from farming. But you would earn even more if you kept this amount in a deposit account all this time and ended up with 2 ETH and 5,000 WTON.