DeFi: Do you understand the risk? 🥊 (Part 1)
The is the first of a two-part series, talking about risks associated with DeFi and Yield Farming. In the next series, we talk about how to protect yourself from it.
DeFi Yields are definitely lucrative, but they entail a whole set of risks: from smart contract risk, exit scam risk, impermanent loss, to leverage risks. Let’s look at leverage risks in-depth.
People take leverage for granted. They underestimate the risk of leverage, and I won’t blame them. That risk is exacerbated when the leveraged trade is on-chain. The exponential gains and free money from farming food tokens have promoted this high-risk approach.
The yield farmers, interacting with a smart contract that rewards you for the capital invested with inflationary tokens, feel invincible seeing these gains over the last couple of months. That behaviour, however, should not come by turning a blind eye to downside risk. Ask anyone who opened a leveraged position on 12th March, and you will realize how you can wipe out two months of gains in a mere two hours.
Yield farming in DeFi is the first-in-first-out race since most of these yield tokens are unsustainable in the long run. The best thing is to do in such a scenario is to ride the wave, and minimize your risk.
It works because the winners or early farmers benefit the most by farming more than others (assuming for the same amount of capital). However, few participants understand the risks associated with these yield farming games. It’s like giving a Mercedes Formula One car to a normal person and asking him to drive; they will love the speed, but without proper risk management, they can lose their life.
Let’s explain with an example. In simple words, in DeFi, when you lock your capital and borrow, you are essentially trading on-chain derivatives. With proper risk management, you can ensure you minimize your downside, however, few do it.
To explain:
Let's say, you have 100 ETH (~$38,500), but to participate in yield farming, you need token A.
You can lock your ETH at a price of $385 per ETH, and borrow token A by paying an interest borrow fee.
The maximum amount you can borrow is decided by a metric “loan to value” LTV ratio - For example, if the collateral has an LTV of 75%, the user can borrow up to 0.75 of the principal currency for every 1 ETH worth of collateral (via Aave)
After you borrow, you need to ensure that you maintain a collateralization ratio i.e ratio between your collateral assets compared to any open loans. E.g Makerdao has a collateralization ratio of 150% for ETH v/s DAI.
After all this, you have to ensure that the reward (farm tokens) you receive is greater than the (transaction fees + withdrawal fees + borrow fee) fees you received from farming to turn a profit.
Why does it matter?
Risks are real and more complex because you need to track multiple asset prices to manage your risk.
If your positions fall below the threshold amount, you risk losing all of your collateral, which is 100% loss.
Chainlinkgod lists his best practices for DeFi yield farming:
The Big Picture
Yield farming, in the current form, allows for bootstrapping liquidity in a protocol and is a good token distribution method, yearn.finance ($YFI) is a great example of this.
However, few understand the risk while participating in it.
“You have to learn the rules of the game. And then, you have to play better than anyone else “
Now that you’ve understood the risks, next week we’ll look at how you can protect yourself against these risks.