The biggest risk that yield farmers deal with aside from scams is impermanent loss. Yield farming is not as simple as providing liquidity to a decentralized exchange and watching your profits increase over time.
In order to avoid losses, farmers have to monitor crypto markets just like any other trader or investor. But how does impermanent loss work and why is it such a big deal?
What is Impermanent Loss?
Impermanent loss refers to the process of temporarily losing funds while providing liquidity to a Defi platform. Experts often frame it as the opportunity cost between holding an asset as opposed to locking it in a liquidity pool. More often than not impermanent loss occurs in cases where liquidity pools require an equal ratio of two assets and one of them suddenly becomes volatile. If the asset’s value increases or decreases drastically since the time of the original deposit farmers will profit less than if they were to simply store it in a wallet and not engage with liquidity pools.
To sum it up yield farmers can expose themselves to risk when providing assets to a liquidity pool. Whether it’s that their cryptocurrency of choice lost or gained value while farming. It would have been a much better choice to hold on to the assets instead.
Also, think of it as a more advanced risk that is found when opening leveraged positions on a futures market. If prices head in the opposite direction of what you had in mind your position will temporarily be underwater as you start to lose money. If you make the decision to cut your losses by closing the position your losses will be realized but if you wait for the market to go back in the other direction you can close the position at break even and walk away without any losses. It is possible to avoid losses by either joining pools with relatively low volatility or pools with a high yield rate.
In the first case, the chance of facing impermanent loss is low since the assets themselves do not gain or lose too much value in a short time frame. By the time you’re done with yield farming, your realized losses will either be non-existent or small.
In the second case, the yield rate can be high enough to offset the losses incurred by impermanent loss. Liquidity pools use exchange fees to distribute rewards to yield farmers. It is possible to profit greatly from a sudden jump in trading volume. Even if you suffer an impermanent loss the money gained from farming will be enough to remain profitable. But keep in mind that determining future volatility is difficult since analyzing market conditions is hard for even the best traders. An asset that usually ranges might be going through an accumulation phase and could rise in value at any point in time. Therefore it’s important to be cautious when yield farming.
We also note that impermanent loss is only realized once you stop yield farming. If you expect that an asset is about to retrace from a sudden bounce or dump you can avoid all losses by only withdrawing your liquidity once prices are back to normal. certain Defi platforms are specially designed to minimize impermanent losses. For example, curve finance limits its liquidity pool offering to stablecoins and wrapped tokens both of which hold on to a stable price point.
Since there is little to no volatility it’s possible to yield farm without risking any losses. However, yield rates are much lower on these liquidity pools in comparison to ones found on other Defi platforms. What do you think is yield farming riskier than trading in a bull market let us know in the comments below.