Yield Farming: Risks and Rewards

pile of leafed plants
by Advice Chaser
by Advice Chaser

The crypto space, while exciting, is an area where it’s hard to stay informed. New financial tools pop up there all the time, and fortunes are made and lost before there is much reliable information about them. One popular new process is called yield farming. This allows cryptocurrency to function more like a bank does, where you can deposit money for interest. However, it’s important to note that it does not come with the security you expect from a bank account.

pile of leafed plants

What Is Yield Farming?

There are several different ways to put up a certain amount of crypto and earn a percentage on it. However, they aren’t all the same, and not all of them work like a bank account. Generally, they take place through a decentralized finance (DeFi) platform or a cryptocurrency exchange.

The most simple method is using a lending protocol. This works very much like a bank: you deposit crypto, other people borrow it, and you’ll earn interest. The risk and interest involved will vary quite a bit.

A more complex option is providing liquidity for a cryptocurrency exchange. You provide a pair of tokens from different cryptocurrencies, which allows users to easily exchange one type of coin for another.

Somewhat different, though with similar results, is staking. While most crypto is mined using proof of work, meaning many computers have to work on mining it, a few are based on proof of stake. That means simply having your money invested in the currency and pledged to a blockchain protocol gives you a chance at completing the next block in the chain. If this happens, you’ll receive an award in crypto.

Risks and Rewards

The advantages involved in these practices are obvious. You can earn dividends on your cryptocurrency while still continuing to hold it. And in some cases, the promised rewards can be very high—even over 100% annually. Who wouldn’t like to double their money?

Of course, if you know anything about investing, it’s that high rewards always come with high risks. In yield farming, those risks won’t always be disclosed to you. You can lose money in any number of ways. The obvious one is that those who borrow your money won’t give it back, which is the risk you take with any kind of loan.

Next, the yield farming opportunity may in fact be a scam. Sometimes they operate like Ponzi schemes. Some end in rug pulls—the operator of the yield farm leaves the business and takes your coin with them. This is sadly common. 

In all crypto transactions, you’re at risk from volatility. If the crypto you’re using loses value, you’ll lose money no matter how much of it you manage to earn. And by locking your money up in a yield farm, you lose the opportunity to move it into better currencies based on the state of the crypto market.

What Are Smart Contracts?

One danger of yield farming lies in the very contracts that set it up. Instead of a legal contract, crypto arrangements are often enforced by a “smart contract,” which is not really a contract at all, but a program stored on the blockchain. When the right conditions are met, the program self-executes and you automatically get what you were promised. Sounds foolproof, right?

Unfortunately, just as legal contracts can sometimes hide unfavorable terms behind the pages of legalese, smart contracts can also conceal their true purpose from the average user. There might be backdoors built in, or the contract could be hacked by a third party. In the worst cases, you could lose not only your initial stake, but the entire contents of your crypto wallet.

It’s often hard to fully grasp what no regulation means. People today are accustomed to banking regulations, deposit insurance, and money-back guarantees. It sometimes takes falling prey to a scam or two before they realize that there is usually no recourse when you lose money on crypto, even if your money was lost to outright theft.

A Financial Wild West

Decentralized finance is like the Old West—no regulations, no money-back guarantees, and no safety nets for the unwary. Getting in on a new thing can make the quickest profit, but the nature of new things is to be untested and sometimes dangerous. That’s what makes crypto and DeFi so high risk, even while the advertised rewards are so tempting.The wisest course, if you invest with anything more than loose change, is to talk to a professional who can guide you. While most financial advisors focus on long-term investments like retirement funds, some advisors have expertise in crypto spaces as well. We can connect you with an expert with the knowledge you need when you contact us.

Interested in more?

Your financial plan is as unique as you are. We partner with businesses all over the U.S., so that we can help you connect with the right options, all at no cost to you.