Four Ways to DYOR on DeFi Yield Farms

As one of the growing digital trends in the crypto and decentralized finance (DeFi) landscape, yield farming offers a unique way for users and investors to generate funds and earn high returns by lending their tokens to liquidity pools. By staking tokens within a protocol, investors earn interest rates that are significantly higher than those typically offered by traditional banks on savings accounts. Despite the potential of yield farming, it is also laced with several risks, showing the importance of doing your own research (DYOR).

In this article, we will discuss how to do your own research (DYOR) through diligent research and investigation to help mitigate common risks associated with yield farming.

What is DeFi Yield Farming

Yield farming is a concept that allows investors to earn passively by contributing their digital assets and locking them within a DeFi protocol for a certain period of time. It is an effective way to utilize idle tokens, leveraging them to facilitate lending and governance within a network. By lending their assets or tokens to other crypto users, investors earn interest as incentives through smart contracts. Other options to generate a yield from a decentralized finance network including:

Engaging in a crypto lending mechanism to lend digital assets to other users.

• Becoming a liquidity provider within a DeFi protocol and receiving liquidity provider (LP) rewards.
• Staking idle tokens on a protocol.

Risks of Yield Farming

In yield farming, reviewing the total value locked and investigating the past projects of the teams involved are essential due to the inherent risks. While blockchain and decentralized finance (DeFi) may revolutionize finance and wealth creation, they are still prone to several risks. We will examine these risks to understand why doing your own research (DYOR) is crucial.

Impermanent Loss: This is a primary concern for investors in yield farming. When assets are locked within a protocol, they become illiquid and cannot be interacted with during that period. Impermanent loss occurs when there is a significant price divergence in the assets of a liquidity pool from the time they were deposited. The greater the price movement of these tokens, the higher the potential for incurring a loss.

Hacks: Smart contracts are the foundation of DeFi protocols, yet even a single vulnerability can make a network susceptible to hacks. These security breaches can lead to significant financial losses and may cause the price of the associated tokens to plummet. A compounding risk is the potential for malicious actors to manipulate and exploit any discovered vulnerabilities.

Scams: Most DeFi protocols are open-source, permissionless, and transparent, which, while promoting transparency, also makes them prone to attacks and scams by malicious individuals with the right skillset. The ability to copy and replicate underlying code can lead to the creation of new projects with overstated potential, culminating in 'rug pulls' where developers abruptly withdraw funds, leaving investors with worthless assets. Furthermore, newly introduced protocols are often challenging to research due to limited user reviews and information. Therefore, these protocols can pose significant financial risks, sometimes masquerading as legitimate yield farming opportunities.

Gas Fees: Gas fees typically surge following network congestion on blockchain platforms. Such spikes in fees can significantly impact yield farmers, particularly those with limited funds, as these fees can consume a large portion of their generated revenue. Additionally, keeping assets in the liquidity pool exposes them to risks like impermanent loss and potential liquidation, especially during periods of high volatility and fluctuating gas fees.

Four Ways to Conduct Your Own Research (DYOR) in DeFi Yield Farming

When engaging in DeFi yield farming, it's crucial to conduct thorough research to identify potential red flags and minimize risks. To avoid pitfalls and reduce the risks associated with yield farming, consider implementing the following research strategies:

Team Review: A critical step in DYOR is a detailed investigation of the project's team. Assess each member's qualifications, experience, and their vision for the project. Examine their past projects for insights into their professionalism. Scrutinize the project's social media, white paper, and community forums to gauge their expertise and background. Ensure the project's goals align with your investment objectives. Study the underlying technology to evaluate its potential in achieving these goals and identify any possible risks.

Evaluate the Token and Its Use Cases: Assess the token's utility, as tokens without practical use often lack value. Analyze the potential and utility outlined in the project's governance, comparing it with your investment goals. Research key aspects like the token’s total supply, distribution, and practical applications to determine if it has real-world utility or is merely speculative. Review its historical performance, market capitalization, peak value, trading volume, and liquidity to gauge its potential impact on your investment strategies.

Security: A critical aspect of the blockchain trilemma, security is paramount for decentralized projects. Before investing in any yield farming protocol, thoroughly research its security measures. Look for features like two-factor authentication (2FA), cold storage solutions, and data backups. Conducting a security audit of the smart contracts reveals vulnerabilities and clarifies how third-party terms are managed. Reviewing security practices helps identify potential risks and the measures in place to mitigate them. It also indicates whether the project has undergone rigorous testing to uncover its strengths and weaknesses.

Time and Liquidity: Ensure the yield farming protocol's strategies aligns with your investment objectives. Research the project's launch date, future plans, and roadmaps to ensure clarity and transparency in its vision and milestones. Be aware of public updates on upcoming events and key dates to facilitate informed planning. While early adopters may receive incentives, such rewards can sometimes be a tactic to attract investors to underdeveloped projects. Be cautious, as failed projects often result in unrecoverable losses. Providing excessive liquidity or rewards over extended periods can be a warning sign of potential token inflation and price decline, jeopardizing the project's stability.

Bonus Tips

Risk-Reward Ratio: While yield farming can generate high returns, factors such as gas fees and price movements can significantly diminish earnings. Utilizing DeFi tools like DeFi Score to assess the risk-reward ratio of protocols offers a strategic advantage in managing these factors effectively.

Smart Contract Review: Smart contracts, which are fundamental to DeFi protocols, establish the rules and operations of these systems. Their open-source nature allows for external reviews and audits, providing an opportunity for third parties to confirm their reliability and security. Such audits are essential to uncover potential vulnerabilities in the protocols and to verify the existence of effective measures to address these risks.

Conclusion

For investors and early adopters, thorough research and data evaluation are vital in the investment journey. Effective risk management can make yield farming a viable source of passive income. However, given the unpredictability and volatility of the crypto market, diligent research and careful planning is essential to devise a successful yield farming strategy.