Problems of Yield Farming

Liquidity mining is a process of attracting users in DeFi: it can be done to bootstrap liqidity on DEX, attract lending and borrowing liquidity, facilitate onboarding to new ecosystem and more. Basically it is financial incentive for users to make any target action.

Obviously, the riskier the action, the higher incentive is required. So it may be impossible or very costly for a protocol to attract liquidity: generous incentivization leads to increased inflation, selling pressure and finally decreasing efficiency of incentive program.

Details of Yield Farming

Yield Farming is one of the types of Liquidity Mining. It is the incentivization of providing liquidity to AMM DEXes. Examples are: Pancakeswap paying 63%APR in CAKE tokens to CAKE/USDT LP stakers, Lido paying ~30% APR in LDO tokens to wstETH/ETH LPs.

Such incentives can be thought as a risk premium for investors. In this case the risks are:

  • Market risk (the bigger one) To provide liquidity one needs to buy respective tokens at first. If tokens USD price will fall, "holder's" loss will be incurred.

  • Impermanent loss (the smaller one) Every AMM is subject to some sort of impermanent loss, that is caused by tokens relative price change. This type of risk is special to Liquidity Providers.

As we can see, Liquidity Mining issuer needs to pay for a big risk, that is almost entirely consists of market risk. So the protocol is basically paying holders for holding, that can't fit everyones risk profile, as the market price depends on:

  • Protocol technology, tokenomics and team

  • Current state of crypto market as a whole: hacks, FUDs, fleeting narratives make it highly volatile

  • Macroeconomic situation and investment cycle

It's very hard to take all this into account, so early Yield Farmers often lose money due to market risk, even with three-digit incentive APR. Huge inflation caused by those incentive although play against holder's wealth.

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