The mechanism of earning through Liquidity Farming: The light and shadow of DeFi

As DeFi protocols rapidly grow, liquidity farming has become an attractive investment method for many cryptoasset holders. However, it is important to understand that behind the high profit margins lies a correspondingly high level of risk.

The Essence of Liquidity Farming

In liquidity farming (a reward acquisition strategy through liquidity provision), users deposit their held cryptoassets into decentralized exchanges or DeFi platforms, earning interest and fees by providing liquidity. This mechanism is based on a more complex economic design, differing from staking and lending.

From the platform's perspective, without the liquidity provided by users, executing transactions becomes difficult. Therefore, the protocol is trying to attract participants and invigorate the ecosystem by offering token rewards and other incentives.

The Mechanism of Generating Profit and the Gap with Reality

The advantages of liquidity farming are appealing. They include passive income opportunities, high yields that are unimaginable in traditional finance, and access to emerging tokens. However, the theoretical values can differ significantly from reality.

The superficial high interest rates often only persist in the early stages of emerging protocols and can rapidly decrease over time. Additionally, as users actively participate, the supply of the provided tokens can increase rapidly, which may accelerate the decline in token value.

Actual Risks: Ignorance Can Lead to Painful Consequences

Liquidity instability The biggest feature of Liquidity Farming is the concept of impermanent loss. After providing assets for farming, if the price fluctuates significantly, there is a possibility of incurring losses greater than the rewards obtained. This effect is particularly pronounced with highly volatile asset pairs.

Unpredictability of the Project In a scheme called a rug pull, developers abandon the project and make off with investors' funds. Among emerging DeFi protocols, many exist that have not undergone sufficient audits or security reviews.

Smart Contract Security There is a risk that the assets you deposit may be completely lost due to bugs, hacking, or other vulnerabilities. Participating without checking the protocol's history or audit status is extremely dangerous.

Rapid Changes in Regulatory Environment In a situation where regulatory authorities in various countries are rapidly changing their policies towards DeFi, it is important to consider that legitimacy and business continuity may suddenly be threatened.

Approach to Liquidity Farming

Liquidity farming offers a new form of democratization of finance and utilization of individual assets. However, it is also a world that comes with a level of risk that cannot be experienced in traditional finance.

When considering participation, it is essential to take basic precautions such as starting with funds you can afford to lose, diversifying across multiple protocols, and checking the audit history of smart contracts. Do not forget that being blinded by the potential for profit and neglecting risk management can lead to the biggest failures.