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Although the benefits of DeFi liquidity mining are high, the risks and opportunity costs must be understood.
Original title: “DeFi | What are the risks of liquidity mining in full swing? 》
Written by: Defi Yield.info
Translation: Li Hanbo
“DeFi combines various digital assets, the automation of many key processes, and the incentive mechanism for cross-protocol work–each protocol has its own rapidly changing technology and governance practices. But this also creates new security risks. “Said Liz Steininger of Least Authority, an encryption security audit agency. “However, despite these risks, it is undeniable that high yields are attractive to attract more users.”
Although DeFi and liquid mining are both young, especially DeFi, which can be said to be immature, projects that are expected to receive astronomical returns have attracted thousands of people. As with all new and unknown things, it is best to apply appropriate analytical methods to research the projects you are considering investing in. The key is to determine the risks and opportunity costs associated with liquid mining in order to prepare for any possible losses.
Annualized rate of return risk
In the field of high annualized rate of return and promised high returns, it is easy to forget that your annualized rate of return is unstable and depends on the following variables.
- Deposit asset prices
- The liquidity of the pool and your respective share in the pool’s reward distribution
- Token price
In fact, all the above factors are variables. Before investing, you should weigh (i) opportunity cost and (ii) potential benefits.
Mortgage liquidation risk
If you use a mortgage on a platform such as Compound, MakerDAO or Aave, liquidation may occur. When your collateral is no longer sufficient to cover your loan amount due to the volatility of the borrowed assets or collateral, the automatic liquidation (sale) of the collateral is triggered, as well as additional related fees, namely fines and liquidation discounts (when the assets are lower When the market price is urgently sold), liquidation will occur.
In order to reduce the risk of liquidation, ensure that sufficient collateral levels are maintained, and monitor the price trends of borrowed assets and collateral currencies. According to your strategy, you can consider using assets with relatively low volatility in this process, such as DAI, USDT, USDC, PAX, etc.
If the collateral and borrowings are assets or stable currencies with less volatility, such as using DAI collateral to borrow USDC, your liquidation risk will be greatly reduced.
The automation function of DeFiSaver can save your MakerDAO Vault from liquidation.
If you are using MakerDAO for mortgage loans, there is another app that can save you from liquidation-DeFiSaver. DeFiSaver is an application that uses flash loan and your collateral to automatically repay the loan. Just set a Boost point on the automation screen, and when DeFiSaver detects that your loan reaches that point, it will automatically start the repayment process.
Although it is tempting to borrow large amounts, be careful. Try to borrow only the amount you can afford. For example, Compound will show that your loan is in the green area. Be sure to check and think about how much you might lose.
For example, when you provide funds to any automatic market maker (AMM) such as Uniswap, you must understand that if the price changes too much, you may lose a lot of funds.
Permanent loss on Uniswap–Source: uniswap documentation
This phenomenon is called impermanence loss. Simply put, it is the difference between putting tokens in AMM and putting them in a wallet. Why is it called “Impermanence”? Because as long as the relative price of tokens in AMM returns to the original state when you entered AMM, the loss will disappear and you can earn 100% of the transaction fee.
However, this is not always the case. Under normal circumstances, impermanence losses will become permanent, allowing you to gain negative returns.
In order to avoid the problem of impermanence loss, liquidity providers should choose the pool of funds they enter wisely. It is important to choose the timing and consider using protocols other than Unsiwap, such as Curve or Balancer.
Curve only trades different token forms of the same asset. This includes stable coins (DAI, USDC, etc.) or “stable pairs” such as WBTC and SBTC and renBTC. Since the prices of these assets generally do not change much relative to other assets, the loss of instability is reduced to almost negligible. Balancer is another project that can also be used to solve impermanence losses. Uniswap uses 50/50 pools, while Balancer allows other weights. By constructing a pool with a weight of 90/10 to support a single asset, you can retain most of the upside when its price soars.
Transaction fee risk
For anyone who has ever engaged in liquid mining, gas cost is a problem you can’t ignore at all. Want to start liquidity mining by providing liquidity to the fund pool, often accompanied by huge gas costs. At this point, you either wait for the gas fee to decrease or accept high transaction costs. This risk cannot be ignored, because most DeFi protocols run on the Ethereum blockchain. When you consider your actions, you can check the current gas price through the ETH Gas Station.
Smart contract risk
When you plan to start your liquidity mining, it is important to understand that you basically send your assets to smart contracts on the Ethereum chain and hold them for a long time. The risk is inevitable-if someone successfully attacks (or exploits the loopholes in the contract), your financial security will be affected. For example, earlier this year, the lending platform dForce was attacked, resulting in a loss of US$25 million. MakerDAO had a huge incident-“Black Thursday”, and a vulnerability targeting flash loan service provider bZx.
One of the most substantial risks associated with blockchain is the “prophecy problem.” The oracle is a third-party service that obtains external information and provides it to the blockchain. Similarly, smart contracts will execute their instructions based on these data. If the oracle is actually attacked, then the smart contracts that rely on it will also be attacked.
Unlimited coinage risk
In addition to hacking risks, there may also be fraudulent projects. Some projects have an infinite coin backdoor embedded in their code, which means that the project team can mint their tokens indefinitely. The problem occurs when the owner of the smart contract can call this function. Eventually, the owner can sell a large number of tokens of this kind of project on exchanges such as Uniswap or Balancer in exchange for almost all the assets added to a pool by the liquidity provider.
This is why you should be especially careful when investing in unaudited smart contracts. Although an audit does provide some comfort, it is important to remember that even a successful audit cannot completely eliminate risks.
Finally, remember that gains come with risks, and you will have to learn a lot in order to earn your passive income in a smart way.