How are return farming yields calculated?
Typically, the estimated yield farming returns are calculated annualized. This estimates the returns you could expect over the course of a year.
Some commonly used metrics are Annual Percentage Rate (APR) and Annual Percentage Yield (APY). The distinction between them is that APR does not consider the effect of compounding, while APY does. Compounding, in this instance, means directly reinvesting profits to generate more returns. However, be aware that APR and APY may be used interchangeably.
Even short-terms rewards are rather tricky to estimate accurately. Why? Yield farming is a highly aggressive and fast-paced market, and the rewards can fluctuate rapidly. If a yield farming strategy works for some time, many farmers will jump on the chance, and it may stop yielding high returns.
As APR and APY come from the heritage markets, DeFi may need to locate its own metrics for calculating yields. Because of the rapid pace of DeFi, weekly or even daily estimated returns may make more sense.
The dangers of yield farming
Yield farming is not simple. The most profitable yield farming strategies are highly complex and only suggested for advanced users. In addition, yield farming is generally more appropriate to those that have a whole lot of capital to deploy (i.e., whales).
Yield farming is not as simple as it seems, and if you do not see what you’re doing, you’ll likely lose money. But what other risks do you need to know about?
Because of the nature of DeFi, many protocols are built and developed by small teams with limited budgets. This can increase the risk of smart contract bugs.
Even in the case of bigger protocols which are audited by reputable auditing companies, vulnerabilities and bugs are found all of the time. Due to the immutable character of blockchain, this may lead to loss of user funds. You will need to take this into consideration when locking your funds in a intelligent contract.
In addition, one of the biggest advantages of DeFi is also one of its biggest risks. It’s the concept of composability. Let’s see how it impacts yield farming.
As we’ve discussed before, DeFi protocols are permissionless and can seamlessly integrate with one another. This means that the entire DeFi ecosystem is heavily reliant on all its building blocks. This is what we refer to when we say that these programs are composable — they can easily work together.
Why is that a risk? Well, if just one of the building blocks does not function as intended, the whole ecosystem may suffer. This is what introduces one of the best risks to yield farmers and liquidity pools. You not only have to trust that the protocol you deposit your funds to but all the others it may be reliant upon.
