Yield Farming: The underlying risks and how Ratio Finance addresses them

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Ratio Finance

5 min readJul 30, 2021

What is Yield Farming?

The concept of yield farming is familiar to most of us, but to the inexperienced user, it can be a daunting and confusing process. So, what is yield farming?

Yield Farming is the process of “farming” or generating yield through various methods in the decentralized finance space. It is a way to capture passive income on your assets and has become a popular way to make sure that your capital is working efficiently.

The most established way of yield farming is providing liquidity. Most of decentralized finance runs through AMM’s, or Automated Market Makers. Protocols such as Uniswap, Sushiswap, and Raydium use AMM’s to allow users to trade with each other without the use of defined order books. Without a designated market maker providing liquidity to the sell and buy-side of the order books, users must rely on each other for that liquidity. That’s where providing liquidity comes into play. Users can use their assets to generate yield by pairing them together to create what is known as a liquidity pair (LP). For instance, if users want to trade Ethereum for USDC, there would need to be liquidity on both the USDC side and the ETH side. As a result, users are incentivized to provide liquidity to both ETH and USDC in the form of an ETH-USDC liquidity position. In return, they would be given a proportional amount of ETH-USDC LP tokens that represent their ownership of the liquidity provided. Users that provide liquidity to this pair will receive a percentage of trading fees generated from the AMM, thus, generating yield for them. Uniswap V3 has a more complicated version of LP, but that is a lesson for another day.

Risks of Yield Farming

A common risk that users experience when providing liquidity is impermanent loss. We suggest that if the reader is unfamiliar with the concept of impermanent loss, that they read the above link, as it explains in great detail the risks associated with providing liquidity to an AMM.

Another risk is what is known in DeFi as a “rug pull”. A rug pull is essentially the removal of all liquidity by the pool deployer so that tokens can no longer be traded. Basically, envision a scenario where you buy $100 worth of “x” token, and you see the price is going up and your “x” token is now worth $200. You decide you want to sell to capture the 2x profit. For this to happen, there needs to be liquidity on the pair you’re trading. If the deployer of the liquidity pool removes this liquidity, the user will no longer be able to sell their tokens and will instead be left with worthless monopoly money.

Outside of the behavior of malicious actors and the fundamental risks associated with impermanent loss, another danger to liquidity providers comes in the form of smart contract risk. Rushed deployments and sloppy code can lead to exploits and the loss of all user funds. One doesn’t have to look far to find the latest DeFi exploit that has left users holding empty bags while bandits ran off with their money.

How does Ratio Finance address these risks?

Liquidity provisions are one of the foundations upon which Ratio Finance is built. On our platform, users can use their Raydium liquidity positions as collateral to mint Ratio USD (USDr) while still gaining yield, allowing them to leverage their underlying assets to earn yield while also taking advantage of the opportunities that USDr unlocks (farming additional yield, utilizing vaults, buying tokens, etc.). Thus, it is quite important that we outline and mitigate the risks associated with providing liquidity as thoroughly as possible for the end-user.

One way that we are tackling this is through our user interface. We will provide easy-to-read, seamless visualizations that show the user exactly what is happening to their liquidity positions while they remain under Ratio Finance’s care. This means that if one side of the pair goes down in price, the user will be able to see the rebalancing that occurs within the LP token and will be able to make a decision based on the information presented. Defi can already be a confusing, daunting experience, so we feel it is important to make the experience as smooth and easy to understand as possible. We believe real-time analytics and visualizations are of paramount importance when it comes to assessing and managing risk.

Another way we are enhancing the user experience is through providing LP risk analysis. Through a set of predetermined parameters, we are able to assess a risk score to specific liquidity positions that let the user know ahead of time “how risky” the position they may be entering or maintaining is (based on 14-day intervals). We feel that providing additional metrics and information to the user allows them to make a more informed decision on how best to deploy their capital. We will be releasing more information on how we arrived at these scores in the near future, so make sure to stay tuned.

Outside of managing risk, it is important and beneficial to provide the user with as much information as possible, but in an easily digestible manner so that they aren’t overwhelmed. There’s so much information being transferred and translated behind the scenes, that it is important to present relevant information to the user in a way that is easy to understand and easy to digest. As a result, our interface will include metrics that outline the risk to reward ratios that exist for providing liquidity, the current APR, and ultimately provide the user with the necessary information to make informed yield farming decisions. Having this data in one place saves our users valuable time and calculations. As it stands, those wanting to maximize their yield must run calculations on their own, explore Raydium pools to find the best yield, and then determine for themselves if the potential impermanent loss outweighs the potential yield. We simplify this process for the end-user and make advanced risk management available to all.

In Summary

Yield farming is just one of the ways users in DeFi can leverage their assets to earn passive income. This article discusses the most basic fundamentals of yield farming. Many other methods exist to generate revenue with existing assets. With that said, Ratio Finance goes beyond generating revenue by providing liquidity and allows users to leverage existing liquidity positions to generate even more yield. Users are able capitalize on positions they already have by depositing them into LP pools, vaults, funds, and eventually centralized exchanges. We understand that DeFi can be a confusing place, and interacting with different protocols is a daunting task for the inexperienced user. For this reason, we have made it one of our goals to make our platform as user-friendly as possible, catering to both experienced and inexperienced DeFi users. We look forward to building these tools and creating an inclusive DeFi experience for all participants in the Solana ecosystem. Stay tuned, as we’re just getting started.

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