⚡ Risks

Although we take a multitude of safety precautions and Alpaca is audited, farming and participating in DeFi comes with certain risks. Below, we discuss the potential risks associated with using Alpaca Finance.

Potential Risks to Lenders

Bad Debt:

  • Risk: the risk of debt accrued by underwater positions in case liquidators do not liquidate in time during a period of high market volatility.

  • Mitigation: we have taken a cautious approach in setting key parameters to ensure a large buffer. We also have provided enough incentive to liquidators to call and liquidate applicable positions. Hence, we believe this risk scenario is very unlikely to occur.

Timing of Asset Return:

  • Risk: delay in getting deposited asset back in case of the pool’s high level of utilization. Please note that farmers can borrow the funds as long as they like and there is no fixed term for when the funds must be returned.

  • Mitigation: we use a triple-slope interest rate to optimize for 90% fund utilization. The steep increase in interest rate beyond the 90% utilization (lending fees scaling from 20 - 150%) should incentivize more lenders to deposit funds and borrowers to return outstanding loans, optimizing the pool to stay at a flexible level below ~90%.

Potential Risks to Yield Farmers

Price impact when entering/exiting a position:

  • Risk:

    • If you try to open a large position relative to the pool size and require swapping, you transaction could incur a large price impact.

    • As an example, if a liquidity of a pool is USD 100 million, swapping USD 1 million (1% of pool’s liquidity) worth of tokens would incur ~4% price impact.

    • If you are unfamiliar with how price impact works for AMM, please read here on how xy = k AMMs work.

  • Mitigation:

    • Open multiple smaller positions or open a smaller position and add collateral to that position at a later time. You should wait for a short interval for arbitrageur to bring price back to normal.

    • Bring a combination of asset that require lower swapping requirement-e.g., if you want to open a 2x leverage on CAKE-BNB pair. Supplying only CAKE token will result in a very small swap amount because the Vault will loan to you approximately equal value in BUSD.

    • Avoid opening and exiting position in a short period of time.

    • When exiting a large position, choose "Minimize Trading" strategy to reduce price impact from swapping asset and trading fees

Impermanent Loss (IL):

  • Risk:

    • Risk of (impermanent) capital loss from asset rebalancing in the Automated Market Maker ("AMM") pool.

    • Even stablecoin pairs can be subject to impermanent loss if the price of at least one moves off peg. While in general, the IL from this is small and transient, historically, there have been instances where stablecoins have stayed off-peg for extended periods of time. By opening a position with large leverage, you are also amplifying the potential IL on your principal.

  • Mitigation:

    • Impermanent loss is not unique to Alpaca Finance. It is common among all yield farming and AMMs. While we currently do not yet have a way to mitigate IL, users can choose to yield farm asset pairs that have high correlations to minimize potential IL. For more information on IL, you can start with this article.

Negative APY

  • Risk:

    • This is a scenario where the borrowing interest rate is higher than your yield farming gain. This means your debt position will grow faster than your equity value. If this continues for a period of time, it could reduce your equity value down to the level that triggers liquidation.

    • Likely causes for this scenario to occur are 1.) high borrowing pool utilization, pushing up the borrowing interest rate. 2.) A significant price drop in the rewards token - i.e., CAKE causing the farming yield to drop.

  • Mitigation:

    • Monitor your positions closely and have a plan if APY turns negative - i.e., close position, wait and see, or add collateral to the position.

    • If utilization remains high for a period longer than a few days, the team will analyze the situation and likely raise the borrowing interest rate which should lower utilization.

    • Exercise cautions when opening a position if the pool's utilization is high.

Liquidation:

  • Risk:

    • If you open a leveraged yield farming position, Alpaca Finance borrows a base asset for you to farm. You run the risk of being liquidated if price of the borrowed asset appreciates against the farming token pair. Your position will be liquidated when the Debt Ratio (debt / position value) reaches the Liquidation Debt Ratio aka Kill Threshold. See Pool-Specific Parameters for more information.

  • Mitigation:

    • This can be mitigated by using a lower leverage level, monitoring positions during volatile market conditions, and closing them before hitting the liquidation parameters.

Smart Contract Risks

  • Risk:

    • While our smart contracts have been audited by third-party firms, they could theoretically have vulnerabilities.

  • Mitigation:

    • Having smart contracts audited by multiple professional third-party firms decreases the chance of vulnerabilities.

    • You can find the audit report from PeckShield here.

    • We also run a bug bounty program to provide incentives for people to look for vulnerabilities in our live code as an extra layer to filter out any potential issues. More on that here.

While we do our best to eliminate all the possible risks, DeFi is an industry where events that no one predicted can occur(the dreaded black swans). So please don’t invest your life savings, or risk assets you can’t afford to lose. Try to be as careful with your funds as we are with our code. 😊