Yield farming
Yield farming means depositing crypto on a DeFi platform to make trading possible. In return, you may earn rewards.
What is yield farming?
With yield farming, you add tokens to a liquidity pool. This is a shared pool of crypto that others can use to swap tokens. DeFi refers to financial services without a central party, such as a bank or crypto exchange.
The pool is managed by a smart contract: a program that automatically carries out agreements. People who provide liquidity usually receive a share of the transaction fees. Sometimes there are additional rewards. You often also receive LP tokens as proof of your share in the pool.
An example of yield farming
Suppose you deposit two types of tokens in a liquidity pool. Other users swap these tokens through the pool and pay transaction fees. Because your crypto is in the pool, you may receive a share of those fees.
If you withdraw your tokens from the pool, the rewards stop. The value you get back may differ from what you’d have if you’d simply held the tokens.
Why is yield farming important in crypto?
Yield farming provides liquidity to DeFi platforms. With enough liquidity, users can usually swap tokens more easily and at a lower cost. When liquidity is low, trading can be more difficult, and the difference between the buying and selling price may be larger.
In articles about DeFi, you’ll often see APY or APR mentioned with yield farming. APY is an estimated annual return that assumes earnings are reinvested. APR only calculates returns on the original deposit. A high percentage doesn’t automatically mean a pool is safe.
Yield farming comes with significant risks. Large price differences between tokens can lead to impermanent loss. Smart contracts may also contain bugs, or a fraudulent project may carry out a rug pull. As a result, yield farming is often more complicated and riskier than staking.
