Yield Farming

Concept

Yield farming (YF) is the act of employing, or interacting with, a decentralized finance (DeFi) protocol to attain certain incentives such as its governance tokens. It represents an incentives system on DeFi protocols whereby crypto traders gain rewards against depositing (or staking) digital assets onto a dApp. Specifically, decentralized exchanges (DEXs)—which offer peer-to-peer (P2P) crypto trading services—allow users to create and add cryptoassets to their platforms. This process helps supply cryptoassets to liquidity pools and receiving rewards. The assets added and rewards issued constitute the additional liquidity created on the network. Yield farming is a decentralized finance mechanism that allows participants to place their assets to various liquidity pools, in return for rewarded in the form of tokens and fees. By depositing cryptoassets, a participant contributes to liquidity pools and becomes a liquidity provider. In this way, liquidity providers can maximize capital utilization by earning higher yields than with traditional means.

Farming and liquidity

In the context of crypto markets, liquidity refers to the ease by which participants can buy and sell cryptoassets (coins and tokens) without incurring high fees and/ or significantly affecting their prices. High liquidity implies the existence of many buyers and sellers, allowing for efficient and timely transactions. Conversely, low liquidity indicates fewer number of buyers and sellers and as such limited number of offers and trades, where large trades on either side could potentially impact the cryptoasset’s price.

Benefits

Yield farming allows cryptocurrency holders to receive compensation from their holdings, embodied in transaction fees and token rewards. However, this may carry risks such as losses in value, where the value of deposited assets decreases while held in the pool compared to potential benefits of holding them outside the pool. The funds in liquidity pools come from participants who already own the cryptoassets. As liquidity providers, these participants supply their assets to the liquidity pool for a sort of rewards based on their share of the total pool liquidity (for more, see: benefits of yield farming).