What is Yield Farming in DeFi?

Josiah Nang-Bayi, MD
8 Min Read

The explosive growth of decentralized finance (DeFi) has led to the proliferation of yield farming (also called liquidity mining). But what exactly is yield farming and how does it work? In this in-depth guide, we’ll demystify yield farming and its role within the broader DeFi ecosystem.

Defining Yield Farming

At a basic level, yield farming involves locking up cryptocurrency assets in decentralized finance protocols to generate rewards and additional yield. By providing liquidity to the protocol, you earn rewards in the form of trading fees, interest, and newly minted governance tokens from the platform.

Providing liquidity and earning yields incentivizes users to continue parking their assets in the protocol, which in turn expands the platforms capabilities and total value locked (TVL).

Some examples of popular yield farming protocols are Uniswap, Compound, Aave, Curve Finance and Balancer. Providing liquidity looks different depending on the platform, but the incentives are similar.

Yield farming enables new token distributions, grows liquidity pools, boosts trading volume, and expands revenue earning potential for both users and protocols.

How Does Yield Farming Work?

Here is an overview of how yield farming generally works across DeFi protocols:

1. Select Protocol – Choose a DeFi lending protocol, decentralized exchange, or yield aggregator offering compelling liquidity mining incentives.

2. Provide Liquidity – Deposit assets like ETH, stablecoins, or governance tokens into liquidity pools or fund pools to earn rewards.

3. Earn Rewards – Receive automatic yield farming rewards proportional to the liquidity provided, often in the form of governance tokens for the platform.

4. Compound Gains – Take earned governance tokens and stake them to get additional rewards, thereby compounding overall gains.

5. Manage Risks – Pay attention to factors like impermanent loss, token valuations, smart contract risks and liquidation penalties to avoid losses.

6. Change Strategies – Hop between protocols and liquidity pools to maximize yield based on changing reward tokenomics and market conditions.

The basic yield farming process involves maximizing yield generating opportunities by continuously moving capital to the most attractive liquidity pools and mining opportunities.

Yield farmers use a variety of approaches and strategies to maximize their profit potential, including:

– Providing liquidity to AMM DEX pools on platforms like Uniswap, Balancer and Curve to earn trading fees and governance tokens.

– Suppling collateral and assets to lending/borrowing protocols like Aave, Compound and Liquity to earn interest and platform tokens as rewards.

– Staking yield farming reward tokens like COMP, CRV and SUSHI on their native platforms to compound gains.

– Using stablecoins like DAI and USDC to provide low risk liquidity and minimize impermanent loss.

– Leveraging flash loans to dramatically boost capital efficiency when yield farming.

– Migrating liquidity across multiple platforms hourly, daily or weekly chasing the highest yields.

– Providing liquidity across both Layer 1 and Layer 2 platforms like Arbitrum and Optimism to maximize gains.

– Staking LP tokens earned by supplying liquidity to minimize IL risks.

As decentralized finance expands, new yield farming strategies continue to emerge. Savvy farmers combine multiple approaches to optimize profits.

Benefits of Yield Farming

The ability to earn sizable yield farming rewards offers several advantages to users:

– Significantly higher yields than traditional savings and investment accounts.

– Compounding gains by recycling reward tokens into staking.

– Low barriers to entry – no special skills or permission required.

– Supporting new DeFi protocols and liquidity early on.

– Flexible – funds can be unstaked at any point.

– High upside if reward governance tokens appreciate.

– Novel yield generating capabilities beyond just HODLing tokens.

When executed effectively, yield farming enables optimizing returns across crypto holdings through active liquidity management rather than simple static holdings.

risks of investing in defi

Risks and Downsides to Yield Farming

However, yield farming does come with a unique set of risks and downsides:

– Impermanent loss can erode LP gains compared to simply holding assets.

– Smart contract risks like bugs or hacks can lead to loss of funds.

– High Ethereum gas fees can diminish profits.

– Token rewards could fall short of expectations or decline in value. 

– Requires more active management than passive yield options.

– Regulatory uncertainty lingers around DeFi yield offerings.

– Promised high returns often fail to account for risks taken on.

Managing risk factors like impermanent loss, contract security, technical glitches, and token valuations is crucial to long-term yield farming success.

DeFi Yield Farming vs Staking

Yield farming offers similarities to staking, but key differences exist:

Staking involves validating proof-of-stake blockchains for rewards, while yield farming supplies liquidity to DeFi protocols to earn governance tokens.

Staking rewards in native protocol coins, yield farming provides project-specific governance tokens.

Staking requires long lockup periods, yield farming offers flexibility to move funds freely.

Staking is limited to native tokens, yield farming accommodates diverse assets.

Staking aims for consensus security, yield farming incentivizes platform utility and liquidity.

While both generate yields on idle crypto, staking and yield farming serve different primary purposes. Based on goals and risk appetite, one may be preferable over the other.

Future of Yield Farming

As decentralized finance expands across chains like Solana, Polkadot, and Cosmos, expect yield farming to continue growing:

– Automated tools will simplify discovery of top yield farming opportunities.

– Liquidity fragmentation across chains will create arbitrage opportunities.

– Yield farming strategies will become increasingly sophisticated and algorithmic.

– Staking derivative tokens earned through yield farming will gain adoption.

– Yield farming on non-Ethereum chains will mitigate gas fee pain points.

– Institutional capital will participate more in high yield liquidity pools.

– Regulation will provide standards around capital requirements and transparency.

Yield farming aligns incentives between users and protocols to maximize liquidity and reward those providing the foundation for open finance. As adoption grows, participating early on promising new DeFi protocols via yield farming offers potential for outsized gains. TheYield farming aligns incentives between users and protocols to maximize liquidity and reward those providing the foundation for open finance. As adoption grows, participating early on promising new DeFi protocols via yield farming offers potential for outsized gains. The risks exist, but so does the vast opportunity.

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Josiah Nang-Bayi, MD is a medical doctor by profession, an author, a financial literacy and digital assets enthusiast, an entrepreneur and a growing philanthropist.
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