Yield Farming
In short: Yield farming means earning rewards by providing liquidity to DeFi protocols, for example by depositing tokens into a lending market or into a liquidity…
Yield farming means earning rewards by providing liquidity to DeFi protocols, for example by depositing tokens into a lending market or into a liquidity pool on a decentralized exchange. The rewards can come from trading fees, interest paid by borrowers, or extra tokens that a protocol hands out as an incentive.
Why it matters
Yield farming is one of the main ways DeFi protocols attract the liquidity they need, and it is where many users first meet terms such as APY, LP tokens and impermanent loss. Advertised returns are variable and can change quickly as capital moves in or out. The risks include smart contract bugs, impermanent loss when the pooled tokens move apart in price, a falling value of the reward token, and scams such as rug pulls. Returns are never assured, so it helps to understand exactly where the yield comes from.
Example
A user deposits two tokens of equal value into a liquidity pool on a DEX and receives LP tokens that represent their share of the pool. Every time traders swap between those two tokens, a small fee is added to the pool. The user then stakes the LP tokens in a separate "farm" contract that pays an additional governance token. When they exit, they receive their share of the pool, which may hold a different mix of the two tokens than they originally deposited.