What is Yield Farming in DeFi?

Yield farming, also called liquidity mining, is a way to generate rewards with cryptocurrencies. In simple terms, it means locking cryptocurrencies and getting rewards.

In a sense, yield farming can parallel staking. But there is also a lot of complexity going on in the background. In most cases, it works with users called liquidity providers who add funds to their liquidity pools.

The liquidity pool, on the other hand, is basically a smart contract with funds. In exchange for providing liquidity to the pool, liquidity providers receive a reward. This reward may come from fees generated by the underlying DeFi platform or another source.

Some liquidity pools pay their rewards in multiple tokens. These reward tokens can then be deposited into other liquidity pools to earn rewards there, and so on. The basic idea is that a liquidity provider deposits money into a liquidity pool and earns rewards in return.

Yield farming is typically done on Ethereum using ERC-20 tokens, and the rewards are usually some type of ERC-20 token. However, this may change in the future. Currently, most of this activity takes place in the Ethereum ecosystem.

However, cross-chain bridges and other similar developments may allow DeFi applications to become blockchain-independent in the future. This means they can run on other blockchains that also support smart contract capabilities.

With Yield farming, users will often move their funds quite a bit between different protocols as they seek high yields. As a result, DeFi platforms can also provide other economic incentives to attract more capital to their platforms. Just like centralized exchanges, liquidity tends to attract more liquidity.

How Yield Farming Works?

Yield farming is closely related to a model called the automated market maker (AMM). It typically includes liquidity providers and liquidity pools. Liquidity providers deposit funds into a liquidity pool. This pool powers a market where users can lend, borrow or trade tokens. Use of these platforms is subject to fees paid to liquidity providers based on their share in the liquidity pool. This is the operating basis of an AMM. In addition to fees, another incentive for adding funds to a liquidity pool can be the distribution of a new token. For example, there may be no way to buy tokens on the open market, only in small quantities. On the other hand, it can also be accumulated by providing liquidity to a specific pool. All distribution rules will depend on the unique implementation of the protocol. As a result, liquidity providers earn a return based on the amount of liquidity they provide to the pool. Deposits are usually stablecoins pegged to USD. Some of the most common stablecoins used in DeFi are DAI, USDT, and USDC.