Yield Farming

Yield farming protocols/platforms incentivize liquidity providers (LP) to stake or lock up their crypto assets in a smart contract-based liquidity pool. These incentives can be a percentage of transaction fees, or interest from lenders or a governance token (see liquidity mining below). These returns are expressed as an annual percentage yield (APY). As more investors add funds to the related liquidity pool, the value of the issued returns decrease accordingly.

At first, most yield farmers staked well-known stablecoins USDT, DAI and USDC. However, the most popular DeFi protocols now operate on the Ethereum network and offer governance tokens for so-called liquidity mining. Tokens are farmed in these liquidity pools, in exchange for providing liquidity to decentralized exchanges (DEXs).

What is a Liquidity Provider & What is a Liquidity Pool?

A liquidity provider is a user who funds a liquidity pool with crypto assets she owns to facilitate trading on the platform and earn passive income on her deposit.

Liquidity pools are leveraged by the decentralized exchanges that use automated market maker-based systems to allow trading of illiquid trading pairs with limited slippage. Instead of using traditional order book-based trading systems, such exchanges use funds that are held for every asset in every trading pair to allow trades to be executed.

While trading illiquid trading pairs on order book-based exchanges could lead to suffering from great slippage and the inability to execute trades, the advantage of liquidity providers is that trades can always be executed as long as the liquidity pools are big enough. For this reason, liquidity providers are seen as trade facilitators and paid with the transaction fees paid for the trades that they enabled.

How much liquidity providers are paid is based on the percentage of the liquidity pool that they provide. When funding the pool, they are usually required to fund two different assets to enable traders to switch between one to the other by trading them in pairs.

For instance, a liquidity provider may provide a liquidity pool with $5,000 worth of Ether and $5,000 of USD-pegged decentralized stablecoin DAI to allow trading back and forth between the two. This way, every time a trade on the ETH/DAI is executed, the liquidity provider in question would receive compensation for having funded the pool in question.