Introduction to Yield Farming
The rapid growth of decentralized finance (DeFi) has been partially driven by interest in yield farming, also known as liquidity mining. Yield farming is the practice of maximizing returns on crypto holdings through a variety of DeFi liquidity mining methods. While it can be lucrative, it requires a thorough understanding of DeFi protocols to be successful. In most cases, yield farmers enact complicated and evolving strategies, frequently moving crypto assets between lending marketplaces to maximize returns.
Because of this, building a working knowledge of yield farming can be intimidating for newcomers. It's important to be equipped with best practices before engaging in this new sector.
Yield farming crypto can generate passive returns on holdings using decentralized finance (DeFi) protocols — but participating in it is very rarely a passive endeavor. Yield farmers often execute complex strategies, moving crypto assets between platforms to maximize liquidity mining returns. More recently, leveraged DeFi yield farming protocols have begun to issue under-collateralized loans to liquidity providers and yield farmers. Through this mechanism, users borrow crypto assets to increase exposure to risk and reward.
Decentralized Exchanges (DEXs) and Crypto Liquidity Pools
Within the DeFi ecosystem, decentralized exchanges (DEXs) have become some of the most widely used crypto protocols. Unlike centralized exchange (CEX) order books, DEXs utilize liquidity pools to facilitate peer-to-peer (P2P) trades. Structures known as liquidity pools help many DEXs maintain fair market values for the tokens they hold thanks to automated market maker (AMM) algorithms, which maintain the price of tokens relative to one another within any particular pool.
AMM liquidity pools used by today's leading DEXs reduce or remove the need for a centralized entity, and as a result, they require a sustained outside source of liquidity to function properly. This is where liquidity providers (LPs) enter the equation. Liquidity providers are individuals who either create a liquidity pool of their own making or, more often, deposit tokens into an existing one so that traders can purchase tokens on a DEX.
Staking Crypto vs. Yield Farming
Although yield farming and staking crypto are two different practices, some mistakenly refer to them interchangeably. Yield farming — or liquidity mining — is a method of generating rewards with cryptocurrency holdings. The primary purpose of staking, on the other hand, is as part of the consensus mechanism of a Proof-of-Stake (PoS) blockchain network — a process for which stakers also receive rewards.
While crypto yield farming is typically more profitable than staking, it's also riskier. For example, when yield farming on Ethereum, the network gas fees required to collect rewards can reduce earnings from APY rates. In addition, if the market becomes volatile in either direction, impermanent loss can occur and drastically reduce profitability. Finally, because liquidity pools use smart contracts, there's also a chance hackers could find and exploit vulnerabilities in the underlying code.