Yield farming, also referred to as liquidity mining, is a way to generate rewards with cryptocurrency holdings. In simple terms, it means locking up cryptocurrencies and getting rewards.
Yield farming is closely related to a model called automated market maker (AMM). It typically involves liquidity providers (LPs) and liquidity pools. Liquidity providers deposit funds into a liquidity pool. This pool powers a marketplace where users can lend, borrow, or exchange tokens. The usage of these platforms incurs fees, which are then paid out to liquidity providers according to their share of the liquidity pool. On top of fees, another incentive to add funds to a liquidity pool could be the distribution of a new token. For example, there may not be a way to buy a token on the open market, only in small amounts. On the other hand, it may be accumulated by providing liquidity to a specific pool.
The rules of distribution will all depend on the unique implementation of the protocol. The bottom line is that liquidity providers get a return based on the amount of liquidity they are providing to the pool. The funds deposited are commonly stablecoins pegged to the USD – though this isn’t a general requirement. Some of the most common stablecoins used in DeFi are DAI, USDT and others. Some protocols will mint tokens that represent your deposited coins in the system. For example, if you deposit DAI into Compound, you’ll get cDAI, or Compound DAI. If you deposit ETH to Compound, you’ll get cETH.
Yield farming is that you deposit funds into a smart contract and earn rewards in return. But the implementations can vary greatly. As such, it’s generally not a great idea to blindly deposit your hard-earned funds and hope for high returns. As a basic rule of risk management, you need to be able to remain in control of your investment.
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