Yield Farming
🧩 1. Let’s Start with the Question: What is “Yield”?
Before “Yield Farming,” you must understand “Yield” itself.
Yield simply means the return (profit) you earn on your capital.
Example:
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You deposit ₹1000 in a bank,
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Bank gives you ₹50 after one year.
→ Your yield = 5%.
So, yield = reward for putting your money to work.
🌾 2. Now, What is Yield Farming?
💡 Definition (Simple):
Yield farming is the process of earning rewards (interest, tokens, or fees) by providing liquidity or staking assets in a DeFi protocol.
In short:
You “farm” yield by “planting” your crypto assets in “fields” (DeFi protocols).
That’s why it’s called farming — your crypto “grows” more crypto.
💭 3. Why Does Yield Farming Exist?
Let’s think “Why?” —
Why would anyone pay you for just locking your crypto?
Because DeFi protocols need liquidity.
Example:
Suppose you go to Uniswap (a decentralized exchange).
When a user swaps ETH → USDT, there must be liquidity (ETH and USDT) already sitting in the pool.
That liquidity comes from liquidity providers (LPs) — people like you.
So the protocol says:
“If you give us liquidity (ETH + USDT), we’ll reward you with trading fees or tokens.”
That’s the core motivation — protocols need liquidity to function, and yield farmers supply it.
⚙️ 4. How Does Yield Farming Work?
Let’s take a step-by-step technical view.
Example: Uniswap (Liquidity Pool)
Step 1: You provide liquidity
You deposit two tokens — e.g., 1 ETH + 2000 USDT — into a liquidity pool.
Step 2: You get LP Tokens
In return, Uniswap gives you LP tokens (say, UNI-V2 tokens).
These represent your share in that pool.
Step 3: You earn rewards
Whenever people trade ETH ↔ USDT, a 0.3% fee is collected.
That fee is distributed proportionally among LP token holders.
So, you earn yield from trading fees.
Step 4: You can stake LP tokens elsewhere
Some protocols like Curve, Aave, Compound, or Yearn let you stake these LP tokens again to earn extra tokens (like governance rewards).
This is where “farming” truly starts — stacking multiple yield sources.
🧮 5. Let’s Break Down the Yield Sources
Yield farmers can earn from multiple layers of reward:
| Source | Description | Example |
|---|---|---|
| 1. Trading Fees | Earned from users swapping tokens in liquidity pools | 0.3% fee in Uniswap pools |
| 2. Interest | Earned when lending assets | Supplying USDC on Aave |
| 3. Governance Tokens | Protocol rewards LPs with native tokens | COMP (Compound), CRV (Curve), CAKE (PancakeSwap) |
| 4. Staking Rewards | Staking LP tokens or governance tokens | Staking CAKE on PancakeSwap for extra yield |
| 5. Incentive Programs | Projects reward liquidity to attract users | New tokens distributed via liquidity mining |
🧠 6. The Concept of “Liquidity Mining”
Yield farming often includes liquidity mining —
You mine new tokens by providing liquidity.
Example:
You deposit USDC on Compound → you earn COMP tokens as a reward.
These COMP tokens can rise in price → giving extra yield.
That’s how early DeFi users earned massive returns in 2020’s “DeFi Summer”.
⚖️ 7. Risks in Yield Farming
Yield farming isn’t free money — it’s risk vs reward.
| Risk Type | Explanation | Example |
|---|---|---|
| 1. Impermanent Loss | When token prices change, your share value decreases compared to just holding them | ETH price doubles, but your pool share earns less |
| 2. Smart Contract Bugs | Exploits or hacks in protocol code | DAO Hack, Yearn Exploit |
| 3. Rug Pulls | Scam projects drain liquidity pools | Unknown token projects |
| 4. Token Inflation | Too many reward tokens printed, price drops | High APY but token value crashes |
| 5. Gas Fees | Ethereum transactions can eat your yield | $50 fee on each action during congestion |
🧩 8. Example of Yield Farming Strategy (Multi-layered)
Let’s understand a real yield farming cycle:
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You deposit DAI into Curve to earn trading fees + CRV tokens.
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You stake your CRV on Convex to earn extra CVX tokens.
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You sell CRV/CVX periodically to reinvest more DAI into Curve.
→ You’re compounding multiple yields — hence called “farming yield”.
This is what tools like Yearn Finance automate — they auto-move your capital to best-yielding farms.
💰 9. Measuring Yield — APY and APR
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APR (Annual Percentage Rate):
Interest earned without compounding. -
APY (Annual Percentage Yield):
Includes compounding.
Example:
If you earn 10% per month:
→ APR = 120%,
→ APY = (1 + 0.10)¹² − 1 = 213%.
So yield farming protocols often display APY to show compounded returns.
🌍 10. Real World Analogy
Think of DeFi as a digital farm:
| Real Farm | DeFi Equivalent |
|---|---|
| You plant seeds | You lock crypto tokens |
| Fertilizer helps plants grow | Incentives like governance tokens |
| You harvest crops | You withdraw yields |
| Drought or pests harm crops | Smart contract bugs or market risk |
You’re literally planting liquidity and harvesting rewards — the farming metaphor is quite accurate.
🧠 11. Core Technical Underpinnings
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Smart Contracts: Automate yield logic (e.g., distribute rewards)
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AMMs (Automated Market Makers): Replace order books → use liquidity pools
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LP Tokens: Represent ownership of the pool
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Governance Tokens: Reward and incentivize liquidity providers
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Composability: “Money Legos” — protocols built on top of others (Aave → Yearn → Convex, etc.)
⚙️ 12. Why Yield Farming Changed Finance
Yield farming turned users into investors.
Instead of a bank lending your deposits, you lend directly to others through code.
That means:
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No central bank or manager.
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You control your funds (non-custodial).
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You earn real yield from protocol activity, not from promises.
It’s like everyone can be their own mini bank.
✅ 13. Summary Table
| Concept | Meaning | Example |
|---|---|---|
| Yield | Return on capital | 10% APY |
| Yield Farming | Earning rewards by locking crypto | ETH-USDT pool on Uniswap |
| Liquidity Mining | Getting tokens for providing liquidity | COMP rewards |
| Impermanent Loss | Value fluctuation loss | ETH price changes |
| LP Token | Proof of pool ownership | UNI-V2 token |
| Governance Token | Protocol’s native token | CAKE, CRV, COMP |
| Staking | Locking tokens to earn more | Staking CAKE on PancakeSwap |
🎯 14. In One Line
Yield farming = putting your crypto assets to work in DeFi protocols to earn more crypto, by providing liquidity, lending, or staking — but with smart contract and market risks.
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