Yield farming
A DeFi strategy in which a user supplies assets to protocols (for example, liquidity pools) in order to earn interest income or additional tokens.
How it works
Yield farming means placing crypto into DeFi protocols to earn a return. You supply coins to a liquidity pool or a lending protocol and receive a share of fees, interest from borrowers, and often extra tokens issued by the protocol itself.
The practice emerged in the summer of 2020, when the Compound protocol began distributing its own token to platform users. Yields instantly jumped into triple digits and billions of dollars flowed into DeFi within months.
The point most often lost: an advertised yield combines two very different parts. Fees are real and come from trading activity, while distributed tokens are issuance whose value depends on whether demand for them exists.
Breaking down an advertised yield
A pool advertises 120% a year. Here is what that figure consists of.
| Fees from trading volume | 12% a year |
| Protocol token rewards | 108% a year |
| Token price fall over the quarter | −70% |
| Impermanent loss as prices diverge | −5% |
Only the 12% is durable. The rest rests on the price of the distributed token, which usually falls as farmers sell their rewards. Once the token's decline and impermanent loss are counted the real outcome is negative, though the banner promised 120%.
What to watch for
- Separate fees from issuanceA good protocol shows both parts separately. A single combined figure in the interface is itself a reason to dig deeper.
- Smart-contract risk does not go awayFunds sit in code that may contain a flaw. An audit lowers the risk without removing it: audited protocols have been exploited too.
- Network fees eat small amountsEntering, exiting and claiming rewards are separate operations. On a few hundred dollars in Ethereum's main network the fees can exceed the return.
- A high yield is the price of riskA rate in the hundreds of percent means the market prices the chance of loss as high. That is information, not a gift.