Yield Farming Meaning
What is Yield Farming in Crypto?
Yield farming refers to lending or locking up digital assets in a decentralized finance (DeFi) platform to generate interest and other rewards in the form of cryptocurrencies. The reward acts as an incentive for providing liquidity to a liquidity pool – a smart contract for locking up funds.
For instance, instead of idly holding assets in their crypto wallet, a user decides to deposit or lend the assets on a DeFi platform, such as a decentralized exchange (DEX), yield aggregator, liquidity protocol, or a lending and borrowing platform. By providing liquidity to the platform, the user becomes entitled to trading fees collected by the platform. However, yield farming is also prone to high volatility, liquidity risks, regulatory risks, and smart contract bugs.
How Does It Work?
Yield farming involves using smart contracts to maintain the protocol’s liquidation rate, where users lock their assets in liquidity pools. The pool allows the platform users to borrow, lend, and exchange assets. Every transaction on the pool incurs a trading fee, which is then distributed to the yield farmers based on their contribution.
In addition, some protocols use yield farming as a way to distribute new tokens. The protocols accumulate the tokens and distribute them to yield farmers to encourage them to continue funding the pool.
Yield farming also works with lending and borrowing protocols. It entails pooling assets into a lending protocol that provides users with a means to tap into the value of their crypto holding without necessarily liquidating their position. In such instances, the protocols extend overcollateralized loans, meaning that the loan is backed by collateral exceeding the loan amount. The interest collected from the borrowers is rewarded to the yield farmer.