How Does DeFi Yield Farming Work? A Simple Explanation

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What is Yield Farming?

Yield farming is the practice of putting your crypto assets to work in DeFi protocols to earn returns. Instead of holding tokens idle in your wallet, you can deposit them into various protocols to earn fees, interest, or token rewards.

How Yield Farming Works The Yield Farming Flow 1. Deposit Add tokens to liquidity pool 2. LP Token Receive proof of deposit 3. Earn Fees + rewards accumulate 4. Withdraw Claim rewards + original deposit Where Yields Come From Trading Fees DEX users pay fees when swapping LPs earn share of these fees Sustainable Token Rewards Protocols distribute governance tokens to attract liquidity Often unsustainable Interest Borrowers pay interest Lenders receive yield Real yield Key Risks to Understand Impermanent Loss: Value changes between paired tokens can reduce your holdings Smart Contract Risk: Bugs or exploits can drain pools Token Price Risk: Reward tokens often decline in value over time Rug Pulls: Unverified projects may steal deposited funds
The yield farming process and key risks

Types of Yield Farming

Liquidity Provision

Deposit token pairs into DEX pools and earn a share of trading fees plus potential reward tokens.

Lending

Supply assets to lending protocols like Aave or Compound and earn interest from borrowers.

Staking

Lock tokens in protocols to earn rewards, often governance tokens or protocol revenue share.

Key Takeaways

  • Yield farming puts idle crypto to work earning returns
  • Returns come from trading fees, token rewards, or interest
  • Higher APYs typically mean higher risks
  • Impermanent loss is a key risk for liquidity providers
  • Start with established protocols and smaller amounts
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