What is Yield Farming?

Understand what yield farming is and why does it exist

Yield farming, also known as “liquidity mining”, is a term used to describe a way to earn yield (usually denominated in a project’s token) by contributing liquidity for a crypto project. 

The first thought that comes to your mind might be “yield farming? That’s some weird name!”. Fair enough. The reason why it’s called “yield farming” is that the act of providing liquidity and then periodically collecting the rewarded tokens is conceptually similar to you seeding a plant and then harvesting the yields later. Additionally, the fact that the first few projects to adopt this approach have plant-related names, such as Yam Finance, also solidified this term in people’s minds.

The reason why this is a thing is that, right after a new project distributes its tokens, the liquidity for this token on the market will be low, which makes it harder for people to trade the token. So to incentivize people to provide liquidity, ie. park this project’s token and another token (like ETH or USDC) in a pool on a DEX like Uniswap or Pancakeswap, what a crypto project can do is to give out its tokens as rewards to liquidity providers. By doing this, the broader ecosystem can benefit from it: 

  1. Traders who speculate on the token price can buy/sell the token without high price impacts. 
  2. The project owners can use the yield from yield farming as a marketing tool to increase awareness of the project. 
  3. The liquidity providers (or “yield farmers”) can be rewarded with free tokens.

But as the idiom goes, “there is no such thing as free lunch”, there are a few risks when participating in liquidity mining. Let’s go through them one by one in the following.

  1. Smart Contract Risk
    Most of the time, the crypto projects that use yield farming are new ones trying to bootstrap their platform. Due to their nascency, the code in their smart contracts might be buggy. If a bug affects the system or is exploited by a bad actor, the price of the project’s token will likely drop, and yield farmers will end up holding bags of worthless tokens.
  2. Rug-pull
    Another risk is that some projects could be outright fraudulent - they just grab people’s money and leave without any trace (we call this getting “rug-pulled” or “rugged”.)
  3. Impermanent Loss
    Another thing that can impact the profitability of yield farming is impermanent loss, which is a financial risk that happens when providing liquidity on an AMM. The high-level idea of impermanent loss is, when you provide liquidity to an AMM, you put in two tokens at a ratio according to their current prices. If their relative prices change, you will incur a loss if you decide to withdraw your liquidity at that price. But if the price goes back to the initial price (when you provided the liquidity), there is no loss. That’s why it’s called impermanent loss. You can check this post to learn more about this phenomenon.

For the first risk, check that the project’s code has been audited by a reputable auditing firm. Or, if you know how to program, you can check the smart contracts before providing liquidity. For the second risk, as a rule of thumb, if a team is not anonymous and is backed by well-known VCs, then the risks of getting rug-pulled are smaller.

As for the last risk, you can check this article to learn more.