Basically, it means locking up cryptocurrencies and receiving rewards.
In certain sense, yield farming can be paralleled with staking. However, there is a good deal of sophistication going on in the background. Oftentimes, it functions with users called liquidity providers (LP) which include funds to liquidity pools.
What’s a liquidity pool? It is basically a smart contract which has funds. In return for providing liquidity to the pool, LPs get a reward. That reward may come in fees generated by the underlying DeFi platform, or some other source.
Some liquidity pools pay their rewards in multiple tokens. Those reward tokens then may be deposited to other liquidity pools to make rewards there, etc. You may already see how amazingly intricate strategies can emerge very quickly. Nevertheless, the fundamental notion is that a liquidity supplier deposits funds into a liquidity pool and earns benefits in return.
Yield farming is usually done using ERC-20 tokens on Ethereum, and the rewards are often also a type of ERC-20 token. This, however, might change later on. Why? For now, much of this activity is happening in the Ethereum ecosystem.
However, cross-chain bridges and other comparable improvements may allow DeFi applications to turn into blockchain-agnostic in the future. This usually means they could run on additional blockchains which also support intelligent contract capabilities.
Yield farmers will typically move their capital around quite a good deal between different protocols in search of high yields. As a result, DeFi platforms may also offer other economic incentives to bring in more funds to their stage. Just like on centralized exchanges, liquidity tends to attract more liquidity.
How does yield farming operate?
Let us see how it functions.
This pool powers a market where users can lend, borrow, or exchange tokens. The usage of these platforms incurs fees, which are then paid out to liquidity suppliers according to their share of their liquidity pool. This is the foundation of how an AMM works.
But, the implementations can be vastly different — and of course that this is a new technology. It is beyond doubt that we are going to see new strategies that improve upon the present implementations.
On top of fees, another incentive to add funds into a liquidity pool could be the distribution of a new token. By way of instance, there might not be a means to purchase a market on the available, only in small quantities. On the other hand, it may be accumulated by supplying liquidity to a specific pool.
The principles of distribution will depend on the exceptional implementation of the protocol. The bottom line is that liquidity suppliers receive a yield based on the amount of liquidity they are supplying to the pool.
A number of the most typical stablecoins used in DeFi are DAI, USDT, USDC, BUSD, and others. Some protocols will mint tokens that reflect your deposited coins in the system.
You can deposit your cDAI into another protocol that mints a third token to represent your cDAI that represents your DAI. So on, Etc. These chains can become really complex and difficult to follow.