The token represents the user's stake in the liquidity pool and ensures custody of the deposit remains with the user. For example, if a user deposits ETH into the borrowing and lending protocol Compound, they would receive cETH tokens in return. Many DeFi protocols mint liquidity provider tokens when a user deposits cryptocurrencies into a liquidity pool. Obtaining the optimum yield could involve moving to a different liquidity pool on the same platform or changing platforms altogether. Yield farming refers to the process where liquidity providers move liquidity between high-yield pools to take advantage of these dynamic changes in yield. As the AMM calculates interest rates using supply and demand, unlike traditional financial investments, yields can vary daily. This is often written as a percentage, either as annual percentage rate (APR) or annual percentage yield (APY). Yield is the annual return that a liquidity provider can receive for lending cryptocurrency assets. The use of AMMs and liquidity pools has facilitated the growth of yield farming in the sector. Rules surrounding the distribution of fees and the length of time cryptocurrency assets must be locked in can vary between protocols.
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The rewards are usually in the form of cryptocurrency tokens.Īutomated market makers are algorithms (a series of smart contracts) that calculate the exchange prices and interest rates on a platform based on the available liquidity held within liquidity pools.Īutomated market makers (AMMs) explained. These fees are then distributed proportionally to liquidity providers depending on their share of the liquidity pool. To use the pot of cryptocurrencies, the user has to pay a fee. Liquidity pools can be thought of as a "pot" of cryptocurrencies that other users can use for exchanges or loans. Liquidity providers, those seeking to earn interest from idle cryptocurrency holdings, can deposit their funds into a liquidity pool. Yield farming is made possible by the application of automated market makers and liquidity pools, which are used to power decentralized exchanges or lending platforms. As the sector advances, there will undoubtedly be even more use cases in the future.Īt the time of writing, the total value locked (TVL) in DeFi protocols by liquidity providers is $65 billion. The liquidity is often used for decentralized exchanges, trading or loans. Those that take part in yield farming and provide liquidity to DeFi platforms are known as liquidity providers (LPs). However, while staking uses cryptocurrency tokens to power a blockchain or protocol, yield farming uses cryptocurrencies as liquidity for other investors or traders. The process is similar to staking as it involves depositing and locking cryptocurrency holdings for a certain period of time. It is a way for cryptocurrency investors to earn passive income from digital assets that would otherwise be sitting idle. In return for lending digital assets, users are rewarded with more cryptocurrency tokens. Yield farming is the process of lending cryptocurrency assets to DeFi protocols so that the assets, or "liquidity", can be utilized by others. Disclaimer: This information should not be interpreted as an endorsement of cryptocurrency or any specific
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