In this section of the guide users will understand what's yield farming and the steps to start doing yield farming on the different parts of the platform, yield farming and staking are the pillars of DeFi’s passive income-generating strategies.
What is yield farming?
Yield farming, also referred to as liquidity mining, is a way to generate rewards with cryptocurrency holdings. In simple terms, it means locking up cryptocurrencies and getting rewards. In some sense, yield farming can be paralleled with staking. However, there’s a lot of complexity going on in the background. In many cases, it works with users called liquidity providers (LP) that add funds to liquidity pools.
What is a liquidity pool?
It’s basically a smart contract that contains funds. In return for providing liquidity to the pool, LPs get a reward. That reward may come from fees generated by the underlying DeFi platform, or some other source.
How does yield farming work?
Yield farming is closely related to a model called automated market maker (AMM). It typically involves liquidity providers (LPs) and liquidity pools. Liquidity providers deposit funds into a liquidity pool. This pool powers a marketplace where users can lend, borrow, or exchange tokens. The usage of these platforms incurs fees, which are then paid out to liquidity providers according to their share of the liquidity pool. This is the foundation of how an AMM works. On top of fees, another incentive to add funds to a liquidity pool could be the distribution of a new token.
For example, there may not be a way to buy a token on the open market, only in small amounts. On the other hand, it may be accumulated by providing liquidity to a specific pool. The rules of distribution will all depend on the unique implementation of each protocol. The bottom line is that liquidity providers get a return based on the amount of liquidity they are providing to the pool.