Yield farming is the practice of staking or lending crypto assets in order to generate high returns or rewards in the form of additional cryptocurrency.
This innovative yet risky and volatile application of decentralized finance (DeFi) has skyrocketed in popularity recently thanks to further innovations like liquidity mining. Yield farming is currently the biggest growth driver of the still-nascent DeFi sector, helping it to balloon from a market cap of $500 million to $10 billion in 2020.
In short, yield farming protocols incentivize liquidity providers (LP) to stake or lock up their crypto assets in a smart contract-based liquidity pool. These incentives can be a percentage of transaction fees, interest from lenders or a governance token (see liquidity mining below). These returns are expressed as an annual percentage yield (APY). As more investors add funds to the related liquidity pool, the value of the issued returns decrease accordingly.
At first, most yield farmers staked well-known stablecoins USDT, DAI and USDC. However, the most popular DeFi protocols now operate on the Ethereum network and offer governance tokens for so-called liquidity mining. Tokens are farmed in these liquidity pools, in exchange for providing liquidity to decentralized exchanges (DEXs).
Liquidity mining occurs when a yield farming participant earns token rewards as additional compensation, and came to prominence after Compound started issuing the skyrocketing COMP, its governance token, to its platform users.
Most yield farming protocols now reward liquidity providers with governance tokens, which can usually be traded on both centralized exchanges like Binance and decentralized exchanges such as Uniswap.
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