If you want to use your tokens to generate additional income, it is essential that you learn about yield farming. Like many things in DeFi, yield farming has a dual purpose – while you farm tokens and earn rewards, you also contribute to the health of the market by providing it with liquidity.
Therefore, various protocols provide additional incentives for yield farmers to provide liquidity (tokens) to liquidity pools. The growing liquidity then allows other traders to exchange and trade tokens without slippage (disparity between the expected price and the executed buy or sell price).
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What is yield farming?
Yield farming consists of staking tokens – typically LP (Liquidity Provider) tokens – into a liquidity pool to maximize token rewards. You can think of it as a loan that you offer to a protocol and in exchange for that service you receive rewards in the form of tokens.
While there are various strategies for the ever-growing number of yield farming dApps, the basic idea is to move tokens in and out of logs to maximize profit.
How to go about yield farming
Yield farmers typically hunt down liquidity pools with the best APYs, constantly moving their tokens between multiple platforms to optimize their profits. They typically use a combination of liquidity provision and staking, lending and borrowing, but remember your yield farming strategy doesn’t need to be complex.
You can employ more passive strategies, where you repeatedly deposit and reinvest earned tokens in the same log over a longer period of time. Below is an example of what this process might look like:
1. Deposit token A in protocol X’s liquidity pool.
2. Get the native LP tokens of the liquidity pool – each user who puts tokens into the liquidity pool will get LP tokens according to the amount they put into the pool. And every time a trade takes place through the liquidity pool, it distributes part of the fees (depending on the pool’s rules) proportionally to the LP token holders.
3. Deposit received LP tokens into the Protocol X staking pool (or another staking pool that allows staking with the LP tokens).
4. Receive Protocol X’s native token B.
In this example, your escrowed Token A earns tokens and fees in Protocol X’s liquidity pool. But at the same time, the LP tokens you earn from the liquidity pool earn you Token B as a reward for your continued liquidity provision by the LP tokens. Thus, with your Token-A deposit, you can earn twice on your deposit.
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