Understanding DeFi
Yield Farming and Liquidity Provision
Yield farming and liquidity provision let users earn on-chain rewards by supplying assets to DeFi protocols. You’ll learn how liquidity pools work, where APYs come from, and what risks (like impermanent loss) you should weigh before participating.
1. What is Yield Farming?
Yield farming is earning incentives (fees and/or tokens) for locking assets in DeFi protocols. On AMM DEXs like Uniswap or Raydium, users deposit token pairs into pools so traders can swap against that liquidity; LPs earn a share of trading fees and may receive extra token rewards.
2. Liquidity Provision
Liquidity providers (LPs) deposit pairs (e.g., ETH/DAI) and receive LP tokens that represent their share of the pool. LP tokens can sometimes be staked elsewhere to “stack” yield across multiple protocols.
3. How Rewards Are Calculated
Rewards typically come from swap fees (proportional to your pool share) and incentive tokens. Published APYs vary with volume, incentives, and pool depth. High APYs often imply higher risk or short-lived incentives.
4. Key Risks
- Impermanent Loss: Price divergence between pooled assets can make you worse off than simply holding.
- Smart Contract Bugs: Vulnerabilities can put funds at risk.
- Market Volatility: Rewards and principal values fluctuate.
- Regulatory Uncertainty: Rules are evolving.
5. Practical Strategies
Diversify pools, favor correlated or stable pairs to reduce IL, monitor APYs versus risk, and consider periodically harvesting rewards. Start small to learn mechanics before scaling.
What's Next
Up next: DeFi Risks and Challenges—a focused look at smart contract risk, liquidation dynamics, impermanent loss, regulation, and how to build a safer operating playbook.
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