What is yield farming?

Yield farming is the practice of putting crypto to work in DeFi programs and moving it between them to earn the highest return. The farmer deposits tokens, collects rewards and often reinvests them. The returns can look far higher than anything a bank offers, and they come with matching risk.

How does yield farming work?

A farmer starts by depositing tokens in a program that needs them. That might be a liquidity pool, which lets other people swap tokens, or a lending program, which lends the deposit to borrowers.

In return, the farmer earns a share of the fees or interest. Many projects add a bonus on top, paid in their own token. The farmer may then deposit that reward somewhere else to earn again, stacking one return on another.

The practice took off in June 2020, when the lending project Compound began handing its new token to users. Other projects copied the idea, and money started moving quickly between them.

Where does the yield come from?

There are three sources, and they are not equal:

• Trading fees. Each swap in a pool pays a small fee to the people who funded it.
• Interest. Borrowers pay to use deposited funds.
• Reward tokens. The project issues new tokens to depositors to attract money.

The first two depend on real activity by other users. The third is a subsidy. Its worth depends entirely on what the market will pay for the project's token.

Returns are usually quoted as APY, or annual percentage yield. That figure assumes today's reward rate continues for a full year and that rewards are reinvested. Neither is promised.

Why do high APYs fade?

A quoted rate is a snapshot. When a pool pays well, more money arrives, and the same rewards are split among more depositors. Farmers also tend to sell their reward tokens as soon as they get them, which pushes the token's price down and shrinks the yield further.

Reward programs also end. When they do, deposits often leave for the next project. Critics call this mercenary capital and argue that yields funded only by new token issuance are circular, because they pay early users with tokens that later buyers must support.

What are the risks?

• Code bugs. Each added program is another smart contract that could be exploited.
• Impermanent loss. Funding a pool can leave a farmer with less than simply holding the tokens. See impermanent loss.
• Scams. Some farms exist only to collect deposits and disappear, a scheme known as a rug pull.
• Costs. Network fees on each move can exceed the reward on a small deposit.
• Collapse. In May 2022, the Terra network's Anchor program, which had advertised close to 20% a year on a stablecoin, failed along with the stablecoin itself.