Yield Farming

Overview

Yield Farming refers to the process of providing liquidity to specific AMM pools for the purposes of receiving additional rewards that are external to the market making fees. The practice of Yield Farming gained traction as protocols could incentivize liquidity to be locked by distributing protocol tokens to liquidity providers of a preferred pool. In effect, by allocating protocol funds to Yield Farms, protocols were directly incentivizing greater market depth for the selected pools.

Prior to the creation of Yield Farms, LPs could only earn yield in the form of trading fees whenever their liquidity in the pool was used to facilitate a trade. This meant that the trading fees generated had to be sufficiently large to cover their market making risks (i.e. impermanent loss, etc.). Yield Farming rewards helped to offset such risks while also providing additional incentives for LPs to continue supporting the market depth required to create a liquid market for the protocol token.

The majority of Yield Farms are time-based whereby farming rewards are distributed linearly over a predefined time period. To be eligible for the Farming Rewards, LPs must contribute liquidity towards the specified liquidity pool. LPs are allocated a proportion of the Farming Reward pool that is equal to their effective liquidity contribution throughout the Yield Farm period. Note that the above is a general rule as more complex farming mechanisms have been developed especially with the introduction of concentrated liquidity pools.