Actively moving cryptocurrency between DeFi protocols to maximise returns from liquidity provision, lending, and token incentives.
Yield farming emerged during the 2020 'DeFi Summer' when protocols began distributing governance tokens to users who provided liquidity - a practice called liquidity mining. Farmers earn multiple layers of yield simultaneously: the base protocol fee (e.g. Uniswap trading fees), token incentives from the protocol being farmed, and sometimes additional rewards from depositing LP tokens into secondary reward contracts.
The headline APYs advertised by farming protocols - sometimes thousands of percent - reflect token incentive rates that are often unsustainable. As more capital floods in, the yield per dollar decreases. Token incentives dilute existing holders. Farmers who enter early capture high yields; latecomers may earn below their cost of capital after accounting for gas fees, impermanent loss, and token price depreciation.
Risk management in yield farming requires monitoring smart contract audit status, protocol TVL trends (falling TVL often precedes fee and incentive rate reductions), token emission schedules, and the correlation between farmed tokens and the assets deposited. Complex multi-step strategies - borrow, farm, loop - amplify both yield and liquidation risk. Yield aggregators like Yearn Finance automate harvesting and compounding across strategies, reducing gas overhead for individual users.
Worked Example
A yield farmer deposits USD 10,000 USDC and USD 10,000 DAI into a Curve stablecoin pool. Base LP fee APY: 1.2%. Protocol incentive: 8% APY in CRV governance tokens. After 30 days the farmer harvests USD 167 in fees and 23 CRV tokens. However, CRV's price fell 40% since deposit - the CRV tokens are now worth USD 248 instead of the expected USD 414. Net monthly return: USD 415, roughly 2.5%, with the shortfall caused entirely by token price depreciation. Without the price decline, the strategy would have returned 9.2% annualised.