How Does Yield Farming Work?
There are two major types of yield farming opportunities: LP farms and staking farms. At the basal level, both of these farming opportunities entail users depositing cryptocurrency into smart contracts. The difference is the type of smart contract involved.
I. LP farms: In an LP farm, a user deposits crypto into a smart contract that = facilitates a liquidity pool. Such a pool functions as a decentralized trading pair between two, or sometimes more, cryptocurrencies, and the trading is made possible by the crypto supplied by LPs.
In exchange for deposits, DeFi apps reward LPs with what are called LP tokens — e.g. SLP tokens for Sushi liquidity providers. These tokens can be used to retrieve your underlying deposits from the liquidity pool at any time, plus any interest you’ve accrued by way of trading fees.
These LP tokens are necessary because DeFi apps that run liquidity mining programs set up “staking” interfaces for depositing these LP tokens. This locks in your liquidity and automatically and continuously earns you governance token rewards for as long as your LP tokens are staked.
II. Stake farms: Users deposit crypto into a smart contract in a stake farm that facilitates a staking pool. Rather than being a decentralized trading pair, a staking pool is akin to a decentralized vault for a single kind of asset. It doesn’t facilitate trades but instead secures deposits.
These farms provide a more effortless experience for people compared to LP farms. That’s because stake farms only require users to deposit a single asset to earn passive income in contrast to serving as an LP on a DEX and thereafter staking LP tokens, too.
III. Other kinds of yield farming: In crypto, parlance says yield farming is the practice of LPing or staking your crypto to receive passive income. Yet as an increasingly extensive range of DeFi projects have launched liquidity mining programs, other types of participatory DeFi activities get incentivized with governance tokens are springing up.
The benefits to yield farming; it's so effective, because it:
- Gives users the ability to earn passive income on crypto.
- Offers a range of opportunities, from conservative low-yield farms to aggressive high-yield farms.
- Allows users to participate in DeFi protocol decisions via governance token rewards.
- People can gain DeFi literacy, which builds a base layer of skills that will help people master future DeFi innovations.
Indeed, yield farms are now the primary means for upstart DeFi projects to bootstrap their projects with liquidity. As DeFi and yield farming continue to grow more popular, users will gravitate toward opportunities where they can transact affordably and quickly.