If you want to put your tokens to work to earn additional revenue, it’s imperative you familiarize yourself with yield farming. Like many things in DeFi, yield farming has a dual purpose – while farming tokens and earning rewards, you are also contributing to the health of the market by providing it with liquidity.
As such, various protocols offer additional incentives for yield farmers to provide liquidity (tokens) to liquidity pools. The growing liquidity then allows other traders to swap and trade tokens without any slippage (disparity between the expected price and executed purchase or sale price).
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What is yield farming?
Yield farming consists of staking tokens — usually liquidity provider (LP) tokens — in a liquidity pool to maximize token rewards. You can think of it as a loan you offer to a protocol, and in return for that service, you earn rewards in the form of tokens.
While there are various strategies for the ever-increasing number of dApps for yield farming, the basic idea is to move tokens in and out of protocols to maximize profits.
How to go about yield farming
Yield farmers usually chase liquidity pools with the best APYs and constantly shift their tokens between multiple platforms to optimize their gains. They typically use a combination of liquidity provision and staking, lending and borrowing but remember that your yield farming strategy doesn’t have to be complex.
You can employ more passive strategies, whereby you deposit and reinvest earned tokens repeatedly in the same protocol over a prolonged period. Below is an example of how this process may look:
1. Deposit Token A to Protocol X’s liquidity pool.
2. Receive the liquidity pool’s native LP tokens — every user who stakes tokens to the liquidity pool receives LP tokens according to the amount they have supplied to the pool. And each time a trade happens through the liquidity pool, it distributes a part of the fees (depending on the pool’s rules) proportionally to the LP token holders.
3. Deposit received LP tokens to the Protocol X staking pool (or another staking pool that allows staking with the LP tokens.)
4. Receive Protocol X’s native Token B.
In this example, your deposited Token A earns tokens and fees in Protocol X’s liquidity pool. But simultaneously, the LP tokens you earn from the liquidity pool will earn you Token B as a reward for your further liquidity provision through the LP tokens. Thus, your Token A deposit enables you to earn twice on your deposit.
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