Yield farming is a DeFi strategy where users supply liquidity or stake tokens to earn rewards, typically paid in protocol tokens or trading fees.
This allows crypto holders to earn passive income on their idle assets besides price appreciation. Users typically lock up their assets in a liquidity pool and earn rewards in the form of Liquidity Provider (LP) tokens, which represent their share in the pool.
Besides this, they also earn a share of the trading fee or interest earned by the pool, depending on their contribution size.
Yield farming exists because of one major market mechanism – liquidity. DeFi protocols, DEXs, and platforms need liquidity to operate. Think of it like a bank with no cash: as long as banks do not receive deposits, they cannot operate. The same goes with DeFi and liquidity.
To solve this issue, they offer rewards in the form of trading fees, governance tokens, and incentives in exchange for locking tokens on their protocol – just like how banks offer interest on deposits.
Once liquidity kicks in, it results in more network activity, which leads to more fees, and higher LP rewards, which in turn, leads to more liquidity again and the cycle keeps moving.
RugDoc’s Diagnosis: If you’re deep into the crypto space, mastering the concept of yield farming is not so much as an optional, but a requirement.
In this article, we’ll understand in detail how yield farming works with detailed examples, what APY is, and several strategies you can use to put your crypto holdings to work.
How Does Yield Farming Work?
Yield farming works by depositing assets into smart-contract liquidity pools to earn rewards. Liquidity pools are smart contracts that hold two crypto assets instead of one, say $ETH and $USDC.
Now, whenever a user wants to swap their $USDC for $ETH, they can use this liquidity pool instead of relying on a traditional crypto exchange.
However, for this liquidity pool mechanism to work, it requires crypto holders to lock in assets (in this case, $ETH and $USDC) so that the pool has enough liquidity for them.
But, the question is why would someone that owns $ETH just donate their asset to the liquidity pool. Well, it’s because they get LP tokens, which represent their share on the entire pool. They can then swap these LP tokens for real $USD, depending on their current value.
Plus, liquidity providers (LPs) also get a share of the fee collected by the pool along with any liquidity rewards as mandated by the pool. Every time someone uses the pool for token swaps, they have to pay a swap fee.
LPs get a portion of this fee depending on their pool share. For instance, if you’re part of a $10M pool, where you own 0.1% stake, and the pool generates $30,000 fee in a week, you get $30 out of it as rewards.
The LP tokens you receive may also represent your share of voting and governance rights on the platform. However, this may depend on platform to platform and is not always a given. You can redeem these LP tokens whenever you want to unlock your assets from the liquidity pool.
Some platforms like Sushiswap and PancakeSwap also offer additional tokens to encourage liquidity locking. For instance, Sushiswap offers its indigenous token $SUSHI for certain pools like ETH-USDC.
Another way you can earn rewards through yield farming is in the form of lending interest when you lock your tokens on lending platforms like Aave or Compound. These are fast crypto loan DeFi lending applications, where borrowers pay a fixed interest on the borrowed funds. LPs earn a portion of this interest based on their contribution to the lending pool.
Difference between yield farming and staking
People are often confused between yield farming and staking. Staking simply means locking up one crypto asset to help secure the blockchain and earn passive rewards in the process. Staking usually helps validate transactions, participate in platform governance and keep the network decentralized.
For instance, you can stake CRV On Convex Finance to earn passive income. Staking rewards usually come from block and validator rewards, network inflation, and protocol revenue.
Yield farming, on the other hand, requires locking two tokens to a liquidity pool which boost liquidity, reduces slippages, and helps bootstrap new TVLs. This is considered more risky than staking due to impermanent losses and smart contract risks.
That said, rewards in yield farming are also higher than staking.
Impermanent Loss
Impermanent losses happen when the returns you get by locking your crypto assets are less than what you would have received had you simply held the asset in your crypto wallet.
Now, Automated Market Makers (AMMs) must maintain a balance between the two tokens in their liquidity pool through a fixed price ratio. So, whenever the value of an asset increases, your tokens in the pool are rebalanced to maintain that ratio. And this new balance can be worth less than your original tokens.
Let’s say you put $1,000 worth of $ETH and $1,000 worth of $USDC in a liquidity pool and then, $ETH doubles in the next six months. So, if you had only held the assets in your wallet, your portfolio would be worth $3,000 today. ($2,000 ETH + $1,000 USDC).
However, since they are sitting inside a liquidity pool, rebalancing would occur and you may end up with $1,414 USDC and $1,414 worth of ETH, which comes to $2,828. In this case, your impermanent loss stands at $172 or 5.7%.
The impermanent loss keeps fluctuating with the price of the assets and is not fixed. If the price reverts back to what it was when you put them in the pool, your impermanent loss would become zero.
However, instead of viewing this as a loss, investors view it as a trade-off. As long as they are able to make more than the loss in the form of LP tokens, rewards, trading fee, or interest from the pool, yield farming is a win-win situation.
What Is APY in Yield Farming?
Annual Percentage Yield (APY) is the rate of return you can earn on your yield farming strategy in a year. This includes all forms of rewards such as trading fee, interests, token rewards, and so on.
APY in DeFi isn’t fixed but rather dynamic and depends on factors like liquidity, trading volumes, token emission rates, and price changes.
For example, a swapping platform with higher liquidity and trading volume may offer higher APY. However, the biggest catch here is that high APY isn’t always a positive sign in DeFi.
Usually, new platforms mint a lot of reward tokens to attract liquidity providers, known as token emission. However, as demand falls after a certain time, these tokens start losing price value.
So, a reward tokens may be minted at $0.50, showing an APY of 300%. However, if the project demand falls, the tokens may lose 70-80% value over time, resulting in less actual gains.
Plus, as more and more liquidity enters a pool, the rewards are shared across a larger number of people, which eventually depletes your APY. Let’s say you had contributed $30,000 to a $30M pool, which made your share around 0.1%.
But, as the pool swells to $40M, your share dwindles to just 0.075%, resulting in lower APYs.
Besides this, high APY is often used as bait to attract investors towards fundamentally hollow crypto projects with poor tokenomics, unlimited supply, or uncontrolled emissions.
This is why it is important to look into other project factors such as utility, burn mechanism, and token distributions as extremely high APY can be a major red flag.
Types of Yield Farming Strategies
Yield farming strategies refer to the different ways you can earn passive income by locking up your crypto assets. Now, every strategy comes with its own level of complexity and skill requirement along with their associated risks.
Let’s go through the five most popular yield farming strategies in detail.
1. Single-Asset Staking
This is the simplest form of yield farming where you stake your crypto asset into a single protocol and earn rewards in return. The reward can either be in the same token denomination or another token.
This is ideal for beginners who want to start earning passive income through crypto, is less risky, and isn’t susceptible to any impermanent loss.
However, staking your tokens may include a lock up period, where you might not be able to unlock your funds without penalties. Plus, the staking yield keeps decreasing as more and more participants join the pool, resulting in lower APYs.
2. LP Farming (Two-Asset Liquidity Pools)
As discussed in the ETH–USDC example earlier, LP farming is when you deposit two tokens into a liquidity pool such as Uniswap or Sushiswap. These tokens strengthen the liquidity pool of the smart contract and reward you in the form of trading fees and token rewards.
This is usually more rewarding than single staking, but it comes with its fair share of impermanent loss since the assets locked can be pretty volatile.
3. Stablecoin Farming
Stablecoin farming is a form of LP farming where you contribute two stablecoins to a liquidity pool instead of one. Since stablecoins tend to stay close to the value of one dollar, they are less volatile, which reduces impermanent loss.
Plus, the APYs are pretty predictable, sitting between 5% to 20%. However, risks such as smart contract exploits and stablecoin depegging still exist.
This is ideal for those who want to earn more rewards than staking but want to minimise the risk of impermanent loss.
4. Auto-Compounding Vaults
Auto-compounding vaults are smart contracts that collect your LP rewards and reinvest them automatically on your behalf, thereby compounding your returns in the process. When done manually, yield farming can be a lengthy process which involves collecting your reward tokens and claiming, selling, and locking them up again.
Auto-Compounding vaults automate the whole process for you, thereby increasing your APY returns. So, if you are earning 60% APR through manual LP farming, automated vaults can increase that to 75% or 80%.
However, here you’re relying on two smart contracts instead of one, which increases your overall risk.
5. Lending/Borrowing Yield (DeFi Money Markets)
To earn borrowing or lending APY, you’ll need to lock up your tokens on a DeFi platform that offers crypto loans such as Aave, Compound, Venus, or Radiant. Your deposited tokens are then offered as loans to borrowers, allowing you to earn interest in the process.
Some DeFi platforms may also offer additional incentive tokens.
Another advanced version of this strategy is when yield farmers borrow an asset and then farm it to create a loop of passive income.
Although impermanent loss is less with this method, there is still a risk of fluctuating variable interest rates as well as borrower liquidation.
Risks of Yield Farming
Yield farming is a lucrative way to earn passive income by putting your ideal crypto assets to work. However, yield farming isn’t ‘easy money’ as it comes with certain risks such as impermanent losses, smart contract risks, token volatility and reward dilutions.
Let’s look at each risk in detail while finding ways to mitigate them in the process.
1. Impermanent Loss
Impermanent loss arises from the need of liquidity pools to maintain a constant price ratio between the two assets in the pool. Whenever the price of any one asset changes, this price ratio begins to diverge from the constant, which is why the asset balances in the pool must be recalibrated.
However, this rebalancing may lead to a depletion in the value of an asset compared to what it would have been if you had simply held the asset in your online crypto wallet. This difference is known as impermanent loss.
It is called ‘impermanent’ because the loss will return to zero if the price of the asset becomes the same as it was when you deposited them into the liquidity pool.
Impermanent loss is not a realized loss but only a notional or opportunity loss, which can be covered through LP rewards, trading fees, and the interest you earn from the liquidity pool.
2. Smart Contract Risks
Yield farming relies on smart contracts, which are basically complicated series of codes for their day-to-day management and operation. However, these smart contracts can be vulnerable to bugs and can be exploited by malicious entities, which can lead to investor losses.
For example, a threat actor may manipulate price feeds on a smart contract, which can lead to wrong collateral valuations. Similarly, attackers may borrow a lot of funds in a very short time, which can drain liquidity and manipulate prices.
This is why it is very important to read the verified source code on block explorers like Etherscan to look for any prenatal red flags.
Plus, read the audit report of the smart contract to ensure that the devs addressed any bugs, fixed the code, and re-audited to verify the same.
3. Rugpulls and Malicious Contracts
Rugpulls happen when the project developers exploit hidden contract features or design the smart contracts in such a way as to defraud the investors. The most popular type of rugpull is liquidity removal, where the project initially attracts more investors through high APY, and lucrative marketing gimmicks.
Investors buy the project token and add liquidity to the pool. Eventually, the developers withdraw that liquidity out of the pool by redeeming the huge amount of LP tokens they own.
As a result, the token price crashes to near zero and becomes untradable, leaving investors with nothing.
Another popular rugpull is honeypots, where the contract doesn’t allow you to sell your holdings. The price of the asset keeps rising since nobody is able to sell. Ultimately, the developers dump all their holdings and exit the markets at a very high price.
Potential ways to mitigate this risk is looking at the smart contract itself to check functions like mint(), burn(), owner() functions or if the renounceOwnership() function was called. Check if the LP tokens are locked or not, as unlocked LP tokens will allow the developers to suck out liquidity whenever they want.
Always choose a trusted developer with a clean history in the crypto industry as against a new entrant with no due diligence.
4. Token Volatility & Reward Dilution
Liquidity firms often reward LPs through their own native tokens, which can be susceptible to both price risk and inflation risk. Usually, only the developers can mint tokens to offer as participation rewards.
However, as more tokens are minted without a corresponding increase in demand, the tokens start losing their value. So even if the project promises higher APY, your real income would be much less in USD terms.
For example, if a project is minting tokens at 10,000 per day while the current supply is 1,000,000 tokens, the supply is increasing at a rate of 1% every day, which is considered huge. If the demand doesn’t increase by at least 1%, the tokens will lose value with each passing day.
This is why it is important to check the emission schedules, which show how many tokens are minted per block or per day. See if there are any hard upper caps on the supply limit or if there are any vesting schedules attached to the project.
Any large token unlock can result in mass dumping, which can sharply downshoot the token prices.
5. Liquidity/Exit Risk
The LP reward tokens you earn by locking your crypto assets are also susceptible to liquidity or exit risk. This happens when you are unable to sell your reward token due to the lack of a corresponding buyer on the other end. Even if you can find a buyer, the price offered is lower than what you are willing to accept.
This is known as slippage which can be as high as 10-20% in some cases.
6. Stablecoin Depeg Risk (for stablecoin farms)
Stablecoins usually trade near the value of $1. However, there may be instances where the value of a given stablecoin may diverge from the pegged asset, which is known as stablecoin depeg risk.
Depegging may happen due to several reasons such as insufficient or bad backing (as in the case of UST), liquidity issues in AMM pools, loss of market confidence, and so on.
When any asset in the stablecoin pool depegs, it becomes the dominant asset in your portfolio because of arbitrage.
Let’s say you have $1,000 worth of ETH and $1,000 worth of USDC in an ETH-USDC pool and the USDC value depegs 20% to $0.80. However, since the pool calculates $USDC price based on the price ratio and constant formula, the value of $USDC is still $1 inside the pool.
So, traders start selling $USDC (since it is still priced higher than the market) inside the pool and drain out $ETH, leaving the pool with more $USDC than ETH, which creates an imbalance. So, you may now end up with $2,500 $USDC.
To mitigate this risk, ensure that you only choose trusted blue-chip stablecoins with adequately backed collaterals.
What is Yield Farming – Made Simple
Yield farming has evolved over the last five years and has shifted toward safer, stablecoin-based strategies where farmers prefer predictable returns over volatile and speculative farms.
APYs today are moderate, ranging from 5% to 30%, and are mostly driven by real trading fees and interest rather than token emissions. Farmers no longer chase higher APYs but prefer projects with solid tokenomics and smart contract safety that minimize impermanent loss.
At the same time, protocols have also evolved and redesigned themselves to reduce emissions and token inflation along with hard emission caps.
To put it in a nutshell, yield farming in 2026 is becoming more sustainable and stable, with users prioritizing risk management and reliability.
FAQs
What is yield farming?
Yield farming is a passive income earning strategy where you lock up crypto assets in liquidity pools or lending platforms. In return, you earn LP reward tokens, which can be exchanged for any other crypto or $USD.
Plus, you also earn a share of the trading fee or interest (if it’s a lending protocol) collected by the protocol, depending on your share in the pool.
How does yield farming work?
Yield farming works by locking up assets in a liquidity pool in exchange for a portion of the trading fees or interest earned by the smart contract protocol. Every time someone executes a swap, the protocol collects trading fees. You get a portion of this fee, depending on your pool contribution.
The same goes for lending protocols that collect interest on crypto loans. Plus, you also get LP tokens, which you can swap for any other crypto or $USD.
Is yield farming safe?
Yes, yield farming is a safe way of earning passive income by locking up your idle crypto assets in liquidity pools. The protocols are based on smart contracts which are duly audited from time to time to find bugs and vulnerabilities.
That said, yield farming is susceptible to impermanent losses, rug pulls and token volatility, which is why you should only choose trusted platforms with deep liquidities.
What is impermanent loss in yield farming?
Impermanent loss happens when the value of the tokens in a liquidity pool becomes less than what they would have been had the LP provider simply held them in his crypto wallet.
This loss occurs because liquidity pools must maintain a price ratio which requires them to rebalance the value of the locked tokens whenever there is a change in price of the underlying asset.
How do yield farmers earn APY?
Yield farmers earn API through trading fee, interest income and LP reward tokens. Trading fees are earned when LP providers lock their tokens in a liquidity pool used to swap tokens, whereas interest income accrues when tokens are locked on DeFi lending/borrowing pools.
These platforms also offer LP tokens/rewards which represent the contributor’s share in the overall pool.
