Yield Farming Strategies
A DeFi protocol paying an eye-catching yield in its own token is often just paying users to bootstrap liquidity it needs — the real question for a farmer is whether the reward token holds its value long enough to be worth more than the risk taken to earn it.
Prerequisites: Automated Market Makers, DeFi Rate Arbitrage and Looping
New DeFi protocols need liquidity before anyone will trade on them, and a chicken-and-egg problem stands in the way: traders won't use a pool with no depth, and liquidity providers won't deposit into a pool with no volume to earn fees from. Yield farming (also called liquidity mining) solves it by paying depositors in the protocol's own token on top of whatever trading fees the pool earns — a subsidy meant to attract capital while the protocol is new.
The advertised annual percentage yield on a farm is almost always dominated by that token reward, not by trading fees. That matters because the reward token has no guaranteed value: it is newly issued, often has little trading volume of its own, and its price tends to fall as the protocol keeps emitting more of it to pay farmers — a dynamic farmers call "farm and dump."
A yield farm's headline APY is mostly a payment in a token the protocol prints for the purpose, not organic fee revenue — the real return is that reward's market value at the time it's sold, which is usually far lower than the APY implied when the farmer deposited, because early yield attracts sellers who depress the token's price.
Where the yield actually comes from
A farmer also carries the underlying pool risk on top of token-price risk: if the farm requires depositing two assets into an AMM, the farmer is exposed to impermanent loss just as any liquidity provider would be, in addition to betting on the reward token itself.
Worked example
A new protocol offers 40% APY on a stablecoin pair pool: 4% from trading fees, 36% paid in its governance token, currently worth $2.00. A farmer deposits $10,000. After one month, they've earned roughly $33 in fees and accrued reward tokens notionally worth about $300 (36% annualized, one month's worth) at the $2.00 price when they started farming.
But heavy farming has pushed the reward token's price down to $1.20 by the time the farmer claims and sells — a 40% price drop. Their actual reward proceeds are 300 \times (1.20/2.00) = \180, not \300, so their realized one-month return is about , an annualized rate near 26% rather than the advertised 40% — still positive here, but the gap shows how quickly the headline number can decay, and a farmer who joined later, after more emissions had already pushed the price down further, could easily see the token slice turn into a net loss.
Comparing farms purely by advertised APY is comparing mostly unrealized, self-issued token value, not cash yield. The fee component is the only part of the number that doesn't depend on someone else being willing to buy the reward token from you later at a similar price.
Related concepts
Practice in interviews
Further reading
- Cousaert, Xu, Matsui, SoK: Yield Aggregators in DeFi