What is yield farming and how does it work?
Yield farming moves crypto between DeFi pools to earn interest, trading fees and token rewards. The returns are not fixed and rewards are taxable.
Vahe HakobyanEditor-in-chief
Updated Oct 6, 20263 min readFact-checked
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It happens on DeFi platforms, where smart contracts hold assets and pay rewards without a bank. People use it to earn more from crypto they already hold, often by moving assets as incentives change.
How does yield farming work?
You deposit crypto into a liquidity pool. In return, you receive LP tokens that represent your share of the pool. The pool pays rewards from trading fees and extra protocol tokens.
- Trading fees paid by people who swap in the pool.
- Interest paid by borrowers in a lending protocol.
- Extra protocol tokens given as incentives, such as Compound Finance's Comp rewards that began in June 2020.
What risks does yield farming carry?
A high advertised yield is not fixed. It changes with pool activity and token prices. A protocol can pass an audit and still carry risks the audit missed.
How is yield farming different from staking?
Staking secures a blockchain. You lock tokens to help validate transactions or produce blocks. Yield farming provides DeFi liquidity or lending instead. The two can overlap when a staked token is also placed in a pool, but the purpose is different.
Is yield farming taxable in the US?
The IRS treats cryptocurrency as property. A reward you receive is usually taxable income at its fair market value when you get it. If you later sell the reward, that sale can trigger capital gains tax.
Frequently asked questions
A liquidity pool is a smart contract that holds assets so traders can swap against them. Swap fees go to the people who supplied the assets.
It is the gap between the value of your LP tokens and the value of simply holding the crypto you deposited. Price changes between the pool's assets cause it, even if you keep your LP tokens.
Some centralized exchanges offer earn products that pay interest on crypto you deposit. That is not DeFi yield farming because the exchange holds your assets and you rely on its promise rather than a smart contract.
