Yield farming pays users to provide liquidity — depositing token pairs into pools so others can swap between them. Returns come from trading fees and, often, bonus reward tokens.
How returns are generated
- Deposit two tokens (e.g. ETH + USDC) into an automated market maker pool.
- Earn a share of swap fees from traders using the pool.
- Often receive additional governance tokens as incentives — this is what drives headline APY figures.
Reward tokens only hold value while new depositors continue farming them. When inflows stop, token prices and APY typically collapse.
Impermanent loss
As token prices move, the pool rebalances automatically. If one token appreciates significantly, you end up holding more of the other token than if you had simply held both assets separately.
“Impermanent” loss only reverses if prices return to deposit levels. If they don’t, the loss is permanent. Farming rewards may or may not compensate.
Additional risks
- Smart contract exploits draining pools
- Anonymous teams abandoning projects (“rug pulls”)
- Auto-compounders with hidden leverage
- Gas fees consuming rewards on small positions
Treat yield farming as high-risk tactical activity, not passive income. Assume total loss is possible. If you cannot explain impermanent loss or identify the contract author, you are likely providing exit liquidity for someone else.