DeFi Yield Farming Explained: How to Earn From Liquidity Pools

Yield farming became one of the defining phenomena of DeFi’s explosive growth in 2020-2021. At its peak, certain protocols advertised annual yields of 1,000% or more. Most of those protocols — and those yields — no longer exist. But the underlying mechanism of yield farming is real, still widely used, and worth understanding properly.

What Is Yield Farming?

Yield farming is the practice of deploying crypto assets into DeFi protocols to earn returns. These returns come from multiple sources: trading fees from providing liquidity, interest from lending, and governance token rewards.

To understand yield farming, you first need to understand liquidity pools.

Decentralised exchanges like Uniswap do not work like traditional exchanges with order books. Instead, they use automated market makers (AMMs) that set prices based on the ratio of assets in a pool. For this system to function, someone must deposit assets into these pools — these people are called liquidity providers (LPs).

When you provide liquidity to a pool — say, depositing equal values of ETH and USDC into the ETH/USDC pool on Uniswap — you earn a share of the trading fees generated by that pool. Every trade that goes through the pool pays a fee (typically 0.01% to 0.3%), and LPs share these fees proportional to their share of the pool.

Where the “Yield” Comes From

Trading fees: The most fundamental source of yield. Pools with high trading volume generate significant fees for LPs. Stable pairs (USDC/USDT) generate lower but more consistent fees. Volatile pairs (ETH/SOL) can generate higher fees but with more risk.

Liquidity mining rewards: Many protocols distribute their governance tokens to LPs as an incentive to provide liquidity. In 2020-2021, these rewards were often enormous — protocols were essentially giving away tokens to bootstrap liquidity. These rewards have compressed significantly as the market has matured.

Lending interest: Protocols like Aave and Compound pay interest to users who deposit assets for others to borrow against. This is simpler than liquidity provision and does not involve price volatility risk within the protocol (though it does involve protocol risk).

Impermanent Loss: The Yield Farmer’s Biggest Risk

If you provide liquidity to a pool containing two assets, and the price of one changes significantly relative to the other, you can experience impermanent loss. This is the difference between the value of your pool position and what you would have had if you had simply held the two assets separately.

Here is a simplified example. You deposit £1,000 of ETH and £1,000 of USDC into a liquidity pool. The pool value is £2,000. Then ETH price doubles. The pool automatically rebalances — selling some ETH, buying more USDC, to maintain the ratio. When you withdraw, you have less ETH and more USDC than you deposited. Your position is worth less than if you had simply held the original ETH and USDC.

The loss is “impermanent” because if ETH returns to its original price, the loss disappears. But if you withdraw while prices are diverged, the loss is realised. Trading fees partially offset this, but in volatile markets, impermanent loss can significantly exceed fee income.

Stable asset pairs (USDC/USDT, USDC/DAI) are less subject to impermanent loss because both assets track the same peg. This is why stablecoin pools are generally considered lower risk for LPs.