What is yield farming? DeFi yield farming and its risks
Yield farming is putting your crypto to work in decentralised finance (DeFi) apps to earn rewards, for example by depositing tokens into a liquidity pool or lending them out through a smart contract. Yield farmers earn a share of trading fees, interest from borrowers and extra incentive tokens, and often move their funds between platforms to chase higher yields.
It can look like a savings account for crypto, but it isn’t one. The returns are variable and paid in tokens that can lose value, and the risks are much higher than with traditional investments. Read the risk section before you deposit anything.
What is yield farming, in plain words?
Yield farming means lending your digital assets to a DeFi protocol and getting paid for it. Instead of crypto sitting as idle assets in a wallet, you deposit tokens into a smart contract that uses them: to let other people trade, borrow or stake. In return you receive a share of what the protocol earns, plus any rewards it hands out to attract users.
The term took off in 2020, when DeFi lending protocols began paying users in their own newly minted governance tokens. That form of yield farming is also called liquidity mining.
How does DeFi yield farming work?
DeFi yield farming works in a few steps. The details differ between DeFi platforms, but the yield farming process usually looks like this:
- Connect a self-custody wallet to the app and deposit tokens, often a pair such as ETH and a stablecoin.
- Receive a receipt token that shows your share of the pool or loan.
- Earn rewards as the protocol collects fees or interest, and sometimes extra tokens.
- Claim, reinvest or move your rewards. Some yield farmers compound rewards; others move to multiple DeFi platforms or multiple networks as rewards change.
- Withdraw by returning the receipt token and getting your share back.
Every step is a blockchain transaction, so each one costs transaction fees, which can eat into small positions.
Where the rewards come from
Yield in DeFi comes from four main sources:
- Swap fees: traders on decentralised exchanges pay a fee on every swap, which goes to the liquidity providers whose tokens made the trade possible.
- Interest: on lending protocols, borrowers pay interest rates that go to the lenders.
- Token incentives: protocols pay incentive tokens, often their own native token, to attract liquidity. This is the least reliable source, because it adds to the token supply.
- Staking rewards: liquid staking tokens pass on staking rewards from a proof of stake network and can be used in DeFi at the same time.
Liquidity pools and decentralised exchanges
Most yield farming starts with a liquidity pool: a smart contract holding two or more tokens that traders swap against. Decentralised exchanges use an automated market maker to set prices from the ratio of tokens in the pool, instead of an order book.
When you are providing liquidity, you deposit both tokens of a pair in equal value. Traders pay swap fees, and you receive your share. The catch is impermanent loss, explained below.
Common yield farming strategies
Farming strategies range from simple to very complex:
- Lending: deposit stablecoins on a lending platform and earn interest from borrowers.
- Liquidity provision: add a token pair to a pool on a decentralised exchange.
- Liquid staking: stake ETH or another coin through a protocol that gives you a liquid staking token, then use that token elsewhere.
- Yield aggregators: automation tools that move funds between strategies for you, adding another layer of smart contracts.
- Leveraged farming: borrow assets against your deposit and farm with the borrowed money too. This multiplies both rewards and losses, and can lead to liquidation.
Each extra layer adds risk exposure. A yield farming strategy that stacks several protocols fails if any one of them does.
Yield farming risks, explained plainly
Yield farming carries serious risks, and you can lose all of your money. These are the main ones.
Smart contract risk
Your funds are held by code, not by a company. If a smart contract has a bug, an attacker can drain it, and user funds disappear in minutes. Audits reduce smart contract risks but don’t remove them, and many exploited projects had been audited.
Impermanent loss
Impermanent loss is what liquidity providers lose compared with simply holding their tokens, when the prices of the two tokens move apart. Here’s a worked example:
- You deposit €1,000 into an ETH/USDC pool: 0.25 ETH at €2,000 and €500 in USDC.
- ETH doubles to €4,000. The pool rebalances as traders buy ETH from it.
- Your share is now worth about €1,414.
- If you had simply held 0.25 ETH and €500 USDC, you would have €1,500.
That €86 gap, about 5.7%, is impermanent loss. Your fees have to beat it just to break even with holding. Our entry on impermanent loss shows the formula.
Reward tokens that fall in value
High headline rewards are often paid in a project’s own token. If many yield farmers sell those tokens as soon as they receive them, the price can fall faster than the rewards come in. Rewards can change or stop at any time, and an annual percentage yield is only a snapshot of current market conditions.
Scams and rug pulls
Some projects are built to take deposits and disappear. A team that controls the contract can drain it or mint unlimited tokens. See rug pull for the warning signs.
Liquidity pools drying up
Liquidity pools drying up is a common end to a farm: when protocol incentives stop, liquidity providers leave, trading volume falls, and the remaining depositors earn little while still carrying the risks.
No investor protection
There is no deposit guarantee and no investor compensation scheme for crypto. Most DeFi protocols have no company behind them, no customer support and no regulator.
Yield farming vs crypto staking
Yield farming and crypto staking are both ways to earn rewards on crypto, but they work differently:
| Crypto staking | Yield farming | |
|---|---|---|
| What you do | Stake tokens to help secure a blockchain | Deposit tokens into DeFi protocols |
| Where rewards come from | Network rewards and fees | Swap fees, interest and incentive tokens |
| Main risks | Price falls, slashing, lock-ups | Smart contract bugs, impermanent loss, scams |
| Complexity | Lower | Higher |
What yield farming means for you in the EU
For EU residents, yield farming sits mostly outside the protections you get elsewhere:
- DeFi is largely outside MiCA. MiCA regulates companies that provide crypto services. Fully decentralised protocols with no company behind them largely fall outside it, so there is no licence holder to complain to.
- Exchange “earn” products are a different risk. Centralised yield products carry counterparty risk: you depend on the platform and on whoever it lends to. In 2022, about €280 million that Bitvavo had lent to Genesis for off-chain staking became inaccessible; Bitvavo said customer withdrawals weren’t affected. Bitvavo and Crypto.com both state that their earn and staking products are not regulated under MiCA.
- Taxes. In Germany, staking and similar rewards count as other income when you receive them, with a €256 exemption limit. In the Netherlands, crypto, including tokens in DeFi, counts towards your box 3 assets on 1 January. Keep a record of every deposit, claim and withdrawal.
How to manage risk if you try it
If you decide to try yield farming, a few habits help you manage risk:
- Start with a small amount and one well-established protocol.
- Read what the rewards are paid in, and what happens when incentives end.
- Check whether the contracts are audited and how long they have run without incidents.
- Avoid leverage and strategies you can’t explain in one sentence.
- Revoke token approvals you no longer need.
The bottom line
Yield farming is earning fees and token rewards by lending your crypto to DeFi protocols. The rewards are variable and can stop at any time, while the risks are real: smart contract bugs, impermanent loss, falling reward tokens and no investor protection. Understand exactly where the yield comes from before you deposit, and treat any unusually high reward as a warning, not an opportunity.
Related terms
Questions people ask
How risky is yield farming?
Very risky. You can lose money through bugs or hacks in smart contracts, impermanent loss, reward tokens that fall in value and outright scams. There is no investor compensation scheme and usually no company or regulator to turn to.
What is the difference between yield farming and staking?
Staking locks coins to help secure a proof of stake blockchain and earns network rewards. Yield farming puts crypto into DeFi apps, such as liquidity pools or lending protocols, to earn fees and incentive tokens, and usually carries more risks.
What does yield mean in crypto?
Yield is the return you earn on crypto you put to work, usually shown as an annual percentage. In DeFi it is often variable, paid in tokens whose price can fall, and it can change or stop at any time.
Can I lose all my funds while yield farming?
Yes. A hacked or faulty smart contract, a rug pull by the project team or a collapse of the reward token can wipe out most or all of what you deposited.
Is yield farming taxable in the EU?
Usually, yes. In Germany, rewards similar to staking can count as other income when you receive them. In the Netherlands, the value of your crypto on 1 January counts towards box 3. Rules for complex DeFi positions are unclear, so keep detailed records.