Yield farming is closely related to a model called automated market maker (AMM). It typically involves liquidity providers (LPs) and liquidity pools. Let’s see how it works.
Liquidity providers deposit funds into a liquidity pool. This pool powers a marketplace where users can lend, borrow, or exchange tokens. The usage of these platforms incurs fees, which are then paid out to liquidity providers according to their share of the liquidity pool. This is the foundation of how an AMM works.
However, the implementations can be vastly different – not to mention that this is a new technology. It’s beyond doubt that we’re going to see new approaches that improve upon the current implementations.
On top of fees, another incentive to add funds to a liquidity pool could be the distribution of a new token. For example, there may not be a way to buy a token on the open market, only in small amounts. On the other hand, it may be accumulated by providing liquidity to a specific pool.
The rules of distribution will all depend on the unique implementation of the protocol. The bottom line is that liquidity providers get a return based on the amount of liquidity they are providing to the pool.
The funds deposited are commonly stablecoins pegged to the USD – though this isn’t a general requirement. Some of the most common stablecoins used in DeFi are DAI, USDT, USDC, BUSD, and others. Some protocols will mint tokens that represent your deposited coins in the system. For example, if you deposit DAI into Compound, you’ll get cDAI, or Compound DAI. If you deposit ETH to Compound, you’ll get cETH.
As you can imagine, there can be many layers of complexity to this. You could deposit your cDAI to another protocol that mints a third token to represent your cDAI that represents your DAI. And so on, and so on. These chains can become really complex and hard to follow.