Yield Farming, also known as Liquidity Mining, is the financial strategy where users lock up their funds in a liquidity pool and receive rewards from a DeFi protocol. The liquidity pool exists in the form of a smart contract on the blockchain, which holds an inventory of locked (or ‘staked’) currencies (usually pairs of currencies), and serves it to buyers and sellers of that particular market.
Yield farming is characterised by the fact that many DeFi protocols offer rewards in terms of their own protocol’s token. While other forms of rewards and dividends may also exist, such a method of distributing a protocol’s tokens is an effective way of distributing the ownership and governance privileges of the protocol itself. Such a model complements the community operations of the protocol which may receive votes on new proposals from holders of its native token.
Yield farming is also noteworthy because the financial returns it generates on the locked up capital are far greater than similar opportunities in the world of traditional finance. One reason for this is that DeFi is an extremely young industry, and is still growing to meet new and novel use-cases. As such, it is also a volatile space compared to traditional finance, and one must always validate their actions with independent research.