Yield Farming is a catch-all term for a number of financial strategies in which users deposit funds into a DeFi protocol, earning cryptocurrency in return. This may be achieved via lending or staking their tokens, depositing them into liquidity pools on AMMs, or a combination of these.
Yield farming is characterised by the fact that many DeFi protocols offer rewards in terms of their own token. This can be risky for farmers, as both the rate of return (APY) and the value of the tokens themselves are often volatile.
Yields paid to depositors may originate from the protocol's underlying earnings, e.g. a percentage of swap fees, or as emissions of freshly minted tokens.
Depending on the tokenomics of the project, rewarding farmers via emissions may prove an effective way of attracting users quickly, while also distributing the ownership and governance privileges of the protocol itself. Such a model complements the community activity of the protocol, where fresh proposals which affect everyone can be voted upon by governance token holders.
However, excessive inflation due to token emissions can gradually lower the price of a project's token, making the protocol less attractive to yield farmers and token holders in general.
Yield farming is popular because the financial returns it generates on the locked-up capital can be 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. It is important to note that high APYs are down to the experimental and volatile nature of this market, and the risks associated with investing in DeFi in general.