Learn all about how DeFi users take advantage of high APYs to “farm” yield via liquidity pools.

Why is liquidity important? What does providing liquidity involve and where do the rewards come from? And what are some of the risks involved?

Brush up on the following articles and test your knowledge with our quiz.

1. What is Yield Farming?

DeFi offers the potential to make much higher returns on your assets than traditional finance. Many projects will incentivise users with generous rewards to maintain a liquid market for their token via liquidity pools.

What is Yield Farming?
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 currencies (usually

2. What are Liquidity Pools?

Liquidity is important for any asset; something is only worth as much as you’re able to sell it for. Automated market makers (AMMs) use pools of paired assets to provide a liquid market for users to trade.

What are Liquidity Pools?
Liquidity pools, at their simplest, are a collective pool of funds which are used to provide liquidity for a given market and generate rewards in return. Liquidity is an important characteristic of any market, which involves the trade-off between how quickly an asset can be sold and at what price.

3. How do Liquidity Provider tokens work?

AMMs need users to deposit their funds into liquidity pools and the locked funds are represented by tokens which act as receipts. These LP tokens keep track of the underlying assets and the fees earned, and can also be staked to gain further rewards.

How do Liquidity Provider tokens work?
In a decentralised market, the constant trading of currency requires large reserves of many different currencies to facilitate individual trades. These reserves are created by users, who provide liquidity in return for a share of the transaction fees generated by the exchange, typically < 1% of e…

4. What is APY and how is it calculated?

Yield farmers tend to hunt the highest Annual Percentage Yield (APY) in order to maximise returns on their capital. DeFi can be a very lucrative place to invest, but sky-high APYs are often too good to be true. Especially when it comes to long-term investments.

What is APY and how is it calculated?
APY stands for Annual Percentage Yield, and is a figure which represents the financial gain as a percentage of an initial investment, per year. Yield, displayed as APY, is offered as a reward to users who lock funds in a variety of DeFi instruments, such as liquidity pools, lending vaults

5. What is Impermanent Loss?

Providing liquidity earns trading fees for yield farmers as well as potential staking rewards. However, the automated nature of liquidity pools on AMMs can lead to losses when compared to simply holding the tokens. Are the rewards worth the risk of impermanent loss?

What is Impermanent Loss?
A common investment strategy in DeFi is providing liquidity to automated market makers (AMMs). This is done by locking one’s capital in liquidity pools, which usually hold certain specific pairs of assets. This can be very profitable, with returns being generated in terms of trading fees as well as

Summary

The innovative offerings of DeFi tempt many users into chasing high yields around the blockchain space. As we have seen, liquidity is essential for any asset, and many projects are willing to pay handsomely to keep their assets on AMMs. However, high APYs can’t last forever, and when dealing with more volatile assets, the risks may outweigh the returns.

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Try the quiz below before heading over to the Stake DAO app, which offers strategies and staking for a variety of LP tokens.

Quiz

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