What Is Yield Farming and How Does It Work?

Yield farming is the practice of locking up cryptocurrency assets in decentralized finance (DeFi) protocols to generate passive income or rewards. Its primary purpose is to incentivize users to provide liquidity, borrow, or lend assets, which ensures that decentralized platforms have the capital necessary to function efficiently. Users typically deposit tokens into a smart contract—such as a liquidity pool on a decentralized exchange—and receive interest, a share of trading fees, or newly minted governance tokens in return. While it can be highly lucrative, yield farming carries significant risks, including impermanent loss and smart contract vulnerabilities, making it suitable primarily for intermediate to advanced cryptocurrency users.

How Does Yield Farming Work in Decentralized Finance?

Decentralized finance (DeFi) is a financial ecosystem built on blockchain technology that operates without traditional intermediaries like banks or brokerages.

To understand how this ecosystem functions, you must understand the mechanics of liquidity. Traditional financial markets rely on centralized market makers—large financial institutions that provide liquidity by constantly buying and selling assets. In contrast, defi relies on crowdsourced liquidity. This is where yield farming comes into play.

Protocols need capital to facilitate trades, process loans, and maintain market stability. To attract this capital, they offer financial incentives. When you participate in yield farming, you act as a decentralized market maker or lender. You deposit your cryptocurrency into a smart contract, which is a self-executing program stored on the blockchain. In exchange for locking up your capital, the protocol compensates you.

The standard process generally follows these steps:

1. Asset Acquisition: A user acquires a pair of cryptocurrency tokens (e.g., SEI and USDC).
2. Liquidity Deposit: The user deposits these tokens into a protocol's smart contract, known as a liquidity pool.
3. LP Token Issuance: The protocol issues Liquidity Provider (LP) tokens to the user, which act as a digital receipt representing their share of the total pool.
4. Reward Accumulation: As other users trade against the pool or borrow from it, fees are generated. A portion of these fees is continuously added to the pool, increasing the value of the user's LP tokens.
5. Secondary Farming (Optional): The user can often stake their LP tokens in a separate "farm" contract to earn additional governance tokens issued by the protocol.

According to data from DeFiLlama, at its peak during the 2021 bull market, the total value locked (TVL) in decentralized finance protocols surpassed $170 billion, highlighting the massive scale and adoption of these crowdsourced liquidity mechanisms.

What Are the Main Types of Liquidity Strategies?

The DeFi landscape has evolved rapidly, resulting in a variety of strategies for generating returns. While they all fall under the broader umbrella of generating yield, the mechanics and risk profiles differ significantly.

Liquidity Provision on Decentralized Exchanges

This is the most common form of generating yield. Users deposit an equal value of two different tokens into a DEX that has an Automated Market Maker (AMM). The AMM uses these tokens to facilitate decentralized trading. Every time a trader swaps one token for another using that pool, they pay a small trading fee (typically between 0.01% and 0.30%). These fees are distributed proportionally among all liquidity providers in the pool.

Lending and Borrowing

Similar to traditional banking, users can supply their cryptocurrency to decentralized lending platforms. Borrowers must over-collateralize their loans (deposit more value than they borrow) to ensure the system remains solvent. The interest paid by borrowers is distributed to the lenders. This strategy generally offers lower yields than AMM liquidity provision but carries different risk dynamics, as it is usually single-sided (requiring only one type of token).

Yield Aggregators and Vaults

Yield aggregators are automated smart contracts (vaults) that pool user funds and automatically deploy them across various DeFi protocols to find the highest possible returns. These vaults also automate the process of "compounding"—taking the earned rewards, selling them for more of the underlying asset, and reinvesting them to maximize the Annual Percentage Yield (APY).

Here is a comparison of the primary strategies:

What Are the Core Risks of Providing On-Chain Liquidity?

While the potential for double or triple-digit APYs is enticing, these returns exist precisely because users are taking on substantial risks. The DeFi ecosystem is experimental, and capital can be lost through several vectors.

Impermanent loss is the temporary loss of funds experienced by liquidity providers when the price of deposited assets changes compared to when they were initially deposited.

When you provide liquidity to an AMM, you must deposit two assets in a specific ratio (usually 50/50). If the price of one asset skyrockets, the AMM's algorithm will automatically rebalance the pool by selling the appreciating asset for the depreciating one to maintain the ratio. If you withdraw your funds at that moment, you will have less of the appreciating asset and more of the depreciating one than if you had simply held them in your wallet. The loss is "impermanent" because if the prices return to their original ratio before you withdraw, the loss disappears. However, if you withdraw while the prices are divergent, the liquidity becomes permanent.

Smart Contract Vulnerabilities

Because DeFi protocols are run entirely by code, any bug or logical flaw in that code can be exploited by malicious actors. A report by Chainalysis noted that in 2022, cross-chain bridge and DeFi vulnerabilities accounted for over $3.1 billion in stolen funds. Even protocols that have been audited by professional security firms can fall victim to sophisticated economic exploits, flash loan attacks, or reentrancy bugs.

Regulatory and Systemic Risks

The interconnected nature of DeFi means that a failure in one protocol can cascade across the ecosystem. For example, if a major stablecoin loses its peg to the US dollar, any liquidity pool or lending market utilizing that stablecoin will suffer immediate and severe disruptions. Additionally, the regulatory landscape surrounding decentralized finance remains uncertain, and future enforcement actions could impact protocol operations or user access.

How Do High-Performance Blockchains Improve Capital Efficiency?

The profitability of any decentralized strategy is heavily dependent on the underlying blockchain's performance. On legacy networks like Ethereum, high network congestion leads to exorbitant gas fees. If a user earns $50 in yield but has to pay $80 in transaction fees to deposit, compound, and withdraw their funds, the strategy is fundamentally broken for all but the largest "whale" investors.

High-performance Layer 1 blockchains solve this critical capital efficiency problem. Sei, for example, is engineered specifically to address the scalability trilemma for digital asset exchange and DeFi protocols. Sei combines the deep tooling and developer familiarity of an EVM-compatible chain with the speed and low costs typically associated with alternative architectures.

Sei's performance advantages directly benefit DeFi users:

• Sub-400ms Finality: Transactions are confirmed almost instantly. This rapid execution prevents front-running and slippage, ensuring that liquidity providers enter and exit pools at the exact prices they intend.
• Parallel EVM Execution: By using optimistic parallelization, Sei processes non-conflicting transactions simultaneously. This allows the network to handle up to 100 megagas per second peak throughput, ensuring that gas fees remain fractions of a cent even during periods of high network demand.
• Frequent Compounding: Because transaction fees are negligible on Sei, users can compound their rewards multiple times a day—or utilize automated aggregators that do so—dramatically increasing their effective APY without losing profits to gas costs.

As highlighted in the Sei documentation, "By parallelizing execution, Sei can process non-conflicting transactions simultaneously, dramatically increasing throughput and reducing latency for decentralized applications." This architectural innovation fundamentally changes the math for retail liquidity providers, making advanced strategies accessible to everyone, regardless of portfolio size.

How to Start Yield Farming: A Step-by-Step Practical Guide

If you understand the risks and are ready to participate in the decentralized economy, here is a practical framework for getting started safely.

1. Set Up a Web3 Wallet: You will need a non-custodial wallet that supports the blockchain you intend to use. For the Sei network, popular EVM-compatible wallets like MetaMask or specific Sei ecosystem wallets are required. Ensure you secure your seed phrase offline.
2. Acquire and Bridge Assets: Purchase the base assets (e.g., SEI, USDC, or ETH) from a centralized exchange and withdraw them to your Web3 wallet. If your assets are on another blockchain, you will need to use a cross-chain bridge to move them to your target network.
3. Research and Select a Protocol: Do not blindly chase the highest APY. Look for established protocols with high Total Value Locked (TVL), active developer communities, and publicly available security audits.
4. Provide Liquidity: Navigate to the protocol's decentralized application (dApp). Select the "Pools" or "Liquidity" tab, choose your desired asset pair, and approve the smart contract to interact with your tokens. Deposit your assets to receive LP tokens.
5. Stake LP Tokens (If Applicable): Many protocols require an additional step. You must take the LP tokens you received and deposit them into a specific "Farm" or "Gauge" to begin earning the protocol's governance token emissions.
6. Monitor and Manage: DeFi is not a "set it and forget it" investment. Regularly monitor your positions for impermanent loss, track the protocol's health, and periodically claim and reinvest your rewards to maximize compound interest.

Frequently Asked Questions

Is yield farming still profitable in 2025?

Yes, it remains profitable, but the landscape has matured. The days of unsustainable 10,000% APYs driven by hyper-inflationary reward tokens are largely gone. Today, profitability is driven by real yield—actual trading fees and lending interest generated by protocol usage. Success requires careful risk management, choosing efficient high-performance blockchains to minimize gas fees, and understanding impermanent loss.

What is the difference between yield farming and staking?

Staking typically refers to locking up a native cryptocurrency (like SEI or ETH) to help secure a Proof-of-Stake blockchain network, earning network issuance rewards in return. Yield farming, on the other hand, involves providing liquidity to DeFi protocols (like DEXs or lending platforms) to facilitate financial services, earning trading fees and protocol-specific tokens. Staking generally carries lower risk, while farming offers higher potential returns with higher risks.

How are APY and APR calculated in DeFi?

Annual Percentage Rate (APR) represents the simple interest earned over a year without taking compounding into account. Annual Percentage Yield (APY) includes the effects of compounding interest—meaning you reinvest your earned rewards to generate even more rewards. In DeFi, APY calculations often assume you are manually claiming and reinvesting your rewards daily or utilizing an auto-compounding vault.

For related insights, see USDY on Sei: A Guide to Tokenized Treasury Yield on the Sei blog.

Key Takeaways

• Yield farming is the backbone of decentralized finance, incentivizing users to provide the liquidity necessary for decentralized exchanges and lending markets to operate.
• The primary mechanisms include DEX liquidity provision (AMMs), lending/borrowing markets, and automated yield aggregators.
• While lucrative, providing liquidity carries significant risks, most notably impermanent loss and smart contract vulnerabilities.
• High-performance Layer 1 blockchains like Sei drastically improve the profitability of these strategies by offering sub-400ms finality and parallel execution, which reduces gas fees to fractions of a cent and allows for high-frequency compounding.
• Success in DeFi requires diligent research, active portfolio management, and a thorough understanding of the underlying mechanics of the protocols being used.

Last updated: February 24, 2026