What Are Liquidity Pools and Yield Farming?
Liquidity pools power decentralised trading, and yield farming is how users earn from them. Here is how both work — and where the risks hide.
Not financial advice. This article is for informational purposes only. Cryptocurrency is volatile and high-risk — do your own research.
Most decentralised exchanges do not use a traditional order book. Instead they use liquidity pools — shared pots of two or more tokens that traders swap against. Understanding pools is the key to understanding much of DeFi.
How liquidity pools work
Anyone can become a liquidity provider by depositing a pair of tokens into a pool. In return they receive a share of the trading fees. A formula sets the price automatically based on the ratio of tokens in the pool, so trades can happen at any time without a matching buyer or seller.
What is yield farming?
Yield farming is the practice of moving funds between protocols to earn the best available returns — trading fees, lending interest and extra token rewards handed out to attract liquidity. At its peak, farming can produce eye-catching headline yields.
The catch: impermanent loss and more
Providing liquidity carries a specific risk called impermanent loss: if the two tokens’ prices diverge, you can end up worse off than if you had simply held them. On top of that sit smart-contract risk, reward tokens that can fall faster than the yield pays out, and short-lived programmes designed to lure liquidity that later leaves. High advertised returns almost always signal high risk.
Browse the DeFi tokens we track on our DeFi hub. Educational only — not financial advice.