Yield Farming Uses Lending, Trading Fees and Token Rewards to Generate Returns

Yield farming places crypto assets in decentralized finance (DeFi) strategies that may earn lending interest, trading fees or token rewards, but rates and risks differ by strategy.

The term covers several activities. A user might supply one asset to a lending market or deposit a pair of assets in a trading pool. Some vaults collect rewards, exchange them for the vault’s underlying asset and deposit them again. Reinvestment changes how returns accumulate; it does not create a separate source of earnings.

Where yield comes from

In a lending market, interest is tied to a supply rate. On Aave, supply rates can change with pool utilization and governance parameters. Pool utilization reflects how much of the supplied assets are in use. The rate can therefore move over time, rather than remain fixed at the level shown when a deposit is made.

Liquidity providers may earn fees from trades in a pool. Other strategies distribute token incentives set by a protocol. These sources work differently: lending interest is tied to a lending market, trading fees come from pool activity, and incentive rewards depend on the tokens being distributed. A displayed yield does not by itself show which source contributes most or how long a rate will last.

Some vaults reinvest returns automatically by collecting rewards, swapping them into the vault’s underlying asset and redepositing them. That process can involve swaps, network fees and strategy costs. More frequent reinvestment can raise the modeled balance when the rate stays constant, but added costs can outweigh the difference.

APR and APY

Annual percentage rate (APR) expresses an annualized return without including the effect of reinvesting earnings. Annual percentage yield (APY) includes compounding. For a fixed APR compounded a set number of times each year, a simplified calculation is:

APY = (1 + APR / n)^n − 1

Here, n is the number of compounding periods in a year. The formula assumes the rate stays fixed and that returns are reinvested on schedule. DeFi products may use different methods to display APY. Some vaults calculate it from share-price changes over a recent seven-day or 30-day period. Gross APR is before fees, while net APY can reflect them, so two displayed rates may not use the same assumptions.

Consider a hypothetical deposit of 10,000 USD Coin (USDC) at a constant 12% APR for one year. Without compounding, it would earn 1,200 USDC and reach 11,200 USDC. Monthly compounding would produce a balance of about 11,268.25 USDC; daily compounding would produce about 11,274.75 USDC. Under those assumptions, daily reinvestment adds about 6.50 USDC over monthly reinvestment before costs.

If the daily strategy incurred an assumed 100 USDC in annual costs, its modeled ending balance would be 11,174.75 USDC. That is below the 11,200 USDC no-compounding balance before costs. The example holds both the rate and the asset value constant; it is a calculation, not a current rate offer.

Risks behind the rate

Liquidity providers can face impermanent loss when the relative prices of assets in a pool change. A fee return may not offset that effect. Smart-contract and operational problems can also put deposited assets at risk, while swaps, network fees and strategy charges reduce what remains after costs.

Borrowing adds a separate liquidation risk. On Aave v3, a borrowing position becomes eligible for liquidation when its Health Factor falls below one. That threshold concerns borrowing positions; it does not apply to a supply-only deposit with no loan. USD Coin (USDC) can also trade above or below $1 on third-party platforms.

A yield figure alone leaves key details unstated: where earnings come from, how the rate is calculated, which costs are included, what assets a strategy uses and whether it involves borrowing. Those differences matter when interpreting a displayed APR or APY.