Yield farming closely relates with the automated market maker (AMM) model, usually involving LPs and liquidity pools. Here’s how it works:
Funds are deposited into a liquidity pool by LPs. This pool supports a marketplace for the lending, borrowing or exchange of tokens. This platform requires fees from its users, which are paid out as rewards to liquidity providers in accordance with their share of the pool. This is the fundamental principle behind an AMM.
Yet, implementation can differ greatly here as this technology is still quite new. Beyond any doubt, new approaches to improve current implementations will evolve.
In addition to fees, new token distributions could provide yet another incentive for funding liquidity pools. For instance, there may be no way to purchase tokens on the open market, other than in nominal amounts. Alternatively, funding a specific liquidity pool may accumulate it.
The distribution arrangement will be subject to the protocol’s unique implementation. The main thing is that LPs receive returns commensurate with the liquidity provided to the pool.
Deposited funds are usually stablecoins attached to the USD – although this is not a general requirement. USDT, DAI, BUSD, USDC, and others are some of the most popular DeFi stablecoins. In some protocols, tokens will be minted to represent the coins you deposit in the system. For instance, if DAI is deposited into Compound, you’ll get Compound DAI or cDAI. And if ETH is deposited to Compound, what you’ll get is cETH.
As you may think, this may be greatly complex. Your cDAI could be deposited to another protocol which mints a third token so as to represent your cDAI already representing your DAI. This goes on and on, until they become very complex and impossible to keep track of.
