What is yield farming?

In June 2020, the lending protocol Compound introduced a new DeFi (Decentralized Finance) incentive model by distributing a governance token called COMP to anyone who deposited or borrowed crypto on its platform. Within 24 hours, Compound became the largest DeFi protocol by total value locked. Users deposited crypto into protocols and received additional crypto in return. Within weeks, similar programs spread across Ethereum, encouraging users to move capital between platforms in search of the highest returns. This activity soon became known as yield farming. Between early 2020 and late 2021, TVL (Total Value Locked) in decentralized finance rose rapidly from under $700 million to over $170 billion. This article explains what yield farming is, how it became a dominant DeFi narrative, and how unsustainable incentive models contributed to the sector's later collapse.

What is yield farming?

Yield farming is the practice of depositing crypto assets into DeFi protocols to earn returns. Those returns can come from lending interest, trading fees, or token rewards, usually paid in the protocol's own token or in stablecoins. In traditional finance, you deposit money in a bank, which lends it out and pays you interest. The rate is usually below 2%, but it is predictable and insured. In DeFi, the same concept operates through smart contracts instead of banks, allowing users to participate without intermediaries or traditional KYC checks. Anyone with a crypto wallet can deposit assets into a lending pool, provide liquidity for a decentralized exchange, or stake tokens, and begin earning yield immediately.

Yield farming attracted widespread attention because protocols distributed their own governance tokens to depositors on top of the underlying interest. This mechanism, known as liquidity mining, could turn a 5% lending yield into an effective 200%, 500%, or even 1,000% APY (Annual Percentage Yield). However, these unusually high returns were often tied to significant underlying risk, including token price volatility and the sustainability of the incentives. These incentives helped move yield farming from a small DeFi niche into a major market trend.

The Origins of Yield Farming

Before yield farming, DeFi already had its foundations in place. MakerDAO launched in 2017 and let users mint DAI by locking ETH. Compound launched in 2018 and offered permissionless lending. Uniswap launched in late 2018 and removed order books entirely with its automated market maker. These protocols worked, but by early 2020, total DeFi TVL sat under $700 million. Everything changed on June 15, 2020, when Compound activated its COMP token distribution, giving out 2,880 COMP tokens per day to lenders and borrowers. Capital moved into the protocol rapidly, and competing platforms soon adopted similar incentive models.

Balancer launched BAL token rewards, Synthetix expanded its staking incentives, and Andre Cronje, often referred to as the "Father of DeFi," launched Yearn Finance in August 2020. Yearn Finance automated the entire farming process by allowing users to deposit into Vaults while smart contracts rotated their capital across the highest-yielding opportunities. Uniswap dropped its UNI token in September 2020 through what it called a "fair launch," distributing 400 UNI to every wallet that had ever used the protocol without conducting a token sale. At peak prices, each allocation was worth around $17,000. The airdrop quickly became one of the most celebrated events in DeFi, reinforcing the idea that early users could be directly rewarded for their participation and encouraging more capital and users to flow into emerging DeFi protocols.

Together, these launches created a feedback loop in which token incentives attracted capital, rising token prices increased advertised APYs, and those higher returns brought in more users. This period became known as DeFi Summer.

Why Did Yield Farming Become So Attractive?

In 2020, the US Federal Reserve had cut rates to 0-0.25%, and banks offered savings rates below 0.5%. In contrast, a stablecoin deposit on Aave could earn 8-15% APY, a Uniswap liquidity pool could generate 20-50%, and a leveraged Yearn Finance strategy could reach 100% or more. These returns were significantly higher than what traditional financial markets could offer at the time, making DeFi an increasingly attractive destination for investors seeking yield. With just a MetaMask wallet, anyone could connect to DeFi protocols and begin earning yields within minutes.

At the same time, farming strategies grew more complex. Users would deposit on Aave, borrow stablecoins against it, deposit those into Curve, stake the LP tokens on Convex for boosted CRV rewards, then sell CRV back to start the loop again. This recursive farming could multiply base yield by 3-10x.

Some protocols, such as Anchor Protocol on Terra, offered a fixed 20% APY on UST deposits. Unlike earlier farming strategies, users only needed to deposit stablecoins to earn the advertised return. At its peak in April 2022, Anchor held over $14 billion in deposits. By 2021, yield farming had evolved from a niche activity into a mass-market product.

Where Does the Yield Actually Come From?

The source of returns determines whether a yield strategy is supported by economic activity or depends on incentives that may not last.

Lending interest is the most straightforward source. When you deposit USDC on Aave, borrowers pay interest and a portion goes to you. The return is backed by genuine demand for borrowed capital. As of 2026, stablecoin lending on Aave pays 3-7% APY, far below 2020 levels but more closely aligned with genuine borrowing demand.

Trading fees come from providing liquidity. Depositing assets into a Uniswap pool earns you a share of fees from every swap that goes through that pool. Concentrated liquidity on Uniswap V3/V4 can generate 8-25% APY, but requires active management and comes with impermanent loss risk. Impermanent loss happens when the value of your deposited assets changes relative to each other, meaning the AMM rebalances your position and you end up with less value than if you had simply held the tokens. On volatile pairs like ETH/USDC during a 50% price move, impermanent loss can reach 5-6% of your position, often exceeding all the fees you earned.

Token emissions become unsustainable when rewards depend mainly on continued demand for newly issued tokens. If those tokens have little utility beyond being farmed and sold, selling pressure lowers their price and the advertised APY, eventually prompting capital to leave the protocol. Most of DeFi Summer's triple-digit APYs came from this source.

Staking rewards come from proof-of-stake networks. Liquid staking protocols like Lido let users earn ETH staking yield while keeping capital liquid.

Basis trade yield is a newer source, pioneered by Ethena. The strategy holds spot ETH while shorting perpetual futures, earning the funding rate that long traders pay to short traders. Ethena's sUSDe has offered 15-29% APY during bullish periods, backed by real market flows rather than token printing.

The common DeFi warning “If you don't know where the yield comes from, you are the yield” summarizes the risk of returns without a clear economic source.

The Risks of Yield Farming

Beyond unsustainable APYs, yield farming carries risks that can destroy capital overnight. Smart contract failures are a major risk because coding flaws can expose users to substantial losses . More than $10 billion has been lost to DeFi exploits since 2020, including major incidents such as $326 million from Wormhole and $620 million from Ronin Network. Audits reduce risk but they are not guarantees. Multiple audited protocols have been exploited, because audits examine code at a point in time and cannot catch every edge case, especially when protocols interact with other protocols in ways that were never tested together.

Impermanent loss is unique to liquidity providers. When you deposit two assets into a pool and one moves significantly in price, the AMM rebalances your position, leaving you with more of the depreciating asset and less of the appreciating one. Impermanent loss is usually minimal on stablecoin pairs, while on volatile pairs it can exceed all the fees earned and leave the position worse off than simply holding.

Liquidation risk compounds when farmers use leverage. Borrowing against deposited collateral amplifies returns but creates a liquidation threshold. If the collateral value drops too fast, the position gets liquidated automatically, often at the worst possible price during a market-wide sell-off when everyone is getting liquidated at the same time.

Why Did Yield Farming Nearly Collapse?

The 2022 bear market weakened demand for governance tokens, which fell by 90-95% as advertised APYs declined and capital moved out of emission-driven protocols. Yearn Finance’s Vaults that once generated 50-100% APY dropped to single digits. The downturn intensified in May 2022 when Terra's UST lost its peg. $12 billion was withdrawn from Anchor within days. The death spiral between UST and LUNA erased roughly $45 billion in market value and triggered a chain of bankruptcies. Three Arrows Capital, Celsius, Voyager, BlockFi, and eventually FTX all fell within months. Total ecosystem losses exceeded $2 trillion.

Anchor's 20% yield was subsidized by Terra's reserves, which were funded through LUNA sales. Those sales depended on market confidence, while the UST peg depended on Anchor deposits. The resulting incentive loop lacked sufficient external revenue to sustain the promised yield.

The 2022 downturn in DeFi served as a necessary market correction, removing unsustainable yield models and paving the way for a more sustainable form of yield farming, albeit with lower APY levels.

Conclusion

Yield farming helped turn DeFi from a niche experiment into one of the fastest growing sectors in crypto. The promise of triple and even four digit APYs attracted billions of dollars and introduced millions of users to decentralized finance for the first time. But the collapse of many early yield farming projects showed that high returns alone are not enough. When rewards depended largely on continuous token emissions, growth became difficult to sustain once new capital stopped entering the market. Although the DeFi Summer era has ended, its impact can still be seen across the industry today. The lending protocols, decentralized exchanges, and other infrastructure built during that period remain widely used. The difference is that the focus has gradually shifted from chasing the highest APY to building products supported by real economic activity and sustainable revenue.