How Liquidity Pools Enhance Yield Farming

Yield farming, already in the billions of dollars, is among the latest trends growing rapidly in DeFi. For its objectives, liquidity pools are as enhancing as they are essential.

Yield farming is the new hype in the DeFi space, with the total locked value of liquidity pools in yield farming projects reaching as high as over $13 billion in March 2021. While that number dipped to a more modest $7 billion by July, according to CoinMarketCap, yield farming continues to offer a safe and better investment option, attracting cryptocurrency investors looking to make a significant profit while keeping investment risks minimal.

Yield farming participants earn over $1 billion a day from various platforms providing yield farming services. According to DeFi Pulse, 95% of the $41.5 billion total value locked (TVL) in DeFi platforms is accredited to yield farming indicating just how profitable it is.

Also referred to as liquidity farming, yield farming essentially involves providing liquidity to decentralized exchanges for rewards in native governance tokens. The concept of liquidity pools has been instrumental in the growth of yield farming in DeFi platforms by solving the problem of liquidity. 

Liquidity pools are vital for making a project run smoothly, with yield farmers benefiting from fees and governance tokens. This article explores ways in which liquidity pools facilitate and enhance yield farming.  

Defining DeFi Yield Farming 

Yield farming is one of the latest trends that has rapidly grown in the decentralized finance (DeFi) world. Simply put, it involves locking cryptocurrency assets into platforms that offer lending and borrowing services. 

Yield farmers, also referred to as token holders and investors, generate passive income in DeFi by locking up their coins for a particular period. They receive tokens regarded as the user’s share in the liquidity pool together with rewards. What’s more, these tokens can be transferred to other platforms to enhance the potential gains.

Liquidity Pools Explained

Liquidity pools encompass smart contracts that lock up tokens to facilitate trading via high liquidity provision. These pools are vital for different platforms to provide liquidity for various cryptocurrencies. Liquidity providers, or LPs, are necessary for liquidity pools to function correctly. 

LPs stake their coins in liquidity pools to earn rewards generated on the DeFi platform. These rewards are essentially interest generated from the staked assets. While liquidity pools pay liquidity providers in the form of their specific governance token, like UNI for Uniswap, some liquidity pools pay their rewards in different tokens providing an array of benefits. 

These reward tokens can further be deposited to other liquidity pools to multiply the earnings. Uniswap and SushiSwap DeFi platforms are the biggest liquidity pools providing rewards to LPs for locking their assets within the platforms. 

Earn Passive Income Through Yield Farming

Yield farming is not possible without liquidity pools or liquidity farming. LPs, also referred to as market makers, are responsible for staking funds in liquidity pools that allow sellers and buyers to transact conveniently by executing a buyer-seller agreement using smart contracts. 

Liquidity pools are vital for making yield farming platforms run smoothly, with yield farmers typically earning from fees and governance tokens. Yield farming encompasses the use of one or several DeFi cornerstones. These include lending and borrowing platforms, decentralized exchanges (DEXs) and liquidity pools, staking, and so-called “second-layer” farms that utilize the more extensive protocols. Each has a slightly different yield farming platform with various means of rewarding crypto holders for locking up their assets. 

Platforms such as Compound, Uniswap and Aave are best known for yield farming with minimal risks. Newer, second-layer liquidity pools such as Yearn Finance, CORE and Harvest Finance offer better returns but at significant risk. 

Enhancing Yield Farming 

Yield farming platforms incentivize liquidity providers to lock up their crypto assets in a smart contract-based liquidity pool. Liquidity pools enable yield farming platforms to provide decentralized opportunities for crypto holders to earn passive income by holding their assets on yield farming platforms. 

Yield farming largely involves liquidity providers and liquidity pools that deposit cryptocurrencies in smart contracts. The liquidity pools are based on specialized DEXs known as Automated Market Makers (AMMs). Liquidity pools enhance yield farming in the following ways: 

Facilitate Deposits 

Liquidity pools allow yield farmers to deposit funds into smart contracts. Deposited funds are usually stablecoins pegged to the US dollar, such as USDT, USDC, DAI and more. The deposited funds are locked by smart contracts in the yield farming platforms. 

Control the Marketplace 

Liquidity pools control the DeFi marketplace allowing players to borrow, lend and exchange funds seamlessly. Liquidity providers earn rewards based on the value of their holdings. 

Guarantees Liquidity at Every Price Level

Liquidity pools guarantee liquidity at every price, meaning that traders do not have to be directly connected to other traders. Liquidity is constant as long as customers have their assets invested in the liquidity pool. 

Facilitates Passive Market Making   

Liquidity pools enable passive market making where LPs deposit their funds into the pool with the smart contract taking care of the pricing. As such, it creates a fairground in yield farming platforms. 

Enhance Yield Farming Rewards 

Once yield farming rewards or tokens are channeled to liquidity pools, LPs have the opportunity of multiplying the said rewards. This is possible via reinvesting and shifting the rewarded tokens into other liquidity pools to earn more rewards. As such, the LPs can diversify their crypto-asset portfolio by leveraging a proper reinvesting strategy that will ensure maximum returns from yield farming.

In a Nutshell… 

Liquidity providers and liquidity pools are the cornerstones of yield farming, which involves staking or lending crypto assets on DeFi protocols to earn incentives, interest, or additional cryptocurrency. Liquidity pools enable yield farming platforms to provide trustless opportunities for crypto holders to earn passive income by lending their holdings via smart contracts. 

Furthermore, liquidity pools boost yield farming by facilitating deposits, guaranteeing liquidity at every price level, facilitating passive income making, and enhancing yield farming rewards through reinvestments.