As decentralized finance (DeFi) grows in popularity, and everyone explores to understand what makes the DeFi applications so unique. A new concept of Yield farming has emerged, which means to generate rewards through cryptocurrency holding or staking.
Yield farming appears to be confusing to a large segment of people due to its technicality. Therefore, not everyone finds it easy to understand. If you are interested to know what yield farming is in absolute simple prospects, then read on!
Imagine a self-help-group where you and your friends put your unused coins and get rewarded accordingly for putting your funds in holdings. Now, the reason why we took coins as an example rather than notes, is to represent the liquidity factor. The foundation of yield farming is that a certain group of people is putting their coins on work.
Now, simply replace yourself from the providers - the people who are providing these coins - the liquidity providers, and the self-help-group can be considered as a liquidity pool, which is again a smart contract.
If you don’t know what a smart contract is then you can take it as a set of a computer program that is automatically executing the set of activities according to the terms of the contract or agreement.
So, you, the liquidity provider is putting your unused coins in the liquidity pool as there are some benefits attached to it. In self-help groups, people do it for accessing a large amount of money when needed, even when they are paying ( or providing ) a very small amount of money every time.
The only difference here is that the providers are themselves rich. Which means they do not need collective money in return for depositing a small amount.
Consider a market place where a third person wants a certain type of currency. Now, this liquidity pool provides this third person (s) the money they need in the form of borrowing, lending, exchanging, etc which includes certain fees. And these fees are the reward of the liquidity providers, which clarifies the reason why someone will lock their cryptocurrencies.
In technical terms yield farming enables users to borrow, lend, and exchange cryptocurrencies through liquidity pools. Hence, yield farming is also referred to as liquidity mining. The liquidity providers then are rewarded. These rewards can be in terms of tokens as well. To attract these providers multiple protocols have emerged which provide them with economic incentives as well while the yield farmers will move their funds around different protocols in search of higher yields.
Now, if you are confused about the new term, yield farmers. This is another term for liquidity providers.