Understand what yield farming is and why does it exist
Yield farming, also known as “liquidity mining”, is a term used to describe a way to earn yield (usually denominated in a project’s token) by contributing liquidity for a crypto project.
The first thought that comes to your mind might be “yield farming? That’s some weird name!”. Fair enough. The reason why it’s called “yield farming” is that the act of providing liquidity and then periodically collecting the rewarded tokens is conceptually similar to you seeding a plant and then harvesting the yields later. Additionally, the fact that the first few projects to adopt this approach have plant-related names, such as Yam Finance, also solidified this term in people’s minds.
The reason why this is a thing is that, right after a new project distributes its tokens, the liquidity for this token on the market will be low, which makes it harder for people to trade the token. So to incentivize people to provide liquidity, ie. park this project’s token and another token (like ETH or USDC) in a pool on a DEX like Uniswap or Pancakeswap, what a crypto project can do is to give out its tokens as rewards to liquidity providers. By doing this, the broader ecosystem can benefit from it:
But as the idiom goes, “there is no such thing as free lunch”, there are a few risks when participating in liquidity mining. Let’s go through them one by one in the following.
For the first risk, check that the project’s code has been audited by a reputable auditing firm. Or, if you know how to program, you can check the smart contracts before providing liquidity. For the second risk, as a rule of thumb, if a team is not anonymous and is backed by well-known VCs, then the risks of getting rug-pulled are smaller.
As for the last risk, you can check this article to learn more.