Yield farming is closely related to a model called automated market maker (AMM). It typically involves liquidity providers (LPs) and liquidity pools. Let’s see how it works.
Liquidity providers deposit funds into a liquidity pool. This pool powers a marketplace where users can lend, borrow, or exchange tokens. The usage of these platforms incurs fees, which are then paid out to liquidity providers according to their share of the liquidity pool. This is the foundation of how an AMM works.
However, the implementations can be vastly different – not to mention that this is a new technology. It’s beyond doubt that we’re going to see new approaches that improve upon the current implementations.
On top of fees, another incentive to add funds to a liquidity pool could be the distribution of a new token. For example, there may not be a way to buy a token on the open market, only in small amounts. On the other hand, it may be accumulated by providing liquidity to a specific pool.
The rules of distribution will all depend on the unique implementation of the protocol. The bottom line is that liquidity providers get a return based on the amount of liquidity they are providing to the pool.