DeFi holds as users weigh LP tokens and impermanent loss

Yield farming explained: how liquidity pools and LP tokens pay

Yield farming refers to allocating crypto assets to decentralized finance protocols to earn rewards. In a common setup, users deposit two tokens, such as ETH and USDC, into a liquidity pool on a decentralized exchange. In return, they receive a proportional claim on trading fees and may earn additional token incentives.

According to Britannica, automated market makers and smart contracts coordinate these pools, set rules for pricing and execution, and distribute fees without intermediaries. When traders swap through the pool, a portion of each trade is collected as a fee and shared with liquidity providers based on their contribution.

Finst explains that providers receive LP (liquidity provider) tokens representing their share of the pool, which can often be staked in separate reward programs for extra incentives. These LP tokens are transferable receipts of ownership, and their value changes as pool balances and prices evolve over time.

Why yield farming matters: rewards, strategies, and trade-offs

Yield typically comes from a mix of trading fees and protocol incentives. Exolix notes that governance or incentive tokens can supplement fee income, though these rewards depend on program design and may change as emissions or activity shift.

According to Kiplinger, some users also deploy lending strategies on platforms such as Aave, where interest paid by borrowers provides another source of return. Farmers may combine lending yields with DEX liquidity to layer rewards, but complexity and monitoring requirements increase.

Experts often contrast yield farming with staking: potential returns can be higher but so are the risks. “It’s like renting out your crypto in return for transaction fees and/or additional tokens. Returns can be better than staking, but with more risk,” said Lucas Wennersten, CFA, in an Investopedia interview.

As reported by CoinDesk, a 2025 staff statement from the U.S. Securities and Exchange Commission (SEC) indicated that staking in some forms does not necessarily constitute a securities offering. The statement is not binding law, and yield farming arrangements can differ materially, so regulatory treatment may vary based on specific features and disclosures.

Immediate risks and costs: impermanent loss, smart contracts, gas

Impermanent loss arises when the prices of pooled assets diverge after you add liquidity. Because AMM pools rebalance positions to keep a constant ratio, you can end up with more of the underperforming asset and less of the outperforming one, leaving you behind simple holding even after fees.

Bitpanda warns that smart-contract vulnerabilities, incomplete audits, and hidden bugs can result in partial or total loss of funds. Code composability, stacking multiple protocols, can amplify these risks if an upstream dependency fails.

CryptoSlate highlights the danger of unsustainable incentives and “rug pulls,” where high headline APYs mask weak economics or outright fraud. Rewards that rely solely on token emissions can decline sharply, reducing net yield or reversing it if token prices fall.

Gas fees and operational frictions also reduce net returns, especially on congested networks. Slippage, price impact, and the need to claim, restake, or rebalance positions add costs that compound over time.

At the time of this writing, based on data from Nasdaq, Coinbase Global, Inc. (COIN) traded around 158.47, down about 1.10% intraday. Such moves illustrate broader market volatility that can influence trading volumes, token prices, and ultimately fee-driven yields in DeFi.

Step-by-step: provide ETH/USDC liquidity and stake LP tokens

First, connect a compatible wallet to a decentralized exchange such as Uniswap and select the ETH/USDC pool. Review the pool’s fee tier and historical activity if available, since fee levels influence how much traders pay and what LPs potentially earn.

Approve both tokens for use by the DEX’s smart contracts, then supply equal values of ETH and USDC to the chosen pool. Confirm the transaction, accounting for gas costs, and wait for onchain confirmation.

After providing liquidity, you will receive LP tokens representing your share of the pool. These tokens track your position and entitle you to a proportional claim on accumulated trading fees.

If the protocol or an associated program offers additional incentives, stake the LP tokens in the designated rewards contract. Monitor your position for impermanent loss, changing APR components (fees vs. incentives), and net returns after gas.

When exiting, unstake LP tokens if staked, then remove liquidity to receive your ETH and USDC back in whatever proportions the pool currently holds. Consider record-keeping for tax and reporting purposes, as regulatory treatment can depend on the specifics of each transaction and jurisdiction.