Where Do Rewards Come From?

To ensure deep liquidity, Automated Market Makers (AMMs) need to encourage users to contribute their tokens to liquidity pools. This is where yield farming, also known as liquidity mining, becomes important.

In yield farming, users earn token rewards for supplying liquidity to AMM pools, which supports token exchanges. It’s similar to depositing money in a bank savings account and earning interest on your deposit. Users who provide tokens to these pools are known as liquidity providers (LPs), and the rewards they earn are called LP fees or LP rewards. To become an LP, users must deposit equal amounts of both tokens in the pool.

The LP rewards are generated from the token swaps that take place in the pool and are distributed among all LPs based on their share of the pool’s total liquidity. Additionally, some projects, in an effort to promote their tokens, offer extra rewards to liquidity providers in specific pools. These additional rewards can significantly boost a provider’s overall annual return.

The yield a user earns from supplying tokens to a liquidity pool can vary widely, depending on factors like the protocol, the specific pool, the tokens deposited, and overall market conditions. Some pools offer higher rewards, but they may also carry greater volatility and risk.