Crypto Decoded

What Is Yield Farming, and Why Is It Risky?

Yield farming can offer high DeFi rewards, but smart contract failures, impermanent loss and tax complexity can quickly change the result.

By Oliver Crane · May 23, 2026

Yield farming can promise returns that make a high-street savings account look tiny. Hundreds of percent annually, in some cases. But what is actually going on, and what could go wrong?

Reviewed by James Whitfield, Senior Editor · May 23, 2026, 20:09

In this article

The Short Version

Yield farming is a way of earning returns on cryptocurrency by putting it to work inside decentralised finance (DeFi) protocols, rather than simply holding it.

You deposit crypto into a liquidity pool or lending protocol and earn rewards in return.
The rewards come from trading fees, interest paid by borrowers, or new tokens issued by the protocol itself.
Yields can be very high, but so can the risks: you can lose money even if the market moves in your favour.
Impermanent loss, smart contract exploits, and protocol collapses are all genuine threats.
Yield farming is best understood as an advanced DeFi activity, not a savings account equivalent. Yield farming risk starts with that distinction.

Where the yield actually comes from

To understand yield farming, you first need to understand liquidity pools. A liquidity pool is a pot of tokens locked into a smart contract. It lets a decentralised exchange, or DEX, work without a traditional order book.

When someone wants to swap one token for another on a platform like Uniswap or Curve, they trade against the pool rather than against another person. The people who deposit tokens are liquidity providers. They earn a cut of each swap fee.

Lending protocols work slightly differently. Platforms such as Aave and Compound allow users to lend out their crypto to borrowers, who pay interest. Lenders receive that interest. It may come as the deposited token, the platform’s governance token, or both.

A third source of yield is what the industry calls liquidity mining or token incentives. A new protocol wants people to use it, so it issues its own tokens as rewards to anyone who deposits funds. In the early days of DeFi in 2020, this produced some extraordinary headline figures: protocols were issuing so many new tokens that annualised yields ran into four figures.

In practice, yields compress over time as more capital flows in. A pool offering 300% APY in week one might settle at 12% a month later. That happens once word spreads. The very high numbers you see advertised tend to be temporary and reflect either a new protocol throwing tokens at early users, or a small pool with minimal capital.

How liquidity pools work in practice

When you add liquidity to a pool, you typically deposit two tokens in equal value. A pool for ETH and USDC requires both tokens. You usually provide ETH and an equivalent value of USDC. You receive LP tokens in return, which represent your share of the pool.

The pool uses an automated market maker (AMM) formula to set prices. As trades happen, the ratio of tokens in the pool shifts. If lots of people are buying ETH from the pool, the pool ends up with more USDC and less ETH. Your LP tokens still represent the same percentage of the pool, but the composition of what you would get back has changed.

This is where impermanent loss comes in, which is one of the most misunderstood risks in DeFi and worth understanding properly before putting money into any pool.

Impermanent loss explained

Impermanent loss occurs when the price of the tokens you deposited changes relative to each other after you deposit them. The more the prices diverge, the more value you lose compared to simply holding the tokens in your wallet.

The loss is called “impermanent” because it only crystallises when you withdraw. If prices return to their original ratio before you exit, the loss disappears. In practice, many people do withdraw before prices recover, and the fees earned do not always compensate for the loss.

Impermanent loss is most severe in pools containing volatile token pairs. Pools that contain two stablecoins, or a stablecoin paired with a wrapped version of the same asset, suffer much less impermanent loss because the prices are pegged and do not diverge significantly.

The other risks that matter

Impermanent loss is not the only risk. Several others can cause significant or total loss of funds.

Smart contract risk is arguably the most serious. DeFi protocols run on code, and code can contain bugs. If a vulnerability is discovered and exploited, funds locked in the protocol can be drained in seconds.

This has happened to major protocols, including Euler Finance (which lost around $197 million in a 2023 flash loan attack) and dozens of smaller platforms. Unlike a bank, there is no deposit protection scheme. If the funds go, they are gone.

Protocol risk covers the possibility that the team behind a protocol abandons it, executes a rug pull (draining the treasury and disappearing), or simply makes poor decisions that cause the platform to collapse. Newer and less audited protocols carry this risk far more than established ones.

Token price risk is easy to overlook when yields are quoted in percentage terms. If you are farming a token that is worth 10p today and it falls to 2p by the time you collect your rewards, the percentage yield becomes largely irrelevant. Many farmers in the 2020 to 2021 DeFi boom earned large quantities of new tokens that then lost 90% of their value.

Liquidation risk applies to leveraged farming, where people borrow additional capital to amplify their positions. If the collateral value drops below a threshold, the protocol automatically liquidates the position, often at a loss.

A Worked Example

Suppose you have £2,000 to put to work. You split it equally: £1,000 of ETH and £1,000 of USDC. You deposit both into an ETH/USDC liquidity pool on a DEX that charges a 0.3% swap fee, and the pool is earning an annualised yield of 15% in fees.

Over six months, the pool generates approximately £150 in fees for your share of the pool. However, over that same period, the ETH price doubles. Because of impermanent loss, your LP position is now worth less than it would have been had you simply held £1,000 of ETH and £1,000 of USDC separately. The fee income partially offsets this, but in a scenario where ETH doubles, you would likely have been better off just holding.

Conversely, if ETH stays broadly flat and the pool quietly accumulates fees, the yield farming strategy would have outperformed holding.

The outcome depends heavily on what the underlying assets do. That is what makes yield farming genuinely difficult to evaluate in advance.

What This Means For You

Yield farming is not a passive income strategy in the way a savings account or a dividend-paying investment is. The yields are variable, the risks are real and sometimes catastrophic, and the tax position in the UK is still evolving. HMRC guidance on DeFi lending and staking treats the tax position as fact-specific. The rules around pooled crypto positions and capital gains are not always straightforward.

If you are exploring DeFi, starting with established protocols that have been running for several years and have undergone multiple independent security audits is a more cautious approach than chasing the highest current yield on a new platform.

It is also worth separating two questions: is yield farming interesting as a concept to understand, and is it right for your money? The answer to the first can be yes. The answer to the second may still be no.

In Plain English

Yield farming is lending your crypto to a decentralised platform in exchange for a share of its fees or newly issued tokens. The returns can be high, but so can the losses. You can lose money from the underlying token prices moving, from the ratio of your deposited tokens shifting in ways that work against you, from smart contract bugs, or from the protocol simply failing. Yield farming is one of the higher-risk activities in crypto, and the advertised yields rarely tell the whole story.