To make up for the lack of centralized institutions on the blockchain, crypto market participants are incentivized to provide liquidity. As a reward, they gain interest rate, thus becoming yield farmers.
To understand liquidity providers, one must first understand why liquidity is so important for any market to function. If you were to try to sell a stock right now, this means you would put forward an ask. However, what happens if there are no available buyers for your stock to be sold? That would mean you couldn't sell it when you need to sell it.
However, on the stock market, that seldom happens thanks to market makers. These large institutions, such as Nasdaq or NYSE, cover both asks and bids for any asset, regardless of whether there are available buyers or sellers. By doing this, they ensure the liquidity of the market because transactions can proceed almost instantly.
Moreover, these transactions are settled within a day or two. In return, market makers gain profit from these bid-ask spreads. In a decentralized finance powered by blockchain, how can liquidity happen without market makers?
The answer is - Automated Market Makers. Instead of having centralized exchanges like Nasdaq, AMMs create decentralized exchanges with liquidity providers as market makers. In practice, this means that you can become a liquidity provider (LP) whenever you create a liquidity pool for exchanging tokens. For instance, such a liquidity pool could consist of ETH/USDT token pairs on Uniswap.
As a liquidity provider, you would then lock in a certain number of tokens in the ETH/USDT liquidity pool. Then, whenever someone taps into your pool to exchange ETH for USDT and vice-versa, you would receive a reward as an interest rate depending on how many tokens you have staked. This is commonly known as yield farming.
Therefore, liquidity providers are both market makers and yield farmers. Since the summer of 2020, such a form of passive income has grown enormously, going from €0.8 billion to nearly €70 billion TVL - total value locked.