Decentralized finance (DeFi) is a rapidly growing sector of the blockchain industry built with smart contracts. It influences traditional financial services by eliminating the need for intermediaries and creating alternative avenues for earning passively. In addition to swapping cryptocurrencies and profiting from the price differences between two coins, crypto users can generate passive income on DeFi protocols through various methods.
Yield farming is the process of depositing into a DeFi liquidity pool to earn a profit, while staking involves earning interest by locking cryptocurrency to support a blockchain’s operation.
Yield farming and staking are among the passive earning methods available to crypto investors. While these methods share close similarities, they are distinct and independent. This article closely examines the distinctive features and shared similarities between yield farming and crypto staking.
What is DeFi?
Recently, the finance sector has witnessed ongoing developments with the introduction of blockchain technologies. Despite some misconceptions about the technology, it has provided solutions to real-life problems, and DeFi is one such solution.
Decentralized Finance is a financial solution leveraging blockchain technology to offer ledger-based financial services without central intermediaries like banks and brokers. It involves peer-to-peer exchange systems that provide services such as lending, borrowing, and other investments using smart contracts on a blockchain.
Here is a comprehensive article by DroomDroom explaining the concept of decentralized finance (DeFi)
DeFi platforms allow users to use digital wallets to engage with financial instruments, assets, and services. This democratizes finance, removing the complexities of traditional banking systems, including banking fees. Alongside an easy finance system is introducing different investment and earning opportunities through innovative features with DeFi protocols, including yield farming and staking.
What is Yield Farming?
Yield farming is a system in DeFi that offers investors earning opportunities in exchange for liquidity. It involves borrowing, lending, and providing liquidity to a DeFi protocol for effective operations to earn rewards for the supplied liquidity. By depositing tokens into liquidity pools for a specific period to enable lending and exchange services on DeFi platforms, investors receive interest higher than traditional interest fees paid by centralized financial institutions. This reward is the annual percentage yield in yield farming protocols and is calculated in real-time.
How Does It Yield Farming Work?
Yield farming primarily operates on the Ethereum blockchain, utilizing its ERC-20 standard and Automated Market Makers (AMMs) to facilitate crypto trading activities without intermediaries. The concepts behind yield farming involve liquidity pool smart contracts that enable the network to collect funds, ensuring the smooth execution of lending, borrowing, and staking activities.
Liquidity providers who contribute funds to the operation of the decentralized platform are rewarded. Various applications allow investors to implement yield farming methods to generate passive income; the most common type is providing liquidity for a lending platform. These liquidity providers are known as yield farmers. Usually, yield farmers deposit tokens in equal pairs (50:50) on decentralized applications (dAPP) or exchanges like Uniswap or PancakeSwap, and they receive a portion of the profit generated through liquidity.
Generating passive income for yield farmers involves depositing crypto assets into a decentralized platform. Users borrowing these crypto assets would pay interest, and the farmers would receive a reward. When users swap between token pairs in the liquidity pool, the relevant liquidity providers receive a percentage of the exchange fees.
Benefits Of Yield Farming
Higher Return
Yield farming is one of the most popular crypto investments due to its high return rate. By staking various high-yield token pairs in liquidity pools, liquidity providers (LPs) can generate rewards passively and actively, depending on market conditions. The returns from yield farming surpass traditional banking rates and the HODLing practice.
Decentralized Process
The yield system does not rely on third parties or exchange platforms to facilitate the process and generate returns. In addition to flexibility, yield farming provides LPs with control over their crypto assets. They can choose the volume of tokens they wish to provide to the pools, asset types, and the duration they want to keep to maximize yields.
Transparency
Improved security and investment confidence are among the benefits users enjoy from yield farming activities. This is because it operates on blockchain networks, providing a transparent and secure environment for earning income from additional tokens and fees.
Risks of Yield Farming
Like most investments, yield farming comes with associated risks:
Hacks And Rugpulls
Yield farming is often considered a high-risk investment strategy in the crypto space. While the blockchain operates on a transparent system, some protocols may be scam projects. This represents a risk in yield farming, where DApp developers could potentially steal the deposited assets or handle them negligently, resulting in losses for liquidity providers (LPs). Such incidents are commonly referred to as ‘Rug Pulls.’ Additionally, smart contracts may sometimes include fraudulent terms.
Constant Management
Yield farming demands constant and close management, which is not a completely hands-off investment. Investors must consistently monitor their assets, test different strategies, and actively participate in lending or borrowing to other users.
Regulatory Concern
Legal concerns may also arise due to regulatory gaps between governmental and financial bodies.
Yield Farming Process
The returns in yield farming are typically calculated annually, measured using the annual percentage rate (APR) and annual percentage yield (APY).
Understanding how to calculate compounding interest before engaging with yield farming is essential.
APR = (Annual Return / Investment) * 100%
APY = Invested Amount * {(1 + Rate / Number of Compound ) ^ Number of Compound Periods – 1}
Numerous DeFi protocols support yield farming, including UniSwap, Curve, Balancer, and Sushi. The process involves several strategies to maximize the use of your crypto assets. You can act as a liquidity provider by depositing two tokens in a decentralized exchange to earn fractions of transaction fees. Another way to engage is as a lender, earning when users pay back with interest on their crypto loans. If the investor is a borrower, they can lock up their tokens as collateral and take out a loan on the yield farm, earning passively. Staking is yet another form of yield farming.
What is Crypto Staking?
The concept of staking exists on the Ethereum blockchain and other proof-of-stake blockchains like Solana. Staking in crypto is another way to generate passive income. The process refers to locking up the blockchain’s native token, which nodes in the network use to aid in transaction validation and securing the blockchain against certain attacks.
How Does Crypto Staking Work?
Staking operates in proof-of-stake blockchain systems like Ethereum, unlike proof-of-work systems like Bitcoin, which consume high computational energy to validate transactions.
PoS systems employ a delegatory method, where honest nodes are selected to validate new transaction blocks on the network. These validators deposit and lock away some tokens to the network to ensure their honest participation. If the blockchain network is corrupted or a malicious block of data is validated, the staked native tokens would be burnt up and become worthless, causing the stakers or validators to lose money.
While this does not require as much computational force as PoW networks, the staked tokens may not solely belong to one participant. Other nodes could participate by delegating their tokens to the validating node. In return, all participating nodes are rewarded for their contribution.
In summary, liquidity providers (LPs) deposit a certain amount of their tokens as collateral to participate in network stability by validating data blocks and earning rewards. In the event of a default in operation, LPs risk losing their deposited assets.
LPs in a staking protocol generate income from new tokens and transaction fees. The new tokens are distributed as an incentive by the network, while users pay transaction fees to have their transactions processed and validated. Major platforms such as Crypto.com and Binance have been at the forefront of staking.
Is Staking Similar to Crypto Mining?
Staking is similar to mining in that both methods contribute to network stability through block validation, but they are fundamentally different. While staking operates within a Proof-of-Stake system, mining is the process of validating new transactions within a Proof-of-Work blockchain system. Mining involves solving complex mathematical problems with heavy computer hardware and consumes high energy, whereas staking is more sustainable and does not require complex computational power.
Step-by-Step Guide to Crypto Staking
- Conduct Research: First and foremost, research staking protocols to understand the terms and benefits.
- Choose a Crypto Asset: Select an appropriate crypto asset to stake, considering its staking capabilities, such as ETH.
- Create Your Wallet: Set up a decentralized wallet that enables staking functionality.
- Gather Your Crypto: Collect the crypto assets you intend to stake.
- Choose Staking Plans: Consider the staking plans available for your selected asset.
- Select Staking Platform: Choose a preferred staking platform.
- Choose Staking Form: There are different staking forms, including delegating your tokens, staking directly, or joining a pool. Select the option that suits you.
- Stake Your Tokens: Proceed to stake your tokens.
Benefits of Staking
Passive Income
Staking provides a reliable way to earn passive income without engaging in time-intensive activities like trading tokens, which often require fundamental and technical analysis knowledge. Individuals can achieve a good return Depending on network structure, the volume of the crypto asset staked, and market conditions.
Safety
Staking is considered a safer crypto investment compared to some alternatives. Investors can choose a staking protocol with a sustained positive record, enhancing the overall safety of their investment.
Blockchain Security
Staking contributes to ensuring the secure operation of the blockchain by helping to fend off issues such as malicious attacks. This proactive approach safeguards against potential losses resulting from validating incorrect transactions.
Risks of Staking
Price Fluctuation and Volatility
Crypto assets are highly volatile, and their prices can change rapidly, making them unpredictable. The value of assets at the expiration of the lock-up period may be less than the value during the deposit. For example, if $100 was worth 100 DOGE tokens during deposit collateral, and at the end of the staked time, 1 DOGE token was worth 50 cents, a loss would be incurred.
Consensus Failure
Many platforms include smart contracts to protect the network with penalties for situations like a malicious block or software failure. In such cases, staked tokens risk becoming worthless or being lost.
Passive Management
While passive management is an advantage of staking, it also comes with risks. Unlike yield farming, which requires active management, staking may expose investors to risks due to less frequent monitoring.
Security Risks
These risks are not entirely avoidable, whether due to hacks or cautionary setups. Therefore, it is advisable to diversify staking portfolios to minimize overall risks.
Similarities Between Yield Farming and Staking
Passive Earning Techniques
Both yield farming and staking are passive-earning techniques. Investors get involved in these activities to generate income without actively trading or managing their assets regularly.
Volatility
Both yield farming and staking involve volatile investment choices, although the degree of volatility may vary. The value of crypto assets in both methods can be subject to fluctuations in the market, impacting the overall returns for investors.
Differences Between Yield Farming and Staking
Both staking and yield farming share similarities, with staking considered a form of yield farming. However, there are distinctive features that set them apart:
Underlying Protocols
Yield farming and staking operate differently. Yield farming runs on Automated Market Makers (AMMs), while staking operates on Proof-of-Stake (PoS) platforms. AMMs are blockchain protocols executing market or trade orders on decentralized exchanges using liquidity pools and blockchain algorithms.
Risk and Return Rates
Yield farming and staking generate different returns. Yield farming is generally riskier but offers higher returns than staking. Staking typically has a profit yield ranging from 5% to 14%, whereas yield farming has an Annual Percentage Yield (APY) range of 1% to 100%.
Locked Assets
The approach to locking assets differs for yield farming and staking. Staking requires locking a single token type, while yield farming involves locking token pairs in equal amounts to facilitate borrowing and lending. Staking assets are locked until the specified time elapses, unlike yield farming, which has no minimum lock time.
Association with DeFI Projects
Yield farming and staking are linked to different aspects of the crypto market. Yield farming is often associated with new DeFi projects, making it more susceptible to ‘rug pulls,’ where tokens with low trading volume are traded to manage risks and losses.
Degree of Complexity
Yield farming and staking, while they require some level of knowledge, one is more complex. Staking has a less complicated outlook, requiring depositing and locking up crypto assets without constant engagement. Yield farming, on the other hand, involves LPs deciding which tokens to lend across platforms, requiring frequent engagement and management.
Control Over Assets
Investors have limited control over their staked assets in staking. In yield farming, LPs are not required to lock up their tokens, providing more control and flexibility. Return levels depend on the amount invested in both earning methods.
Market Inflation Impact
Tokens in staking protocols may be affected by market inflation, potentially reducing the values of staked assets during the lockup period. Yield farming, however, is less susceptible to this.
Security
The level of security is different for yield farming and staking. Staking is generally considered more secure, with investors often choosing protocols with established records and a strong community, reducing the risk of losing investments. Yield farming is more prone to hacking risks.
Impermanent Loss
Yield farmers may encounter impermanent losses in dual liquidity pools due to price fluctuations, unlike staking, which does not result in temporary losses.
Flexibility and Switching Costs
Yield farming provides flexibility to increase and maximize income but comes with gas fees when moving across various platforms. Switching costs should be considered when comparing yield farming and staking.
Investment Duration
Staking is a better choice for earning income over a long period, while yield farming is more suitable for short-term investments, providing flexibility and potentially higher revenue.
Conclusion
Both yield farming and staking techniques have benefits and risks. Each provides liquidity to DeFi protocols and incentivizes the providers with higher returns than traditional investments like stocks and bonds. Usually, the question revolves around which is the best investment technique. As passive earning methods, both are good strategies. However, it is best to consider other factors relating to the investor. Yield farming is highly volatile and short-term, while staking has low volatility and a longer term. Conduct proper research and evaluate the necessary features before engaging with either strategy. Consider other forms of risk management, including portfolio diversity and investing in tokens with low trading volume.
Frequently Asked Questions
What is the Difference Between Staking and Yield Farming?
Staking and yield farming are passive earning methods in cryptocurrency, but they have key differences. Staking involves locking cryptocurrency to support a blockchain’s operation and earning interest, typically on a Proof-of-Stake (PoS) platform. Yield farming, on the other hand, involves depositing into a DeFi liquidity pool, often on Automated Market Makers (AMMs), to earn profits. Yield farming is generally riskier but offers higher returns, while staking is more secure and provides steadier returns.
What is Yield Farming?
Yield farming is a DeFi process where investors provide liquidity to a protocol by lending, borrowing, or depositing tokens into liquidity pools. In return, they earn rewards, typically higher than traditional banking rates. It operates primarily on the Ethereum blockchain and involves strategies like providing liquidity for lending platforms or participating in liquidity pools on decentralized exchanges.
How Does Staking Work in Cryptocurrency?
Staking in cryptocurrency involves locking up the blockchain’s native tokens to validate and secure the blockchain. This process is common in PoS blockchain systems, where validators deposit tokens as a form of security for honest participation. Stakers earn rewards for their contribution to maintaining network stability and validating transactions.
What are the Risks and Benefits of Yield Farming?
Yield farming offers high returns and operates in a decentralized, transparent environment, allowing liquidity providers control over their crypto assets. However, it carries risks like potential scams (rug pulls), the need for active management, and regulatory uncertainties. It’s a high-return, high-risk strategy.
Is Staking a Safer Investment Option Compared to Yield Farming?
Staking is generally considered safer than yield farming. It contributes to blockchain security and offers a more reliable way to earn passive income with less intensive management compared to yield farming. However, it’s still subject to risks like price volatility, consensus failure, and security issues. Staking is better suited for long-term investments with lower risk tolerance.
