What Is Yield Farming?
Yield farming is a method of generating cryptocurrency from your crypto holdings. It has drawn analogies to farming because it’s an innovative way to “grow your own cryptocurrency.” The process involves lending crypto assets for interest to DeFi
Decentralized Finance (DeFi) takes the decentralized concept of blockchain and applies it to the world of finance. Build...
platforms, who lock them up in a liquidity pool, essentially a smart contract for holding funds.
The funds locked in the liquidity pool provide liquidity to a DeFi protocol, where they’re used to facilitate trading, lending and borrowing. By providing liquidity, the platform earns fees that are paid out to investors according to their share of the liquidity pool. Yield farming is also known as liquidity mining.
Liquidity pools are essential for AMMs, or automated market makers. AMMs offer permissionless and automated trading using liquidity pools instead of a traditional system of sellers and buyers. Liquidity provider tokens, or LP tokens, are issued to liquidity providers to track their individual contributions to the liquidity pool.
For example, if a trader wants to exchange Ethereum (ETH) for Dai (DAI), they pay a fee. This fee is paid to the liquidity providers in proportion to the amount of liquidity they add to the pool. The more capital provided to the liquidity pool, the higher the rewards.
Yield Farming: Advantages
As a yield farmer, you might lend digital assets such as Dai through a DApp, such as Compound (COMP), which then lends coins to borrowers. Interest rates change depending on how high demand is. The interest earned accrues daily, and you get paid in new COMP coins, which can also appreciate in value. Compound (COMP) and Aave (AAVE) are a couple of the most popular DeFi protocols for yield farming which have helped popularize this section of the DeFi market.
Instead of just having your cryptocurrency stored in a wallet, you can effectively earn more crypto by yield farming. Yield farmers can earn from transaction fees, token rewards, interest, and price appreciation. Yield farming is also an inexpensive alternative to mining — since you don’t have to purchase expensive mining equipment or pay for electricity.
More sophisticated yield farming strategies can be executed using smart contracts, or by depositing a few different tokens onto a crypto platform. A yield farming protocol typically focuses on maximizing returns, while at the same time taking liquidity and security into consideration.
What Is Staking?
Staking is the process of supporting a blockchain network and participating in transaction validation by committing your crypto assets to that network. It’s used by blockchain networks which use the proof of stake (PoS) consensus mechanism. Investors earn interest on their investments while they wait for block rewards to be released.
PoS blockchains are less energy intensive than proof of work (PoW) blockchains, such as Bitcoin, because unlike PoW networks, they don’t require massive computing power to validate new blocks. Instead, nodes — servers that process transactions — on a PoS blockchain are used to validate transactions and act as checkpoints. “Validators” are users on the network who set up nodes, are randomly chosen to sign blocks, and receive rewards for doing so.
You might not even have to understand the technicalities of setting up a node, because crypto exchanges often allow investors to provide their crypto assets, and then the network handles the node setup and validation process. For instance, brokerages such as Binance, Coinbase and Kraken offer this service. Kraken reported in January that its customers already have more than $1 billion worth of crypto assets staked on the platform.
Since PoS consensus is based on ownership, it requires an initial setup to distribute coins fairly among the validators in order for the protocol to work correctly. This can be done through a trusted source, or via proof of burn. Once the staking has started up, and all nodes are synced with the blockchain, proof of stake becomes secure and fully decentralized.
Staking ensures a blockchain network is secure against attacks. The more stakes that are on a blockchain network, the more decentralized and secure it will be. Since stakers are rewarded for maintaining the integrity of the network, it’s possible for them to earn higher returns than those who invest in other financial markets. However, there are also risks involved in staking, since the stability of networks may fluctuate over time.
How DeFi Impacts Staking
DeFi stands for decentralized finance, which is an umbrella term for financial applications using blockchain networks to obviate the use of intermediaries in transactions.
For example, if you take out a bank loan now, the bank acts as an intermediary by issuing a loan. DeFi aims to remove the need to rely on such an intermediary through the use of smart contracts, which are essentially computer code that executes based on predetermined conditions. The overall goal is to reduce costs and transaction fees associated with financial products like lending, borrowing and saving.
When it comes to staking, there are a few extra measures investors should take into account, as they’re engaging in DeFi. These include:
Considering the security of the DeFi platform
Evaluating the liquidity of staking tokens
Looking into whether or not rewards are inflationary
Diversifying into other staking projects and platforms
DeFi platforms are often more secure than traditional finance applications because they’re decentralized — and therefore less susceptible to security breaches. You can stake tokens with a variety of already established projects, such as Polkadot and The Graph. Ethereum is also transitioning from PoW to PoS validation, which means network transactions will be entirely confirmed by staking.
Yield Farming vs. Staking: What’s the Difference?
Curious about which is better suited for the average investor when deciding between yield farming vs. staking? Yield farming is very similar to staking because both require holding some amount of crypto assets to generate profits.
Some investors consider staking to be a part of yield farming. While the terms “yield farming” and “staking” are sometimes used interchangeably, there are distinct ways in which they differ. Here are the key differences.
Complexity
When looking at yield farming vs. staking, staking is often the simpler strategy for earning passive income, because investors simply decide on the staking pool and then lock in their crypto. Yield farming, on the other hand, can require a bit of work — as investors choose which tokens to lend and on which platform, with the possibility of continuously switching platforms or tokens.
Providing liquidity as a yield farmer on a decentralized exchange (DEX
Decentralise Exchange (DEX) is a crypto exchange platform that is built upon blockchain technology and negates the need ...
) may require depositing a pair of coins in sufficient quantities. These can range from niche altcoins to high volume stablecoins. Rewards are then paid based on the amount of liquidity deposited. It often pays well to switch between yield farming pools constantly, though this also requires paying additional gas fees. As a result, yield farming can benefit more than staking from active management. This is how the top yield farmers go about achieving the highest possible returns.
Ultimately, yield farming is more complex than staking — but it may also yield higher returns if you have the time, wherewithal and know-how to manage it.