Yield Farming: How it Differs from Staking
The crypto world is vast, and there are different ways you can earn from your assets. The most popular or commonly known method is through crypto trading and taking payments in blockchain enterprise services. But there are also other more promising ways to earn. In 2020, yield farming rose in popularity in the decentralized finance (Defi) world. However, before yield farming, there was staking and mining.
But time and the advancement in blockchain technology have created ways for investors to earn passively through crypto assets. And because providing liquidity to decentralized exchanges is more profitable than staking, investors shifted their focus to yield farming. This article looks at yield farming and the key differences with the other Defi mechanisms staking.
What is Yield Farming
This can be said to be the most popular way to earn a good return on your crypto assets besides other investments such as blockchain technology stocks. Essentially, yield farming helps you earn a passive income by depositing your coins into a liquidity pool. You can take these pools as a form of centralized finance that works similarly to a bank account.
The bank typically uses your funds to lend to other investors and compensates you with interest. In yield farming, you lock your crypto assets in a smart contract-based pool where it’s made available to borrowers within the same protocol. The users then borrow the tokens and use them for margin trading.
The foundation of the Defi protocols is the yield farmers who offer lending and exchange services. They’re also responsible for maintaining the liquidity of the decentralized exchanges (Dex). Yield farmers are rewarded for their effort with an Annual Percentage Yield(APY).
How the Yield Farming Model Works
The model used automated market makers (AMM), the equivalent or order books in the traditional finance world. These AMMs are a type of smart contract that enables the trading of assets through algorithms. Liquidity is maintained because they don’t require a counterpart for a trade to take place.
Liquidity Providers and Liquidity Pools
There are two primary components of an AMM; liquidity providers and pools.
- Liquidity pools: these are smart contracts that are the power behind the decentralized finance marketplace. They carry the digital funds that users within the pool lend, borrow, swap, buy or sell.
- Liquidity providers: These ate the investors who put their assets in the pool and earn a return or an incentive for it.
Yield farming crypto also works as a lifeline for the tokens with low trading volumes as it creates an avenue for them to be traded with ease.
What is Staking?
In the crypto world, staking basically means letting your crypto assets work for you. You commit your crypto assets to support the crypto network and transaction confirmation. It utilizes the proof of stake model to complete transactions and process payments. It’s considered a better alternative to the proof of work model that consumes more energy because mining requires devices that use a lot of energy to solve mathematical equations.
Apart from being energy-efficient, when staking, you also have an opportunity to earn rewards and also a way of making a passive income. The rewards are proportional to the stakes you hold.
Yield Farming Vs. Staking
Both avenues aim to help you make a profit by giving you an avenue to invest your crypto assets to generate a passive income. In the battle of profitability in yield farming vs staking, yield farming is the more profitable between the two. However, it’s also riskier, and Ethereum gas fees can ravage your APY. On the other hand, staking earns you a profit and a sense of satisfaction by being part of the construction of a blockchain project.
Regarding security, the risk in yield farming is higher, particularly in newer projects that may list tokens and close down after investors have deposited the funds. Even if that’s not the intention of the project owners, there’s still the threat of hacking. If the hacker gets to the liquidity pool, there’s no way to recover the assets.
With staking, the drawbacks are timelocks and low APY. Transaction validation is not as profitable as yield farming rewards. Also, some projects enforce timelocks, and you may be forced to lock your assets for long periods. During a timelock, you can’t utilize the assets in whatever way. If the market suddenly turns to a bear market, you can suffer heavy losses than the rewards you earned from staking.
While yield farming and staling aim at creating profits and a passive income for investors, their goals differ. Yield farming focuses on generating high interest while staking leans more towards helping the blockchain network be more energy-efficient and secure while earning a reward. It’s always recommended to educate yourself first on any investment opportunity before putting your money down.