Staking vs Yield Farming: An Advanced Guide by Senior Business Analyst (Blockchain) Tilmar Goos
There are several ways to earn significant passive income in the crypto market. Yield farming and crypto staking are the best ways crypto investors can use to generate additional income. Unlike crypto trading, collecting DeFi returns is far safer and users often make a decent profit.
DeFi stands for Decentralized Finance. It refers to all dApps based on blockchain networks like Ethereum. It allows users to buy, sell, lend and borrow cryptocurrency like the traditional banking system. Crypto investors can easily generate passive income through DeFi lending platforms and liquidity pools. Since the DeFi space boomed in 2020, many lending platforms have been launched, allowing users to be yield farmers. Since then, many crypto enthusiasts have been talking about yield farming vs. staking — and which is better.
What is staking: proof-of-work vs. proof-of-stake.
Proof-of-Work (PoW) and Proof-of-Stake (PoS) are two consensus mechanisms used to validate transactions on a blockchain platform. Bitcoin is the first blockchain ever created and here we use PoW. This consensus, often referred to as mining, uses hardware to validate nodes and create new blocks on the blockchain. Because the computers have to do these complicated calculations, they tend to be more expensive, and the electricity bill can get expensive. Therefore, mining is not a sustainable system and not everyone can be a miner on the network. However, proof-of-stake is an alternative to PoW. Instead of mining, validators use their cryptocurrency to create new blocks. The process of staking is far less energy consuming. Many new platforms prefer staking, and it’s a much greener mechanism for blockchains. Ethereum is the most popular network for DeFi. It has already started converting its network to a PoS mechanism to ensure sufficient transaction throughput. Ethereum 2.0 will be ready in 2022, but investors can start staking Ethereum right now.
How does staking work? Users either have to stake a fixed amount to become a validator or they can participate in liquidity pools. Each platform may have slightly different rules; the most common method is using staking pools. Staking helps secure the network and generate passive income. Typically, staking means locking your crypto coins for a period of time. Each liquidity pool has different terms and APYs which stands for the annual percentage return and represents the annual income for that pool. Pay attention to the terms of a liquidity pool as some have a fixed time frame or lower APY than others. To get the highest possible passive income from crypto staking, you should discuss and compare all the different crypto staking options. Staking is easy and can be done with any relevant cryptocurrency. Only cryptocurrencies that belong to a proof-of-stake mechanism can be used for staking. Bitcoin, for example, belongs to a PoW blockchain and cannot be staked. The most common staking methods are: Using a wallet Using a crypto exchange Participate in a staking pool, become a validator. each cryptocurrency can have slightly different staking methods and that is why it is important to learn about each cryptocurrency and its staking process. Normally, after the research, you do the following: Set up a crypto wallet for staking. Transfer your cryptocurrency to this wallet. Decide on a staking pool. Crypto exchanges may not offer too many options. Lock your funds for staking. Wait for your staking profits to be paid out.
Cold wallet staking is also possible. This provides maximum protection for your staked cryptos as there is no internet connection. Crypto staking has already raised hundreds of millions of dollars, and the DeFi space continues to grow. Staking platforms allow regular crypto investors to increase their income and generate passive income. A lucrative blockchain network requires an active team of developers and real use cases for the platform. As more investors become interested in it, the network will grow and attract the interest of new investors and developers.
The most popular staking cryptocurrencies are:
· Ethereum
· Cardano
· Tezos
· Polygon
What is yield farming?
Yield farming is a newer concept than crypto staking and refers to an investor’s ability to carefully plan and choose which tokens to lend and on which platform. Cryptocurrency holders have the opportunity to lend their funds using liquidity pools and receive a reward for their efforts. Yield farming, also known as token farming, has been around since 2020 when Compound — the first DeFi lending protocol — was launched. Today there are several DeFi lending platforms used for yield farming, each with their own benefits. Crypto holders can use a lending platform like Compound or Aave, or they can provide liquidity directly on a DEX like Uniswap or PancakeSwap. The process of token farming is fairly simple as users need to deposit their funds on one of these lending platforms and receive an APY and the platform’s token which in turn can be used for yield farming. However, if you want to go through a decentralized exchange, a DEX, then keep an eye out for available liquidity pools. There you can stake your coins and receive a percentage of the pool’s earnings. The passive income for yield farmers results from the interest rate paid by the borrower or the users of the liquidity pool in the case of DEXs. Yield farming is considered more reliable than crypto trading, and most of the risk-free returns come from stablecoins.
How does yield farming work? In the traditional banking system, financial transactions such as lending and borrowing are handled by banks acting as intermediaries. While banks use “order books,” yield farming uses smart contracts or automated market makers (AMM) to facilitate crypto trading. Liquidity Providers (LPs) contribute funds to the liquidity pool to maintain the system and receive compensation for doing so. Other users can lend, borrow and trade cryptocurrencies thanks to liquidity providers who make their funds available to specific liquidity pools. All crypto transactions have a service fee that is distributed among the LPs. Additionally, a native token will be distributed to LPs on all lending protocols to further incentivize liquidity pool funding. When comparing yield farming to staking, it’s important to remember that yield farming is still a new practice and only through experience can you learn how to get the maximum benefit from yield farming.Liquidity Providers (LPs) and Liquidity Pools The order book is maintained by the AMM system and the liquidity pools and liquidity providers (LPs) are the two main components.
What is a liquidity pool? Basically, it is a smart contract that collects funds to make it easier for crypto users to lend, borrow, buy, and sell cryptocurrency. Those who deposit funds into liquidity pools are known as Liquidity Providers (LPs) and use their funds to power the DeFi ecosystem. You receive incentives from the liquidity pool. Oftentimes, it is tokens with low trading volume that benefit the most from yield farming as this is the only way to easily trade them.
What are the risks of yield farming?
When comparing yield farming and staking, it is important to note that these two practices work in different ways. There are risks associated with yield farming that every crypto investor should be aware of. Depreciation is a risk If a user wants to borrow crypto, they must post collateral to cover the loan. How DeFi lending works. Some loan protocols require up to 200% of the borrowed value to be pledged as collateral. This means that a user must deposit an asset in order to borrow another. If the escrow or collateral suddenly falls in value, the pool will attempt to recover the loss by selling the collateral on the open market, but a fall in value may still occur, leaving liquidity providers at risk. The borrower then loses the collateral. Therefore, it is better to borrow from a highly funded pool of collateral to avoid liquidating the collateral if the price of an asset falls. Price Fluctuations The crypto market is known for its volatility. While this can bring big profits for traders and some investors, yield generators can suffer losses if tokens suddenly drop in value. This can happen when certain trends cause the market to buy or sell certain tokens. Bugs in the protocol Yield farming and the entire DeFi ecosystem relies on smart contracts to facilitate all financial operations offered by these dApps. But smart contracts are pieces of programming code that are still written by humans. people can make mistakes. A poorly designed protocol or smart contract can lead to hacking or other malfunctions resulting in loss of funds.
As with any system, yield farms support the system because they are incentivized by the platform they use. The best yield farms tend to be the ones that are the safest and produce the highest yields. There are a number of yield farms on each blockchain, each offering different conditions. Some investors choose to purchase the funds needed to become a good yield farm. Others focus on finding the best yield farm for the assets they already own. Considering the current trends and interest in the crypto space, the top five yield farms on the following networks are good choices:
· Ethereum
· Polygon
· Binance Smart Chain (BSC)
Yield farming vs staking: Overview & Comparison
Yield farming and staking have a lot in common and are both great ways to generate passive income as a crypto holder. The main difference is that yield farming requires users to deposit their cryptocurrency on DeFi platforms. With staking, crypto investors use their funds to support the blockchain and help validate transactions and blocks on the network. Let’s summarize the main differences between yield farming and staking.
Staking vs Yield Farming: Comparison
Profit
Staking has a fixed reward expressed as APY. It is typically 5% but can be higher depending on the bet token and method.
Yield farming requires a well thought out investment strategy and is not as easy as staking but can yield much higher returns or up to 100%.
Rewards
Staking rewards are the network incentive for validators that help the blockchain reach consensus and generate new blocks.
Yield farming rewards are determined by the liquidity pool and may fluctuate as the token price changes.
Security
Staking is governed by strict rules that tie directly to the blockchain consensus. When scammers try to trick the system, they risk losing their funds.
Yield farming rewards are determined by the liquidity pool and may fluctuate as the token price changes.
Impermanent Loss Risk
When you stack cryptocurrencies, there is no impermanent loss risk.
Yield drivers face some risks that arise from the volatile price of digital assets. Impermanent Loss can occur when your funds are locked in a liquidity pool and the ratio of tokens in the pool is uneven.
Time
Various blockchain networks require users to stake their funds for a specific period of time. Some also require a minimum amount.
With yield farming, users do not have to invest their money for a specific period of time.
Yield farming vs staking, which is better
Choosing the best option to generate passive income from your crypto funds can boil down to choosing between yield farming and staking. However, both variants require a different level of crypto knowledge. Calculating the best ROI between yield farming and staking might bias users toward yield farming, but the debate should go deeper. Yield farming can be a lot more confusing for new crypto investors and may require more time and daily research. Crypto staking, while yielding fewer profits, does not require an investor’s constant attention, and some funds may be locked for longer periods of time. Ultimately, it comes down to what type of investor you want to be and how well you know the DeFi space.
About the Author:
Tilmar Wilhelm Goos, former Legal Counsel of Cardano Foundation, ex Business Analyst at SEBA Bank Switzerland. Ph.D. Researcher specializing in Accounting and Data Science at the Universidade do Minho in Portugal and Senior Business Analyst Blockchain at Bank Frick in Liechtenstein. Tilmar combines Philosophy with Finance through Tech. During his life in China, he first heard about Bitcoin. His professional involvement in blockchain technology started in late 2016 and ranges from working at Cardano Foundation, being involved in the set up of Bitcoin Mining Farms in Canada, or contributing to the building of SEBA Bank — a Swiss pioneer in digital asset banking fully licensed by the Swiss Financial Authorities. In 2022 Tilmar joined Bank Frick the first Bank offering bank accounts to crypto corporates based in Liechtenstein. Moreover, Tilmar acts as an advisor and tutor. He is the author of the “Banking Bitcoin Taxation Handbook — The Handbook of International Money Management and Digital Assets”. In his Ph.D. in Accounting in Data Science he researches the neo-liberal phenomena which he pinpointed as Algorithmic Anthropometry. The digital measurement of the human individual. Through this academic endeavor, he Chairs the Working Group Education of the Crypto Valley Association — among the largest non-profit organizations in the crypto industry.
