Staking and yield farming are the two potential passive income streams for DeFi enthusiasts.
Yield farming rewards investors who commit their assets to liquidity pools on decentralized lending or exchange protocols.
Staking in Proof-of-Stake blockchains and DeFi protocols reward investors for locking up their crypto assets on validator nodes and staking pools respectively.
While yield farming and staking operate around different principles, both are powered by smart contracts, offering investors passive token rewards in exchange for committing their assets.
There is a difference in risk levels between staking and yield farming, and often an essential factor investors consider when calculating the net profitability of both activities.
Decentralized Finance (DeFi) refers to financial services that operate on the blockchain with no central intermediaries. They offer users an alternative and inclusive way to engage in financial activities from trading to lending. The reception has been mostly positive as cryptocurrency investors adopt almost all of its provisions, including the opportunity to earn crypto from yield farming and staking.
Through yield farming and staking, DeFi enthusiasts are generating extra income by taking part in support activities for DeFi protocols. Both programs work by incentivizing investors to ensure that the DeFi protocol continues to operate without issues caused by a lack of resources.
Here, we explain staking and yield farming and take a look at how they differ from each other.
What is Yield Farming?
Yield farming is a high-interest incentivization program for liquidity providers on DeFi protocols. As its name suggests, contributors usually receive passive rewards in the form of interest, in exchange for contributing their tokens as liquidity to the liquidity pools.
Yield farming was one of the highlights of the DeFi wave in 2020-2021, and a strong point of attraction for DeFi enthusiasts. For investors, it is a reward program; for DeFi projects, yield farming is essential for a strong and sustainable liquidity pool.
How Yield Farming Works
Contemporary DeFi protocols don’t operate an end-to-end service where buyers are matched with sellers; rather they operate using a pool system. This is in contrast to earlier decentralized exchange technologies like Atomic Swap, which operates time-based peer-to-peer transactions.
DeFi protocols utilize pools of assets to serve requests for asset exchange. These pools are known as liquidity pools. Assets in the liquidity pools are contributed by individual holders. The liquidity pool feeds the Automated Market Marker (AMM) while the AMM executes the requests and updates the protocol with the state of assets in the pool. This is the basic mode of operation of decentralized swaps and lending protocols.
Investors who contribute to the pool usually provide an equal value of the assets paired in the pool (for instance an ETH-USDC pool). There are also DeFi projects that operate a unitary vault (like Beethoven X), which allow investors to contribute a single asset to the liquidity pool. Contributors receive liquidity pool (LP) tokens, a representation of their share of the total liquidity.
Through yield farming, investors are rewarded for playing this very important role. Liquidity providers grow their investments through income earned from fees paid by the platform users, which are known as liquidity provider fees. Liquidity providers also generate yields by staking their LP tokens in liquidity pool farms, as seen in PancakeSwap, where LP tokens can be staked in the Farm to earn rewards (more CAKE tokens). The lucrativeness of such programs depends on the APR/APY offered by the platform, as well as whether the platform’s token has tokenomics to sustain the value of rewards.
What is Staking?
In general, staking is the act of locking up a crypto asset on a proof-of-stake (PoS) blockchain, where holders lock their tokens to validator nodes and receive rewards in the blockchain’s native token. PoS staking strengthens the network through decentralization and holding more tokens may improve a validator’s chances of winning a block.
DeFi has since widened the scope of staking. Staking on DeFi protocols assumes this basic form, but with a different spin. The major difference is the absence of a validator, along with the presence of a unified pool, and the absence of an unstaking period. Staking rewards in DeFi protocols can also be distributed in any token selected by the project, and most commonly features the project’s native token. DeFi staking programs can be developed by any DeFi project, provided the blockchain supports smart contracts and web3 products.
Unlike POS staking, DeFi staking is more of a tokenomics program than a security program. Stakers on DeFi platforms, in fact, do not contribute to the security of the blockchain network; rather the supply is regulated as their staked tokens are locked away from active circulation.
Tokens staked on DeFi platforms can usually be unstaked instantly and the presiding APR/APY is a function of how many investors committed to the pool. In contrast, PoS staking usually has an unstaking period (7 days to a month) and the APR/APY is relatively stable.
More recently, there’s also the rise of liquid staking derivatives on the PoS blockchain front, where users can stake their ETH with a liquid staking provider and receive a Liquid Staked Derivative token of similar value in exchange. This token essentially allows users to use their staked ETH in DeFi activities, including yield farming, enabling users to earn additional yield on top of their staking yield.
How to Stake Crypto
To stake your crypto asset on a PoS blockchain, visit the project’s staking portal, select a desired validator, and stake your asset to the validator’s node.
To stake on DeFi protocols, visit the platform and navigate to the staking pools. From the list of tokens, select the staking pool that matches the token in your custody, stake, and start earning.
Differences between Yield Farming and Staking
Yield farming and staking have two things in common. Investors commit their asset(s) in both scenarios and they earn rewards for doing so. Here are some differences between yield farming and staking:
On the surface and for investors, both staking and yield farming serve the same purpose: “Lock up crypto assets and receive rewards.” However, for developers and the protocol, both programs serve different purposes.
Staking is a validation program for proof-of-stake blockchains and a tokenomics practice for DeFi protocols. Yield farming on the other hand is native to decentralized finance and is a sustainability program to ensure liquidity on the protocol.
Proof-of-stake networks benefit from assets staked by validators and those staked to the validator nodes by individual holders. Staked tokens strengthen the network and make it more resistant to 51% attack. For the validator, staking more tokens means they stand more chances of being selected to validate a block and receive rewards.
DeFi staking programs help DeFi projects to keep a check on the tokens in active circulation. It simply rewards investors for holding on to their tokens. The staked tokens are not used by the DeFi protocol but stay dormant on the pool until the investor unstakes their asset.
Another utility for staking is governance. Blockchain projects that operate via a DAO require investors to lock their tokens in a pool and receive governance (Ve) tokens that can be used to vote on the DAO portal.
However, in the case of yield farming, the DeFi protocol uses tokens contributed to the pool for routine activities. Lending protocols serve loan requests from assets committed to the lending pool while rewarding the lender through interest paid by the borrower. Decentralized swap and leverage trading protocols serve trade and leverage requests from the liquidity pool. Finally, funds in the liquidity pools are in active use as long as the protocol is running.
Staking and yield farming both involve high-level smart contract computing. But even the level of complexity differs. Single-side DeFi staking is a relatively straightforward process, especially from the stakers’ side, as stakers can complete the staking process in just a few clicks. The smart contract is designed to accept assets and keep a record of the number of tokens contributed by each wallet.
In the case of proof-of-stake staking, validator nodes are connected to the network and so is the record of tokens staked to the node. However, from the staker’s end, the procedure is almost as simple as single-side staking on DeFi protocols.
Yield farming, in comparison, is a more complex procedure. Unlike the staking scenario described above, liquidity providers will need to provide two assets (in most cases) to the pool. At the back end, automating the token pooling procedure and yield computations, on top of LP token computation, adds to this load for smart contract developers.
Level of Risk (Impermanent Loss)
Apart from unfortunate cases of technical exploitations on a staking smart contract, single-side staking on DeFi protocol is considered a zero-risk passive income program. Investors simply lock up their tokens without worrying about the tokens diminishing in number. However, there is the question of real yield, where the protocol’s token may have unsustainable token emissions, which leads to a plunge in value.
For yield farmers, there is a risk of the committed tokens changing in number and value as well. This is mainly due to impermanent loss. Impermanent loss is the loss incurred on tokens contributed to the liquidity pool due to a disproportionate demand for the assets, where investors receive a lower value of assets than if they had just left the tokens in their wallet. This loss is considered ‘impermanent’ since the contributed assets will return to the original proportion if the two assets return to their original values (value at the time they were contributed to the pool)
This is what happens in the event of impermanent loss: if one of the assets supplied to the pool continues to rise in demand and value against the other, liquidity providers receive the other asset as the supply is increased by traders depositing more of it to the pool in exchange for the other.
Assuming you supply 100 USD worth of ETH and 100 USDC to a liquidity pool, the total value of the liquidity you provided is 200 USD. As more traders exchange ETH for USDC, the value of ETH increases and the amount of ETH you supplied continues to decrease while you receive more USDC, as the pool is designed to retain the 200 USD you added to the liquidity pool.
The ‘loss’ comes from the fact that the gains which would have supposedly come from the increase in the value of ETH will be lost. It is illusional because there is in fact, no loss; your total 200 USD value is maintained, where the only difference is that you have more USDC now. It is temporary because if the liquidity provider can wait until the price returns to what it was when this liquidity was provided, they will receive the same amount of tokens they supplied when they withdraw the liquidity.
Yield farming programs rarely have a lock-up period. The lock-up period is a time interval during which tokens committed to the contract are inaccessible. This is usually seen in PoS and DeFi staking. There is also an unstaking or ‘cooling’ period in PoS staking. The cooling (or cool-down) period is the time between an unstaking request and the token release. During the cool-down period, stakers usually don’t receive staking rewards.
In the case of yield farmers, they can withdraw and move around the assets they contributed to the liquidity pool whenever they wish.
Yield farming programs are notably more profitable. On-chain ETH staking yield is around 4%, while yield farming programs can offer APR of more than 100%. This is expected, due to investors committing multiple assets to the pool and also the fact that assets in the liquidity pool are vital to the functionality of the protocol. DeFi projects usually offer higher APR or APY for liquidity farms to offset the risk of impermanent loss and also retain liquidity providers. Meanwhile, a scenario where single-side staking pools have higher reward rates is unsustainable for the project.
However, the net profitability of a yield farming program is also dependent on the volatility of the tokens in the pool, provided the APR remains the same. When the assets are overly volatile, the impermanent loss might offset the rewards.
On the other hand, staking rewards are solely dependent on the APR or APY offered by the project.
DeFi staking is usually a two-step procedure, approving tokens for use on the protocol and approving the staking function. This process is also guided by a less complex smart contract, and therefore, doesn’t consume much gas, relatively.
Yield farming, on the other hand, involves more processes and more complex smart contract computing. Providing liquidity and completing the yield farming process consumes more gas and therefore costs more. The blockchain network’s transaction fee is a big factor here, but if both (staking and yield) activities are performed on the same network, yield farming is likely to be costlier.
Is Yield Farming Riskier Than Staking?
This is a popular question amongst DeFi enthusiasts and PoS stakers. Generally, yield farming is perceived as the riskier option, due to the potential of impermanent loss and the inherent complexity of searching out the highest yield farms for your crypto and moving your assets accordingly.
That said, staking gets riskier if there is a lock-up period and the token is more volatile. The risk here is that the token might suffer a significant fall in value before the lock-up or unstaking period is exhausted. Liquidity providers usually don’t suffer this risk, as they can withdraw their assets at any time.
Is Yield Farming Still Profitable in 2023?
The advent of DeFi has had a major influence on the price action that the 2021 bull run is famed for, with Ethereum leading the rest of the market. The wave brought by DeFi wasn’t only because cryptocurrency enthusiasts can now do more from the comfort of their wallets, but also because they can earn returns by putting their dormant assets up for use on the protocol.
Yield farming was lucrative during this time. This is mainly due to the (relative) low adoption at the time. Each DeFi protocol would offer up to 100% APR for liquidity farms. The high usage statistics on these protocols also mean that the liquidity provider fees accrue even faster. The total value of assets locked (TVL) on DeFi platforms surged to over $170 billion in November 2021 as more investors locked their tokens on the proliferating DeFi platforms.
Unfortunately, these statistics didn’t survive the test of time as the APY on yield platforms began to plummet. The crypto winter didn’t help matters, as the values of DeFi tokens, including Ether, began to respond to the wide sell-off. The profitability of yield farming also dropped; TVL on DeFi platforms dropped below $50 billion in November 2022 and slumped below $40 billion in the following month, while yield APY on DeFi platforms dropped to single digits.
Generally, returns on yield farms have dropped drastically, but the gross profitability depends on the APY and the tokens to be locked. A 10% APY for a stable asset pool (like USDT-USDC) is profitable, considering the absence of impermanent loss due to low volatility. This offer is unfortunately rare. Uniswap offers a 4% APY on its USDC-USDT pool at the time of writing.
If the protocol is established, with a good track record including smart contract audits, then committing your assets to a yield farming program is potentially a more profitable venture than leaving them in your wallets. That said, while there are still protocols offering the chance to earn a yield of over 90,000% APY, it is also important to consider asset security in relation to the offered yield.
Contributors of tokens in liquidity pools and validator nodes are the lifeblood of DeFi protocols and Proof-of-Stake consensus systems. Taking this into consideration, the rewards earned in this process aren’t completely free. But before taking part in any of these, it is important that investors consider both options (yield farming and staking) as it applies to them and concerns profitability and flexibility as well.
That being said, the risks associated with any of these and a basic understanding of the technological principles are important. Apart from inherent risks like impermanent loss, it is also recommended that investors consider the reputation of the project and the presence of a trustable report before committing their assets to any of these processes.
Finally, note that this content is only for educational purposes and not financial advice, and ensure you understand the risks associated with smart contract interactions in general.
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Joel loves discussing cryptocurrency and blockchain technology. He is the founder of CryptocurrencyScripts.
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