Introduction
The cryptocurrency market is a predominantly decentralized space. There are no banks or governments to back their reserves. Therefore, crypto entities use options such as liquidity pools and Automated Market Makers to maintain their liquidity.
In this, the cryptocurrency investors are the ones who are responsible for keeping the crypto entity liquid. The crypto investors who are providing liquidity are incentivized by methods such as Yield Farming and Staking.
What is Yield Farming?
Yield Farming is a way to create a new stream of cryptocurrencies using the existing crypto reserves. It means that every crypto investor has the option to use their crypto holdings and can grow them using the Yield Farming method. The word Yield Farming is a portmanteau of two terms.
The first is Yield, which stands for the income that is generated as a result of committing cryptocurrencies for a required duration for Liquidity or other purposes. The second word is Farming, which means multiplying many folds using the crypto holdings as seed capital. The metaphor has been adopted from the agriculture sector.
Yield Farming was started by a DeFi protocol called Compound in 2020. Since then, cryptocurrency investors have earned in the form of Annual Percentage Yield or APY that has the potential to reach 3 digit returns.
How does Yield Farming Work?
Yield Farmers are like digital sowers who lend virtual estates and wait for their crops to grow in demand. In most cases, the Yield Farming income is generated in the form of interest. However, unlike the centralized banking system, the DeFi sector allows Yield Farmers to use smart contracts for this purpose.
Yield Farmers can take advantage of the Automated Market Makers or AMMs. These protocols are present in the Liquidity Pools of DeFi spaces. The job of AMMs is to assign value to the available cryptocurrency reserves on account of their quantity.
Furthermore, AMMs also keep track of the demand and supply of every cryptocurrency present in a liquidity pool. It is important to mention that Liquidity pools are crypto reserves that are staked or lent, or committed from different sources to ensure that the crypto investors are able to readily convert their crypto reserves from one crypto type to another.
Yield Farmers have the option to stake their crypto reserves in a DeFi Liquidity Pool in exchange for interest income. They may also lend their crypto reserves in P2P lending platforms to earn interest.
In Yield Farming, crypto investors usually find a way to generate several streams of interest incomes by staking the same seed capital at multiple levels.
Terms Associated with Yield Farming
Here are some of the most important terms or metrics that are associated with Yield Farming:
Total Value Locked or TVL
Total Value Locked, or TVL is the representation of the total cryptocurrency reserves that are staked in a given liquidity pool on a DeFi platform.
Annual Percentage Yield or APY
Annual Percentage Yield or APY is the rate of interest returns that cryptocurrency investors can earn from a DeFi protocol by staking per unit investment.
Annual Percentage Rate or APR
Annual Percentage Rate or APR is the rate of annual return for a given amount of cryptocurrency investment on a yearly basis. The difference between APY and APR is that APY is inclusive of compounded interest income.
Types of Yield Farming
There is more than one way to generate income using Yield Farming:
Liquidity Pools
Yield Farmers can become liquidity providers by committing their crypto reserves to the DeFi liquidity pools. In this manner, they are able to lend their crypto reserves to a DeFi protocol. In return, the stakers earn a portion of the transaction fee whenever a crypto investor exchanges two cryptocurrencies in the given Liquidity Pool.
Lending
There are p2p or Peer-to-peer lending protocols available on DeFi protocols. Cryptocurrency investors can lend the tokens or coins under their ownership using smart contracts. In this manner, they can earn interest returns on their lent position from the borrowers.
Borrowing
There is another option of locking crypto reserves as collateral for Yield Farmers. By committing their crypto savings as reserves, these investors can borrow or swap with other crypto tokens. The borrowed crypto yield can be used to add another layer of Yield income using methods such as lending or staking etc.
Staking
Staking is also a type of Yield Farming. Staking allows investors to commit their crypto reserves in various liquidity pools in DeFi. Only PoS or Proof-of-Stake blockchain tokens can be staked. In some cases, the investors can multiply their staking income by staking the tokens earned from the first staked position in another liquidity pool.
Advantages of Yield Farming
Additional Income
Yield Farming is a great way to generate more income with the existing cryptocurrency reserves for a crypto investor at any level. It does not require a lot of technical skill to stake the tokens or join any Yield Farming protocol in DeFi to create an additional stream of interest income.
High Percentage of Returns
In comparison to the traditional savings account internet returns, Yield Farming income percentage is many times higher. It is important to mention that Yield Farming is often attributed to the DeFi alternative for the savings account. The average savings account interest APY is 15% internationally, while in comparison, the average returns on the yield farming can raise as much as three-digit income for the same duration.
Compounding Yield
Compounding is a way of multiplication of an income stream on account of its growth at regular intervals. Yield Farming is an effective way to compound the interest returns by staking the Yield tokens in other DeFi protocols or staking them in a new liquidity pool, among other methods.
Cost Effective
Yield Farming is also a cost-effective method of investing. In most cases, Yield farmers can generate new income streams without investing any additional capital into the mix. However, there are some cases where investors should calculate minor costs, such as transaction fees and transfer charges from one digital wallet to another.
Automated Process
Yield Farming is done using smart contracts. It means that the whole process requires a very limited amount of active surveillance or labor. The yield farmers can pitch in their reserves for a specified duration and keep earning without needing to actively monitor their positions.
Limitations of Yield Farming
Rug Pulls
Rup Pulls are financial scams where the creator of a Yield farming protocol decides to abandon the project. In such cases, the users who have staked positions can end up losing their entire cryptocurrency portfolios in addition to the ownership and all the yield income they have generated. To prevent rug pulls, investors must use the DeFi protocols that are reliable and offer realistic APY.
Smart Contracts
Smart contracts are automation codes, and therefore they carry a risk of containing technical lags. In some cases, new updates can end up opening a smart contract to a technical blind spot or introduce a new bug in them.
In the case of smart contract vulnerability, the Yield farmers can be exposed to exploits or outage times that can affect their returns and affect the value of tokens they are earning as yield income.
Regulatory Risks
Regulatory Risks are one of the most talked about the threat to the entire DeFi market. In case of an unprecedented legislative declaration issued by the local regulatory agency, it can become illegal for the Yield farmers to access their crypto portfolios and yield income. However, in the current economic pretext, it seems an unlikely occurrence.
What is Staking?
Staking is one of the methods that are used for Yield Farming. Staking is used by cryptocurrency investors to generate additional income in the form of staked tokens or other cryptocurrencies. There are some staking platforms that allow users to earn staking rewards in the form of stablecoins. It is important to note that only PoS or proof of stake blockchains issue digital tokens that can be staked.
Currencies that depend on PoW, such as Bitcoin, do not offer to stake privileges for their investors. The nodes on PoS blockchains that act as validators can be used to perform proof of burn for staking.
Staking is also a great way to increase the security of a blockchain project. Many crypto protocols compete with each other to have the biggest TVLs that indicate their security and strength. Furthermore, higher TVL for a DeFi protocol can also result in increasing the yield percentage for its stakers.
How does Staking Work?
The PoS protocols or blockchains allow cryptocurrency owners to stake or commit their reserves in smart contracts. In this manner, the said DeFi protocol could provide greater liquidity for its users. The staked currencies are locked in for a specified amount of time.
Before the expiration of the stake duration, the investors cannot withdraw their staked currencies. In return, these investors can earn rewards or yield income in the form of interest paid as yield tokens or other cryptocurrencies. The range of APY for a typical DeFi stake position can range somewhere from 4% to 20%.
Unlike centralized banking networks, the staking returns are more rewarding, and they are also more democratic. While the stakes are in place generating yield returns, the investors can also benefit from the increasing spot prices of their stakes cryptocurrencies during positive market movement.
Types of Staking in Crypto
Here are two basic types of staking in the DeFi and crypto sector:
Delegating
Delegating staking process is the mainstream process of staking. In delegating positions, the investors are bound to delegate or lock their crypto reserves with a recognized and reliable validator. In return, the stakers are going to earn yield in exchange for their locked crypto assets.
Delegating requires very little amount of technical understanding on the part of the stakers. However, the validators are entitled to earn a small percentage of the yield income on account of their input.
Validating
Validating is an act of working to verify a crypto transaction and operating as a node in a PoS blockchain. Therefore, validators require a considerable amount of knowledge and technical understanding of blockchain protocols.
At the same time, validators also require special machinery, a large portion of the crypto reserve to stake as a warranty, and a premium internet connection.
Advantages of Crypto Staking
Network Security
Staking increases the stability and security of a DeFi network. With an increasing number of staking positions, the number of validators on the network also increases, and the node running operations become more frequent. In this manner, the appreciation of staked reserves on blockchain protocols leads to improving its security against hacks and exploits.
Long-term Returns
Staking is a great way to invest with a long-term vision. The tokens that have a considerable amount of staked positions are bound to retain their demand in the DeFi sector for a long duration. Many stakers aim for compound returns that require locking their crypto reserves for several years.
Easy Access
The stakers who are working with delegated positions have an easy entrance into staking. They don’t need a lot of technical or investment resources to start earning staking rewards. On the other hand, anyone can upgrade to a validator or staker by acquiring the required equipment and technical knowledge.
They do not need to acquire a legal permit from a centralized government like traditional banks or brokers. Their technical knowledge is a prerequisite to their qualification to participate in staking and work as a validator.
Energy Conservation
Staking is a feature of PoS blockchains, and in comparison to the PoW blockchains, they are very energy efficient and require a minimal amount of energy input.
Skill Development
Staking is a great way for cryptocurrency investors to learn more about the inner workings of blockchain networks and smart contracts.
Comparison Between Staking and Yield Farming
Complexity
Staking has different levels of complexity depending on delegating and validating positions. On the other hand, Yield Farming is more complicated in comparison to the Staking positions.
It entails generating multiple streams of income by restaking the yield tokens or performing leveraged trading by staking crypto reserves as the collateral amount. Therefore, the complexity of Yield Farming is many times higher in comparison to other options.
Risk Percentage
Yield Farming is deemed riskier in comparison to staking operations. Yield farmers are prone to threats like smart contract bugs, rug pulls, and hack attacks. Most yield farmers cannot read or work with smart contracts and are unaware of their risk exposures.
In comparison, staking is a method of adding more security to a given network. Therefore, it is less risky and considered to be relatively safer.
Impermanent Loss
Impermanent loss happens when the staked currencies lose their value in the spot market on account of a bear market or crash.
Both yield farmers and stakers can suffer from impermanent losses because they are unable to liquidate their positions before the staking duration is completed. In some cases, yield farming does not require locked positions.
Profitability
Yield Farming is likely to increase the yield returns for a cryptocurrency investor on account of its multilayer investment positions. On the other hand, the profitability of staking depends on the time duration for the commitment.
If stakers wish to compound their returns, they have to wait for several years and renew their staked positions many times.
Duration
The duration for Yield Farming and staking depends on the strategy and the target returns for every investor. If investors are able to locate the staking positions that offer higher percentage yield or APY, they can earn more profits within a short duration.
Inflation
Staking on PoS tokens is an inflationary process. It means that their supply increases with respect to time. The yield returns are generated in the form of the newly minted tokens. However, it is in line with the increasing inflation in economic terms. If investors do not stake their positions, it means that they lose the value of their crypto holdings on account of increasing inflationary forces over time.
Gas Fees
Yield farmers move their cryptocurrency assets from one liquidity pool to another, and thus they have to pay considerable transaction fees. Meanwhile, the stakers mostly remain on single DeFi protocol, and therefore their input costs are often smaller and often non-existent in comparison to Yield farmers.
Security
Yield farmers are only secure if they are participating in high TVL ventures. On the other hand, they are still less secure in comparison to the staking position. In contrast, the stakers are essentially participating in making the DeFi protocol more secure than before.
Long and Short Term Returns
For yield farmers, the short-term returns are higher than the long-term returns of staking positions in most cases.
Conclusion
It is clear that staking is a component of yield farming. However, both processes share some similarities and distinctions with each other. Both these options are relatively new financial concepts, and they have the potential to impact centralized financial networks as well.
Staking is inherently a simpler and automated process; on the other hand, yield farming can require considerable planning and supervision from investors.