Yield Farming Vs. Staking: A guide to Decentralized Finance's passive income strategies
7 min read
Here is the perfect staking and yield farming guide that will make you earn passive income with your crypto assets. At the end of the article you will understand their similarities and differences and, above all, if both of them are suitable for your investment strategy. At StaderLabs you can practice yield farming strategies and crypto staking at the same time: we make both strategies inclusive, sounds good? Stay with us until the end of the article!
Table of Contents:
- What is DeFi? How to earn passive income?
- What is staking (Proof-of-Work vs Proof-of-Stake)?
- How does staking work?
- How can you stake?
- Benefits and risks of staking
- What is yield farming?
- How does yield farming work?
- What are liquidity providers (LPs) and liquidity pools?
- Risks Of Yield Farming
- Why should you choose Stader? How do we make both strategies suitable for you?
What is DeFi? How to earn passive income?
Decentralized finance (DeFi) has encouraged users to perform strategies that differ from the basic crypto swap to earn higher profits through passive income. Before getting to explain each strategy, we want to make sure you are aware of the difference between CeFi and DeFi, as it is so important to understand where the crypto industry is moving towards, and is more aligned with crypto’s mission: a trustless peer-to-peer financial system.
DeFi trading is almost a new concept that emerged on 2020 when platforms like UniSwap and Balancer launched their Decentralized Exhanges, also called DEXes. Binance, on the other hand, is a CEX, a Centralized Exchange that does CeFi. What is the main difference between a DeFi and a CeFi? Basically, with CeFi users trust business’ people to manage funds and execute business’ services, so users don’t have full custody of their funds and transparency is taken away, you need to believe the exchange is going to operate with diligence on your behalf. So here we go again, CeFi works like any other private company, each CeFi platform elaborates its own rules and their smart contracts are not open source.
DeFi is different, there are no intermediaries, is completely trustless, open-source, you fully control your funds, and you can earn potential higher yields. There are two transactions you can do in a blockchain. There are the simple transactions, like sending crypto from A to B, and there are the complex transactions, like lending, borrowing, and trading crypto. DeFi focuses on the complex ones, and here is where staking and yield farming come in!
As DeFi strategies staking and yield farming are at everyone’s reach, i.e., they are permissionless, anyone with an Internet connection can execute them without the need to rely on intermediaries. You decide your strategy and your investment. You only need the knowledge, and we will provide it to you in this article.
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, and each of it is live on Bitcoin and Ethereum, respectively.
Bitcoin, the first blockchain ever created, is PoW-based. This consensus, often called mining, uses the computational power of miners to validate transactions and create new blocks. It requires a lot of electricity and energy so the cost of maintaining the system is high, as is its environmental cost.
Proof-of-Stake, however, is more sustainable. Instead of using computational power, validators (in Bitcoin called miners) stake their digital assets to generate new blocks. Therefore, they consume much less energy. Many new platforms opt for this consensus mechanism, such as Ethereum, which has moved from PoW to PoS in the process of "The Merge" and has become Ethereum 2.0.
How does staking work?
Staking involves locking blockchain's native tokens for a certain period of time to get, in return, crypto rewards for contributing to the blockchain's speed and security. It works more or less like depositing money in a bank: the investor locks his assets in a fund and over time gets a reward (called interest).
In practice, staking rewards come up as an annual percentage (APR) that does not vary greatly (similar to interest when depositing money in a bank). For instance, Ethereum (ETH) and Cardano (ADA) current staking APR is 5%, Solana (SOL) and BNB is 6%; we could go on and on...
By staking, you become a delegator (you block your crypto, as we have seen before, to generate new blocks). You can choose the PoS crypto platform in which you want to stake. And if you don't want to do ‘solo staking’, you can join a staking pool, where different delegators pool their crypto to validate larger transactions and then share the profits proportionally. Each staking pool has different conditions and APR (annual percentage yield), which represents the annual income that the pool will bring you. Before staking you must evaluate very well the liquidity and APR conditions of each pool, since some have a fixed term or a lower APR than others.
How can you stake?
Staking is easy. It can be done in any of these ways:
- Using a crypto wallet: we recommend the cold wallet for greater protection of the funds, as you would have 100% ownership of them.
- Using dedicated staking services, such as Lido or Stader.
- Using crypto exchanges.
- Participating in a staking pool.
- Becoming a validator. This requires specialized hardware and technical knowledge. Sometimes, it even requires deep pockets (Ethereum, for instance, requires a minimum of 32 ETH, which at the time of writing is worth $44,000!)
Each cryptocurrency may have different methods of staking, so it is important to research the staking process of each one in detail.
Benefits and risks of staking
There are many benefits and risks when it comes to staking, here are the most important ones:
- You contribute to the security and efficiency of the blockchain. As we have seen before, staking alone or through a pool improves the security of the blockchain and increases the speed of the network to process transactions.
- You gain voting power on the blockchain, like owning shares in a company and acquiring voting rights.
- Grow and compound your holdings passively. Unless you are setting up your own node, staking is really easy. Staking is regarded as one of the major passive income strategies.
- Be eligible to receive airdrops. On top of the benefits mentioned above, popular platforms like Cosmos or Luna share an added benefit that can be a one-off airdrop (normally during a Token Genesis Event) or a recurring one (e.g weekly or monthly).
- Volatility risk. Cryptocurrencies are significant volatile assets. In other words, the price tends to swing up or down significantly, and fast.
- Explicit lock-up period. Staking requires locking up your funds for a period of time that can vary from a couple weeks to even years. This might come up as a disappointment if you want financial utility by selling your bag after your coin has gone up in price. If so, Liquid Staking (big shoutout to us—StaderLabs) might be for you. Liquid staking is a mechanism created for those who want their holdings to remain liquid (meaning that it can be sold anytime) but at the same time want to benefit from staking.
- Validator risk. Running a validator node requires technical know-how. If you do not have the technical knowledge, it would be very costly, and you could end up putting your capital at risk!
- Validation costs. There are costs involved with staking. If you have your own validator node, these costs are typically the hardware needed to run the node and keep it connected to the network the whole time. If you are delegating your stake, the validator or service provider retains a percentage of the staking rewards.
What is yield farming?
Yield farming is a newer concept in crypto, and refers to an investor's ability to carefully plan and choose which tokens to lend and on which platforms.
Cryptocurrency holders have the option of lending their funds using liquidity pools and receiving a reward in return. The farming process is fairly basic, as users must deposit their funds on one of these lending platforms and receive an APY and platform token, which in turn can be used for further yield farming again.
If using Decentralized Exchanges is preferred, you will need to provide a currency pair according to the availability of liquidity pools. Each liquidity provider will receive a percentage of the pool rewards according to the amount supplied.
The passive income for yield producers comes 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 cryptocurrency trading, and stablecoins generate the most risk-free profits.
What are liquidity providers (LPs) and liquidity pools?
Here AMMs (Automated Market Makers) come into play. AMMs are decentralized exchanges that pool liquidity from users and price the assets within the pool using algorithms (commonly known as price oracles). In AMMs based exchanges, liquidity pools and liquidity providers (LPs) are the two main components.
A liquidity pool is a smart contract that collects funds to facilitate crypto trading. Those who deposit funds into liquidity pools are called liquidity providers (LPs), and they use their funds to make of DeFi a robust ecosystem. They get incentives from the liquidity pool.
Often, tokens with low trading volume benefit the most from yield farming, as this is the only way to exchange them easily.
Yield Farming Risks
- Collateral can be liquidated: When users want to borrow crypto, they must deposit a collateral to cover the loan. Some lending protocols require up to 200% of the borrowed value to be deposited as collateral. This means that users need to deposit one asset to borrow another. If suddenly the collateral drops in value, the pool will attempt to recover the loss by selling the collateral on the open crypto market (DEX), and yet a devaluation in the collateral value can still occur, leaving liquidity providers exposed to losses.
- Impermanent loss: While this can generate large rewards for traders and some investors, yield farmers can experience losses when token prices suddenly lose value.
- Protocol errors: A poorly designed smart contract can be susceptible to cyber-attacks and result in the loss of funds.
Why should you choose Stader? How do we make both strategies suitable for you?
Traditionally, staking and yield farming have been seen as two distinct, different paths to achieve passive income and larger rewards, but not two that can be done together.
But what if you can stake your favorite proof-of-stake coin and, at the same time, take part in attractive yield farming opportunities? Welcome to Stader, the home of non-custodial multi-chain liquid staking.
Liquid staking is the process of locking up funds to earn staking rewards while still having access to the funds. Liquid staking funds remain accessible in the user's wallet. For example, you can use Stader to stake NEAR and get in exchange a NEARX token. As you have staked NEAR in one of our vaults you will be contributing to the speed and safety of the network and you will be receiving rewards for your contribution, but ALSO, your amount staked is not just staked per se because we gave you in exchange NEARX, a token that represents the amount you have staked and you can use it on other protocols to generate even more yield via liquidity mining, lending/borrowing, staking in other protocols, etc…
The premise is simple, yet extremely powerful. As of 16 Aug 2022, there are more than $10 billion in liquid staking platforms across different blockchains, a whopping 15% of the Total Value Locked in DeFi platforms in those same blockchains!
And you? Do you (liquid) stake? What are you waiting for?