Active trading is the most popular way to make money with cryptocurrencies. However, did you know we have several other ways to diversify your income strategy and earn passive income from your idle crypto assets? Today, we’re looking at two of the most popular ways to earn passive income with cryptocurrency: yield farming vs staking.
While the two are often used interchangeably, there are quite explicit differences between them, which we’ll explore in detail in this article, along with settling the debate about which is better. So, without much ado, let’s get right to it, shall we?
What is Yield Farming?
To understand yield farming, you may relate it to lending your financial assets to a traditional banking system to earn interest. You can do so by opening a savings account where the bank lends out the funds stored in such accounts to borrowers and pays out interest on your account, often on an annual basis.
For decades, earning interest through savings accounts has been many investors’ go-to passive income strategy. However, more and more lending institutions have come up, offering competitive rates and lower interest rates to lenders. Today, the national average interest rate on savings accounts is 0.13%.
With the rise of Decentralized Finance (DeFi) applications, it’s possible to lend idle crypto assets through permissionless, trustless protocols that offer higher yield farming rates to users. These two options work similarly, except that instead of lending fiat currency through a third-party intermediary, you’re lending crypto assets through a decentralized protocol. In exchange, crypto investors earn interest at up to 100%+ annualized yields.
How Does Yield Farming Work?
Yield farming is a product offered by Decentralized Finance (DeFi) applications, an emerging financial service that offers peer-to-peer transactions without the need to go through a third-party intermediary. Their services can range from most of the services banks support, including borrowing, trading cryptocurrencies, and more. DeFi platforms require liquidity from which users can borrow and trade their cryptocurrencies to offer these services.
Here is where yield farming comes into play. DeFi platforms offer lending services where crypto investors deposit their crypto assets into a liquidity pool. In exchange, they earn interest on the transaction fees charged to access the platform services. Interest earned is determined by various factors, including the value of the crypto assets, lent, market demand, the lending period, and the platform used. Over time, your crypto assets “grow” in value due to the amount of interest (yield) earned, hence the term “yield farming.”
Annual Percentage Yield (APY)
The returns crypto investors earn on the assets they lend to yield farming platforms are usually expressed as an Annual Percentage Yield (APY) rate. As an estimate, APY rates can range from 1% to 3% or even higher. However, you don’t always earn interest annually. Most yield farming platforms offer flexible terms, where you can decide to withdraw your crypto assets plus the interest earned at any time. Also, some platforms will deposit interest earned daily.
In other cases, decentralized exchange (DEX) platforms that are a part of the growing DeFi ecosystem may require you to lend out crypto assets as a trading pair. For example, let’s say you want to deposit $2,000 worth of crypto assets into a UNI/WETH pool.
You may need to deposit both UNI and WETH worth $1,000 each, at current exchange rates, to earn trading fees. So above all, always make sure to do prior research about the crypto assets a lending platform offers and the estimated interest rate before choosing to invest.
What is Staking?
On the contrary, staking is quite different from yield farming. Instead of depositing idle crypto assets into a liquidity pool, staking requires you to ‘lock up’ a certain amount of native crypto assets into a blockchain protocol that uses the Proof-of-Stake consensus mechanism. Quite a mouthful there, so let’s take it to step by step.
Because blockchain technology is decentralized, it relies on thousands of computers running on a peer-to-peer network to validate transactions. To make this work, the first blockchain, bitcoin, employed a Proof-of-Work consensus mechanism to validate transactions.
So, essentially, thousands of supercomputers worldwide work around the clock to solve complex mathematical equations in a process called mining. The first miner to solve an equation successfully adds the next block of transactions to the blockchain and receives a reward in the form of a newly minted bitcoin.
However, Proof-of-Work uses a high amount of computing power, which consumes a lot of energy and harms the environment. So, recent blockchains have started transitioning to an energy-efficient way of validating transactions called Proof-of-Stake. Some of the most popular staking cryptocurrencies include Cardano, Ethereum, Polygon, Theta, and Tezos, among others.
How Does Staking Work?
Staking is a passive income strategy offered by blockchains that use the Proof-of-Stake consensus mechanism. This works by “locking away” your crypto assets over a fixed period of time to secure the network. Once you stake your crypto assets in a Proof-of-Stake network, you become a validator on the network.
Traditionally, validators would set up “validator nodes” to validate network transactions. So, the network randomly selects a validator node for each next block added to the blockchain to verify those transactions.
Typically, the greater the number of crypto assets you stake and the longer the fixed time period for which you lock them up, the greater your chances of validating transactions and maximizing returns. In exchange, stakeholders are rewarded in the form of native crypto assets that can be used as governance tokens or earn interest on the platform’s transaction fees.
We said, traditionally, because while staking your crypto assets on a Proof-of-Stake network may come easily, the process of setting up a validator node on the network could prove more technical. Fortunately, there are ways to avoid the technicalities of becoming a staker because you can use a DeFi platform’s services to do the technical work for you.
You’ll need to deposit your crypto assets into a staking pool, and the platform will handle the node setup and validator process. Some platforms offering this service include Binance, Coinbase, and Kraken.
The more stakers a network has, the more secure and decentralized the network becomes. Consequently, you may find higher returns in networks with an early rise to encourage more users to stake their assets. You’ll have to own the network’s native crypto assets to get started. Otherwise, always research a network’s stability for better confidence in your prospective income.
The Difference Between Staking and Yield Farming
So, now that we have a good grasp of what exactly yield farming and staking are, let’s further break them down in a thorough comparison between staking and yield farming.
Fixed vs. Flexible Rates
Perhaps the main difference between staking and yield farming is how flexible the rates are. In staking, you’re required to ‘lock up’ a network’s native crypto assets for a fixed period of time. Depending on how much time that is, whether a month, 6 months, or a year, the APY tends to go up if you stake for longer periods of time.
Once you’ve settled on a time period, the APY remains fixed, so you know exactly how much you will make at the end of your agreement. Plus, there’s the requirement that you only stake a specific network’s native crypto assets. So, if you stake an asset like Ethereum, the APY tends to go lower because of how already-established the platform is.
Yield farming, however, is much more flexible. You don’t have to “lock up” your assets for a fixed time period. Instead, you can choose to withdraw at any time you’d like. As with staking, the longer you lend your assets, the higher the approximate APY.
The special caveat here is that you’re free to withdraw assets and invest in a platform offering a higher APY. Keep in mind, though, that additional fees you may have to pay to make these transactions might rack up costs.
In general, APY often differs from platform to platform. However, yield farming tends to offer higher APYs compared to staking. This is because APYs are volatile; they typically change daily based on several factors, including liquidity and arbitrage opportunities.
Risk Involved
Crypto investments are generally volatile in nature. The value of crypto assets changes daily. You may only invest in your idle crypto assets to withdraw them when they have less value.
Volatility
However, volatility risk could vary between yield farming and staking depending on how you play your cards. While staking requires you to stake your assets for a fixed period of time, meaning that you cannot withdraw your funds at any time before the market tanks, yield farming offers more flexibility to salvage your money’s worth.
Platform Risk
Platform risk is another factor to consider. Not every platform provides the same level of service. Some yield farming platforms offer higher APYs. What’s more, The yield rates keep changing every other day. Doing thorough research into the factors that affect a platform’s stability is key here to ensure that your assets are safe and will appreciate in value.
You may have heard about hacking attacks like rug pulls leading to investors losing their funds. If you feel like a platform’s technical features are weak or vulnerable to hackers, then it’s probably not the right option for you.
Impermanent Loss
There are other risks involved that may be more or less beyond your control. Impermanent loss, for example, could mean that you may earn more by leaving your assets in your wallet. Depending on the type of cryptocurrency you have, it could depreciate in value much faster than the interest you may gain from setting it aside in staking and liquidity pools.
Opportunity Cost
Then, of course, the opportunity cost especially applies to staking. Say you hear about an investment opportunity that could earn you more money. However, you won’t be able to do anything about it if your assets are locked up in a staking pool. That said, it’s always a good idea to diversify your income strategies because every strategy has its own peculiar risks.
Ease of Use
In the past, staking was quite complicated to set up validator nodes and sign transaction blocks. However, DeFi platforms offering to take the technical side of things off your hands have simplified the process. Today, you can deposit your crypto assets into a staking pool on your chosen platform. Then, the DeFi platform will set up the nodes and validate your transactions.
On the other hand, yield farming may require a little more industry knowledge to know which platforms offer the most security, the best APY rates, and the lending services suited to your liking.
Often, APYs tend to change, sometimes daily, so you simply may not have the pleasure of putting away your crypto assets into a pool and expecting higher returns over a certain period of time. You may need to deposit and withdraw your funds from one liquidity pool to another, often paying gas fees and other transactional fees, to maximize returns effectively.
Yield Farming vs. Staking: Which is Better?
At this point, you’re probably wondering which is better. Should I invest in yield farming, staking, or none? Is staking or yield farming profitable? To answer you, we’ll say it depends on your specific needs.
Let’s say you’re an avid investor willing to take on additional risk and hope for higher returns. Then you may want to consider yield farming, taking the time to research the best offers out there and investing in the platforms you feel are secure. At any point, you’re free to withdraw your funds and invest in a much better offer. Flexibility is key here, plus there is a multitude of asset types you could choose.
In contrast, you may be looking for peace of mind in knowing exactly how much you will earn in a fixed period of time. You’re also relaxed, knowing you will not need instant access to your assets at any point before your agreed time period is up. And lastly, perhaps you want to support the growth of a specific network as a staker on Ethereum, Cardano, and others, thus championing the platform’s success. If that is the case, then staking is the right option.
FAQS
1. Is Yield Farming Legit? Is it Profitable?
Yield farming, like most investment strategies, is risky. However, it has the potential to provide you with reasonable returns over time. Established DeFi platforms like Aave and Yearn Finance provide yield farming services to users, with Annual Percentage Yield (APY) rates ranging from 1% to 3%, or even higher.
2. Yield Farming Risks
There are three main risks in yield farming: platform, impairment, and volatility. Platform risk varies depending on how secure and safe a platform is. Some platforms have succumbed to hacking attacks. Others have orchestrated rug pulls, leading to the loss of investor funds.
In contrast, impairment risk could mean you may have earned more money by leaving your assets in your wallet. This can happen if a specific cryptocurrency increases in value much more than the yield you earn by depositing into a liquidity pool over a certain period. And lastly, volatility risk can happen and is commonplace in crypto if current market prices go down.
3. Best Platform for Staking and Yield Farming
The best platforms for staking include Kraken, KuCoin, Gemini, Uphold, Binance, and more, while the best platforms for yield farming include Aave, Yearn Finance, Aqru, BlockFi, Crypto.com, and Reef, among others.
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