There are three popular products and terms in the world of DeFi that have received a lot of attention: yield farming, staking, and liquidity mining. Participants in these three DeFi trading strategies must pledge their assets in various ways in support of a decentralized protocol and application. The underlying nature of these paths, however, differs.
What exactly is Yield Farming?
Yield farming is arguably the most common way to profit from crypto assets. You can earn passive income by depositing cryptocurrency into a liquidity pool. Consider these liquidity pools to be the centralized finance (CeFi) equivalent of your bank account, where you keep your money, which your bank then uses to make loans to others and pays you a portion of the interest earned.
Yield farming is the practice of locking crypto assets into a smart contract-based liquidity pool, such as ETH/USDT. The locked assets are then made available to other protocol users. These tokens can be borrowed by users of that lending protocol for margin trading.
Farmers’ yields serve as the foundation for DeFi protocols that provide exchange and lending services. Furthermore, they contribute to the liquidity of crypto assets on decentralized exchanges (DEXs). Yield farmers are rewarded in the form of an annual percentage yield (APY) for their efforts.
Understanding the Yield Farming Model
Yield farming relies on automated market makers (AMM), which are a replacement for order books in the traditional finance space. AMMs are smart contracts that facilitate the trading of digital assets using mathematical algorithms. Since they do not require a counterpart for a trade to take place, consistent liquidity is maintained.
Liquidity Providers (LPs) and Liquidity Pools
An AMM has two essential components: liquidity providers (LPs) and liquidity pools.
- Liquidity pools are smart contracts that power the DeFi marketplace. These pools contain digital funds that facilitate users to buy, sell, borrow, lend, and swap tokens.
- LPs are the investors who pledge their assets in the liquidity pool and earn incentives for it.
Yield farming also provides a lifeline for those tokens with low trading volume in the open market to be traded at ease.
What are the Threats of Yield Farming?
Yield farming is a high-risk, high-reward investment opportunity. Smart contract risk, liquidation risk, impermanent loss, and composability risk are some of the risks. As a result, yield farmers should be aware of these possibilities at all times.
What exactly is staking?
Staking is the practice of pledging your crypto-assets as collateral for blockchain networks that use the PoS (Proof of Stake) consensus algorithm. Stakers are chosen to validate transactions on PoS blockchains in the same way that miners facilitate the achievement of consensus in PoW (Proof of Work) blockchains.
PoS is generally preferred over the more popular PoW algorithm because it is more scalable and energy-efficient. PoS also gives stakeholders the opportunity to earn rewards. With PoS, a staker’s chances of producing a block are proportional to the number of coins staked.
As a result, the higher your stakes, the greater the network’s staking rewards. The rewards in staking are distributed on-chain, which means that each time a block is validated, new tokens of that currency are minted and distributed as staking rewards. When compared to mining, staking is a more viable method of achieving consensus. Stakers do not need to invest in costly equipment to generate the computational power required for mining. There are also staking-as-a-service platforms that make staking easier.
Furthermore, when compared to other forms of passive investment, such as yield farming, the risk factor for staking is lower. The safety of the staked tokens is equal to the protocol’s safety.
What Are the Threats of Staking?
Validator risk, slashing risk, server risk, falling cryptocurrency prices (volatility risk), investors may struggle to sell the assets (liquidity risk), long lock-up periods, waiting periods for receiving rewards, project failure (counterparty risk), minimum holdings, fund loss or theft are all risks associated with staking cryptocurrencies.
What exactly is Liquidity Mining?
Any DeFi project revolves around liquidity mining. Its main goal is to provide liquidity to the DeFi protocol. Participants in this investment process deposit their crypto-assets (trading pairs such as ETH/USDT) into the liquidity pool of DeFi protocols for crypto trading (not for crypto lending and borrowing). The liquidity mining protocol provides users with a Liquidity Provider Token (LP) in exchange for the trading pair, which is required for the final redeem.
As long as the user’s tokens remain in the liquidity pool, the protocol rewards them with native tokens (or governance tokens, GOV) “mined” at each block, in addition to the LP they previously received. The reward percentage is determined by their share of the pool’s total liquidity. These newly issued tokens provide liquidity miners with access to the project’s governance and can be exchanged for better rewards or other cryptocurrencies.
What are the Liquidity Mining Risks?
Smart contract risk, project risk, rug pull, and impermanent loss are some of the risks associated with liquidity mining.
In conclusion, liquidity mining is a subset of yield farming, which is a subset of staking. All three methods are simply methods of putting idle crypto-assets to use. Yield farming seeks the highest possible yield, whereas staking seeks to keep a blockchain network secure. Liquidity mining, on the other hand, seeks to provide liquidity to the DeFi protocol.