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Yield farming vs staking

All you need to know about how these two popular methods for earning passive income differ.

8 Jul 2022by Mohammad Musharraf

Disclaimer: The following is for informational purposes only and should not be construed as financial advice.

The rise of decentralized finance (DeFi) has empowered users to diversify their portfolios and pursue passive income through strategies known as staking and yield farming. 

But these two methods function independently and serve different types of investors. While the allure of earning high-yield passive income is one of DeFi’s biggest draws, it’s important that newcomers understand how these two ways of doing that differ. 

This article takes a closer look at yield farming and staking, explaining their key similarities and differences.

What is yield farming?

Yield farming is the process of providing liquidity to DeFi protocols such as liquidity pools and borrowing and lending services. It offers rewards in the form of interest, with a portion of transaction fees given to the yield farmer.

DeFi platforms like smart contract-enabled decentralized exchanges (DEXs) facilitate crypto trading through Automated Market Makers (AMMs). Liquidity providers can deposit funds into a liquidity pool and leverage AMMs to execute automated trading. In return, they get rewards like liquidity provider (LP) tokens. Yield farmers can also lend and borrow crypto funds from yield farming pools at often lucrative interest rates. 

A pictorial representation of how liquidity pools work.

What is staking?

Staking is the process by which users pledge to lock their crypto assets to secure a Proof-of-Stake blockchain network. Stakers set up individual nodes for validating transactions and adding new blocks to the blockchain network.

Users who lock their crypto funds into a staking pool earn staking rewards for securing blockchain networks from malicious actors. The blockchain network randomly selects a validator node, with high-stake nodes having a greater chance to validate transactions. With the addition of each new block, users earn governance tokens and a percentage of the platform’s fees.

A pictorial representation of how staking works.

Differences

While both yield farming and staking are innovative methods for generating passive income, they differ in several ways.

Complexity levels

Yield farming and staking differ in their ease of access and associated learning curves. Yield farming is usually more complicated since it requires intensive research to make profitable investments.

Liquidity providers need to identify a liquidity pool that offers good interest rates for providing liquidity. Then, they must decide on a token pair and select a DeFi platform that either offers a customizable liquidity pool or an equilibrium liquidity pool. Similarly, lenders and borrowers need to find a DeFi protocol that requires little or no collateralization for loans.

An aerial image of a MoonPay-shaped pool.
Take a dip in the liquidity pool

Staking is much easier to learn since users simply need to select a staking pool in a Proof-of-Stake network to stake their crypto assets. As staking usually involves a lock-up period in which stakers cannot withdraw their deposit for a given time period, the process is mostly passive once users put up their stakes. Unlike yield farming, which requires active management to generate greater returns, staking requires little effort from users.

Deposit periods

Flexibility is a considerable factor in the yield farming vs staking debate. 

Yield farmers don’t need to lock their crypto in a liquidity pool to earn rewards from yield farming protocols. They are free to provide liquidity to any liquidity pool or withdraw their tokens if the returns aren’t high enough for their liking. In the absence of a minimum lock-up pool, yield farmers can even move their funds from one pool to another to maximize their profit.

Staking, on the other hand, involves fixed lock-up periods in which users cannot withdraw their stake. The smart contracts of staking protocols programmatically ensure users cannot withdraw funds before the term ends. No matter the market conditions, you cannot pull out funds or jump from one pool to another.

Transaction fees

When deciding between yield farming and staking, gas fees can be a tiebreaker between the two. 

When yield farmers switch between liquidity pools to maximize profits, they need to pay transaction fees to execute fund transfers. Users on the Ethereum network may have to pay exorbitant gas for a simple on-chain transaction. Farmers must ensure that paying high gas fees won’t diminish their returns when shifting between liquidity pools.

An image of a gas pump.
Users pay more gas on Ethereum for faster transactions (Image source)

Since staking requires locking up user funds with no opportunity to switch pools, stakers don't have to pay transaction costs. Instead, they earn a percentage of network fees when they validate transactions. When compared to liquidity pools, staking has much lower maintenance costs for generating returns. 

Token requirements

Yield farming and staking differ in the number of tokens users need for their investments.

Yield farming requires a pair of tokens like USDT-USDC or BTC-ETH for providing liquidity to liquidity pools. Users can provide a flexible ratio of these tokens to the trading pair for customizable pools. However, they must supply tokens in a 50-50 ratio to equilibrium pools with trading pairs holding equal value.

Staking involves only one token that users can lock up in the staking pool, so stakers don’t need to buy two tokens of equal or variable value to provide liquidity. This reduces the overall expense of participating in staking.

Profit percentage

Profitability is yet another differentiating factor. 

Yield farming offers a dynamic and lucrative Annual Percentage Yield (APY) that varies with each liquidity pool. The APY fluctuates depending on several market metrics: available liquidity, arbitrage options, and overall volatility. Yield farming interest rates are typically higher than staking rates, with new coins offering more returns than high-capital tokens like ETH.

Staking, on the other hand, offers a fixed APY so users can calculate future returns and plan accordingly. Although the interest rate is lower than yield farming, a stable percentage often suits low-risk investors. Moreover, those who lock up their tokens for longer durations earn higher APYs compared to short-term lock-up periods.

Investment risks

Users must be aware of the security infrastructure and associated risks when comparing yield farming vs staking.

Yield farming protocols are subject to a variety of risks that can lead to loss of user funds. Bugs or errors in smart contracts can lead to a smart contract risk, making the protocol vulnerable to hacking. Rug pulls are also pretty common for new yield farming projects with shady, anonymous developers at the helm. Research has shown that users lost more than $10 billion from DeFi hacks in 2021.

Staking is comparatively more secure since stakers have to follow strict guidelines to participate in a blockchain’s consensus mechanism. In a Proof-of-Stake blockchain, malicious users can lose their staked assets if they try to manipulate the network for greater rewards. Unlike yield farming, staking is better protected from hacks and scams. 

Impermanent loss

When yield farmers provide liquidity to liquidity pools, they’re prone to suffer from something called “impermanent loss”. This is when the price of the tokens change from when they were first deposited. 

Liquidity pools maintain equilibrium and adjust for token prices during volatile market conditions. If users decide to withdraw their assets when token prices have deviated from their time of deposit, impermanent loss becomes permanent.

A screenshot of a representative image showing users losing money to impermanent loss.
Impermanent loss is a risk for liquidity pool users (Image source)

Staking, however, is not subject to any kind of impermanent loss. Users may lose out if the token prices of their staked assets fall due to a bear market, but since there is no adjustment of the total value in liquidity pools, stakers won’t lose money to impermanent loss.

Similarities

Despite their differences, yield farming and staking share a few common characteristics.

Passive income

Yield farming and staking are both ways to earn passive income. Users who do not wish to trade crypto can earn interest on their holdings through yield farming and staking. Although each strategy offers a different APY, both can be lucrative and offer high returns. 

Anti-inflationary

Yield farming and staking offer novel opportunities for investors to beat high inflation rates in legacy markets. If users simply hold their assets in a crypto wallet, they won’t be earning anything. Rather than keeping crypto idle, it may be better to invest it through yield farming or staking protocols. Users can earn interest on their crypto holdings to counter inflation-related value depreciation. 

Volatility risk

Users who decide to invest in yield farming and staking platforms are subject to the usual volatility in crypto markets. Tokens held in staking and liquidity pools may depreciate during bearish markets. Both yield farmers and stakers can lose money when prices go down overall. In fact, farmers may face an additional liquidation risk if their collateral depreciates in value and the protocol liquidates assets to recover costs.

Who is yield farming suitable for?

Not all investors are suitable to participate in yield farming protocols. Yield farming is only viable for those with a very high-risk tolerance. If users do not follow proper investment advice, they face a greater chance of losing their money.

Yield farming platforms offer high APY but the required initial investment is also higher than staking platforms. This is what makes yield farming ideal for investors who have the necessary liquidity to invest in these protocols.

A photograph of purple cows.
Note: Yield farming does not require livestock or farming equipment

If investors get involved early in liquidity mining for an upcoming project, they can earn a massive amount of interest. New protocols often incentivize liquidity pool funding with higher APYs. But investors must be careful about vulnerabilities in smart contracts and opt for audited companies with doxxed and active developer teams. 

Yield farming is also suitable for generating passive income for traders holding low trading volume tokens, providing the opportunity to earn interest on otherwise idle assets. Finally, yield farming is ideal for investors who wish to remain flexible with their investments and don’t prefer extensive lock-up periods.

Who is staking suitable for?

Investors with a low-risk appetite are better off earning by staking their assets. Moreover, due to low-risk exposure, staking is easier for novice crypto users who are yet to learn the intricacies of the market. 

Staking is one of the safest methods to generate passive income by simply validating crypto transactions and enhancing sufficient transaction throughput. Additionally, the initial investment in staking is much lower than in yield farming, making it accessible to a wide range of investors.

Staking also has the benefit of offering fixed interest rates, helping users calculate returns upfront while depositing funds. Users may prefer a stable APY from their investments that can better help them predict their financial outcomes.

It’s important to note, however, that staking is not a flexible strategy since the protocols lock up user funds for a fixed time period. If users need continuous access to their funds, staking might not be suitable for them. And although short-term staking options are available, they usually offer lower APYs than yield farming.

Final thoughts

Yield farming and staking are both proven ways to generate passive income for crypto users. Depending on risk tolerance, interest rates, and preference for flexibility, investors can choose either of these strategies to grow their crypto portfolio.

You can also invest in yield farming and staking platforms to diversify your crypto holdings. But first, you’ll first need to purchase cryptocurrencies. Simply buy crypto via MoonPay using a card, mobile payment method like Google Pay, or bank transfer.