4 Jun 2021
5 min read
Imagine if you could make more crypto using crypto. Sounds good, right? You probably have heard of yield farming and staking, and if you're new to the decentralised finance (DeFi) world, those terms might sound strange to you. If you want to make a passive income through these methods, it's essential to know them in-depth because they constitute a massive part of the DeFi boom. Here, we'll try to explain how these two concepts work.
Yield Farming is also referred to as liquidity mining. It surged thanks to crypto traders that considered trading similar to farmlands as investors would expect their coins would generate returns of at least 100% annually. This is how Yield Farming became an innovative practice to the DeFi world.
We can also attribute the Yield Farming boom to the COMP token —the native token of Compound, a lending protocol built on Ethereum. On June 15, 2020, Compound started distributing COMP governance tokens to its users. Compound users were already making money by making deposits that people could borrow. But the protocol wanted users to borrow and deposit more to increase liquidity and reward them with COMP tokens. This triggered something called "farming," and it's now a common way to attract liquidity and to launch a decentralised network —by distributing governance tokens algorithmically with liquidity incentives.
While Compound didn't invent the concept, it did give it a significant boost to the practice we know today as farming. Compound is now one of the major lending DeFi platforms. Other projects follow suit, implementing some changes to attract liquidity to their ecosystems. Yield Farming can be complex, as you might have guessed by now. But Yield Farming is all about maximising a rate of return on capital by leveraging different DeFi protocols through a well-planned set of strategies.
Say you want to become a farmer. What you can do is approach three DeFi protocols, for instance, and deposit tokens to lend them to their borrowers, and borrowers pay interest on the loan to the investor. Deposited funds are locked in a liquidity pool —a collection of locked funds in a smart contract. This pool powers a whole marketplace for decentralised trading, lending, and borrowing. As a liquidity provider, the platform incurs fees that are paid out to you according to your share of the liquidity pool.
You can deposit any currency you want, but most tokens are stablecoins —USD pegged tokens— like USDT, DAI, USDC, and more. However, you can also choose ETH, BTC, or LINK. Yields are based on current rates and might change over time. Here are three examples of the ROI you can earn on some protocols:
Protocols will mint tokens that represent your deposit funds. In the case of Compound, if you deposit DAI, you'll receive cDAI (Compound DAI). This is where it gets tricky because some other protocols might mint a third token to represent your cDAI that already represents your DAI. But again, these networks are usually more complex. Let's stick to the basics.
By depositing tokens on the pool, you're providing liquidity to a protocol. This practice is commonly associated with assets and markets, and Yield Farming is similar to Automated Market Makers because it involves liquidity providers (shorted as LPs) and liquidity pools.
It's hard to point out a strategy as farmers are usually very secretive about it. If everyone used the same method, then it wouldn't be as efficient as before. But usually, farmers look for the highest yield in at least three protocols —like Uniswap, Compound, or Curve— and stick to them until you find other protocols with higher yields. This means that farmers move their assets from platform to platform to seek the highest yield. It's an active process.
Staking and yield farming are usually confused as the same technique, but they are two different ways of making a passive income.
Staking is a much easier concept than Yield Farming (it also has lower risk). It is a mechanism derived from the Proof of Stake (PoS) consensus model —an alternative to Proof of Work (PoW). Staking is similar to mining; the only difference is that you don't need tremendous hardware power and electricity to solve complex mathematical problems to confirm transactions —instead, you lock up your assets in the network to act as nodes and confirm blocks. You earn rewards for doing so.
The main difference between Yield Farming and staking is that staking doesn't provide liquidity to a protocol but secure a blockchain by improving its safety. The more users stake, the more decentralised it becomes.
Generally, stakers set up their own node and join a PoS network to support them as a node validator, but this is not always the case. PoS protocols will handle the node, so you can simply stake your funds without dealing with the technical aspects of setting up a node.
Staking pools play an important role in the DeFi world because they power the blockchain. Here, stakeholders Stakeholders will combine computational resources to power the verification and validation of new blocks in a network, and by doing so, they earn block rewards.
Staking pools focus on combined staking capacity, so the bigger the staking pool, the bigger the chances to be picked to verify a block. Naturally, staking pools return smaller rewards than solo staking, as each validation (block forging) will split the rewards among pool participants.
This is a space with no regulations. Otherwise, it wouldn't be called "decentralised." There are no insurance providers, no mandatory audits of code. The bottom line is there are no laws. This means anyone can launch their own financial project, and by being a lawless space, it prompts malicious actors to launch flashy, shady protocols that usually end up in rugpulls — when the team behind a project dries out liquidity pools and runs away with investors' funds.
So if it's so risky, why do people get into yield farming? Because interest rates are high. Protocols usually pay 12% interest compared to banks —which is near to 0%. The protocol is rewarding you for taking the risk. As it always is, anyone entering this space shouldn't invest money he can't afford to lose.
Yield Farming offers high returns with high safety risks, but it requires a constant hunt for liquidity pools. Staking has lower rewards, usually 3% to 10%. Stakers could be met with time locks, meaning they can't move their assets for a certain period. So if a market suddenly crashes and turns bearish, you will suffer great losses. It really depends on what you're looking for.
Farmers will often seek different DeFi platforms to maximise their returns. These platforms offer different incentivised loans and liquidity pool loans. Whether you're looking to stake or farm, here are seven of the most popular protocols you can approach:
Compound is currently the most famous DeFi lender platform. As a lender, every time you supply assets, you receive cTokens (if you deposit ETH, for instance, you receive cETH —"Compound Ether").
MakerDAO is a pioneer of decentralised credit. Here, users lock cryptocurrencies as collateral assets to borrow DAI —a stablecoin pegged to the USD. Interests are paid in the form of a "stability fee."
Uniswap is a decentralised exchange (DEX) and automated market maker (AMM) that allows users to exchange almost any pair of ERC20 tokens without intermediaries. Liquidity providers must participate on both sides of the liquidity pool in a 50/50 ratio and, in return, earn a chunk of the transaction fees as well as the UNI governance token.
Synthetix offers a great and diverse ecosystem for yield farming. Synthetix is a derivatives liquidity protocol for issuing synthetic assets —these assets are collateralised by the Synthetix Network Token (SBX). You can stake SNX to earn trading fees in sUSD in addition to a slice of the protocol's native inflation.
Yearn.finance is an automated decentralized aggregation protocol that enables Yield Farmers to leverage various loan protocols such as Aave and Compound to obtain the highest returns possible. The protocol algorithmically searches for the most profitable yield performance services and uses rebilling to maximize your profits. Yearn.finance made waves in 2020 when its YFI governance token surged to more than $ 40,000 in value in one stage.
Yield Farming and staking are fairly new technologies to earn a passive income. Many crypto enthusiasts consider them exciting features of the decentralised world. As the sector grows, we can expect more liquidity incentives for users, which will surely boost the DeFi space.
Fintech and finance writer, with keen interest in blockchain and crypto.
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