Introduction

Yield farming and staking are two of the most popular passive income generators in the DeFi space today. The former involves providing liquidity to facilitate trading on DEXs for a percentage of the platform's fees, while the latter has to do with locking up your crypto holdings to participate in protocol governance and/or earn a fixed annual percentage rate on your assets.

Although many think yield farming and staking are the same, they are not. While yield farming in DeFi is exclusive to decentralized exchanges and is a byproduct of liquidity provision, when you stake your coins in crypto, you support a network or protocol's governance, security, or validation.

What is Yield Farming?

Decentralized exchanges need liquidity for market making. They use a crowdsourcing approach to raise it by incentivizing regular crypto users to commit their holdings to liquidity pools for a share of the platform's revenue. This is yield farming.

How Does Yield Farming Work?

Jamie holds Ether and USDC. He joins the ETH/USDC pool and commits $50k worth of ether and USDC to it. Thus, Jamie is entitled to a portion of the fees that Uniswap charges traders when they swap ETH for USDC or vice versa. There are several complexities to how yield farming works. The bottom line is that the user provides liquidity and earns rewards proportional to their pool share.

Yield farming also involves borrowing and lending protocols, which also utilize liquidity pools like DEXs. When users commit their assets to these pools, they earn interest and have a share in the platform's transaction fees. In some cases, protocols may choose to reward yield farmers with new tokens (liquidity mining), which they could trade or restake for more rewards.

Advantages of Yield Farming

• Passive income: Yield farmers earn rewards for providing liquidity. Their earnings could be in the form of the protocol's native tokens, the coins they pooled, NFTs, or new tokens seeking to enter the market.

• Huge earning potential: Although yield farming is complex, it can be profitable if you apply the right strategies and remain in tune with the market.

• Anti-inflationary: Users earn next to nothing for holding their crypto. By putting it to use on DeFi protocols, they can earn rewards to cover any losses due to inflation.

• Diversification: Yield farming helps crypto holders to diversify their portfolios, limiting their exposure to one coin.

• Yield farming is decentralized and community-driven.

Disadvantages of Yield Farming

• Complexity and high entry barrier: Yield farming is complicated and requires heavy research and strategy for profitability. Also, yield farming is highly capital-intensive and incurs high transaction fees.

• Impermanent loss: Yield farmers suffer impermanent losses on their pooled tokens according to market fluctuations. The greater the change, the higher the floating loss. In some cases, however, fees earned may cover the losses.

• Smart contract risks: Yield farming involves interactions with smart contracts, exposing farmers to the risks of smart contract bugs, exploits, malicious activity, and rug pulls.

• Composability: Most DeFi protocols depend on one another directly or indirectly. Thus, when protocols related to the one you're farming run into problems, you could be at risk of losing your funds.

Types of Yield Farming

• Liquidity Provision: This is the most popular type of yield farming, where users commit assets into a pool and earn rewards based on their pool share.

• Liquidity Staking: In this case, LPs stake their LP tokens to earn more yields.

• Liquidity Mining: Sometimes, protocols can choose to reward LPs with new tokens seeking to enter the market, like their governance tokens, as a reward for providing liquidity.

• Borrowing: Farmers sometimes borrow tokens after providing collateral with another cryptocurrency. Then, they provide liquidity with the borrowed assets and earn yields.

• Lending: Yield farmers, through lending protocols, supply liquidity pools from which borrowers can draw funds. These farmers earn interest on the loans as yield.

Staking

Staking is another prominent passive income generator like yield farming. Proof-of-Stake blockchains allow the average user to participate in governance, block production security, and validation, either directly or by delegation. In turn, the network has a fixed reward APR with which it rewards participants according to a unique schedule.

Staking is also applicable in DeFi. Some protocols may require users to lock up their tokens to participate in governance, provide liquidity, provide platform insurance, or earn token (new or existing) rewards.

How Does Staking Work?

PoS blockchains require users to commit coins towards securing the blockchain. Essentially, when you stake your coins, you are putting them to work and supporting the network. To reward you, the network emits a fixed amount of coins as rewards for staking, usually in the native coin.

In essence, the network 'forces' validators or stakers to become part of its failure or success by incentivizing them to remain honest. In staking, users will commit their funds to a lockup period, during which their assets will be illiquid.

In DeFi, staking requires you to commit your holdings into a pool on the DeFi protocol for specific purposes like platform governance and earn the corresponding rewards.

Advantages of Staking

• Passive income generator: Some networks offer rewards as high as 5% APR for validators. These rewards are usually paid in the platform's native coin.

• No danger of impermanent loss: While the value of your holdings may fluctuate depending on market activity, your staked coins do not suffer impermanent losses.

• Security: Compared to yield farming, staking is safer as it draws its security directly from the blockchain. Your assets can only be compromised if the network itself is compromised.

• Lower complexities and risks: Staking does not require strategy or complex research. Also, staking consumes lower energy and transaction fees and is less risky compared to its fellow passive income generators.

Disadvantages of Staking

• Market exposure: Staking does not exonerate your assets from market volatility. Thus, the value of your holdings could increase or decrease exponentially during the lockup period.

• Penalties: Some networks, like Ethereum, require validators to commit a certain amount of coins (32 Ether), which is open to being slashed if the validator is found violating the network's rules.

• Staked assets take some time before they become liquid after unstaking.

• Staking is against the law in some jurisdictions.

Types of staking

• Centralized staking: This type of staking requires users to lock up their assets on centralized platforms like Binance or Coinbase to earn rewards.

• Delegated staking: Some PoS blockchains use a delegated PoS mechanism where users delegate their assets to entities that validate the network and earn rewards.

• Decentralized staking: Some networks allow the average user to participate in staking directly from their wallet applications in exchange for rewards and, maybe, voting power. Mostly, stakers participate in governance and vote on proposals.

• Liquid staking: Liquid staking was born to allow small ETH holders to participate by pooling resources together. Participants that use liquid staking solutions get derivatives of their committed ETH 1:1, with which they can interact with other DeFi products.

• DeFi staking: In this case, users lock up their coins on DeFi protocols for governance, to earn new tokens, or to provide liquidity.

Yield Farming vs. Staking

Here's how they compare to one another:

Yield Farming or Staking: Which is Better for Your Investment Savings?

When choosing a suitable passive income generator, if you want to remain liquid or earn high rewards over the short term, yield farming is your best bet as it requires no lockup and offers higher returns.

If you prefer fewer risks, low costs, and simplicity, staking is a better option, as transaction fees and risk exposure are low, and participation is fairly straightforward. If you have a solid knowledge of farming strategies and blockchain protocols, yield farming will generate better returns than staking for you.

Also, if you have limited capital, you may have to settle for staking because yield farming is capital-intensive. Finally, if you prefer fixed returns, staking is more suitable for you than yield farming.

Conclusion

Yield farming and staking are prominent passive income generators in the crypto space. Although both passive income models are profitable, they require distinct investments (financial and mental) for profitability. Nevertheless, they offer routes for crypto holders to earn income on their holdings instead of leaving them idle.