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There’s no denying that the DeFi sector is broadening. As new decentralized financial solutions emerge, businesses and individuals alike are eager to take advantage of them. Decentralized finance has not only improved financial inclusion around the world but has also made digital assets more accessible and easier to manage.
Disparities between staking, yield farming, and liquidity mining often come up when people talk about DeFi trading. As far as DeFi solutions go, they’re all popular options. In each case, participants are required to pledge their crypto assets in decentralized protocols or applications in a different way.
A further indication of differences between the three approaches can be found in the underlying technologies. You can learn more about DeFi’s three main approaches to generating profits from your crypto assets in the discussion that follows. You can learn about yield farming and the other two strategies together so that you can identify any possible differences between them.
Participants in all three DeFi trading strategies must pledge their assets in support of a decentralized protocol and application. However, the underlying nature of each of these channels has always been distinct.
Let’s start by taking a look at each of these.
Yield Farming – DeFi’s Apple of Eden
Yield farming is the most common way to profit from crypto assets in the DeFi space. Depositing crypto into a liquidity pool is a passive way to make money. Centralized finance (CeFi) equivalents of these liquidity pools can be thought of as the place where you keep your money, and your bank uses it to lend it out to others, paying you a portion of the interest it earns.
A smart contract-based liquidity pool, like ETH/USDT, is a type of yield farming in which investors lock their crypto assets into the pool. Users in the same protocol can now access the assets that were previously locked away from them. Users of the lending protocol can borrow these tokens for margin trading.
DeFi protocols, which provide exchange and lending services, are built on the foundation of yield farmers. Because of this, decentralized exchanges are able to maintain a stable supply of crypto assets (DEXs). Yield farmers are compensated in the form of APY for their efforts.
Understanding Yield Farming
As an alternative to traditional order books, yield farming relies on automated market makers (AMMs). It is possible to trade digital assets using AMM contracts, which are smart contracts that use mathematical algorithms to do so. Consistent liquidity is maintained due to the fact that they do not necessitate a counterparty.
Liquidity Providers (LPs) and Liquidity Pools
Both liquidity providers (LPs) and liquidity pools are essential to an AMM.
- The DeFi marketplace is powered by smart contracts known as liquidity pools. The digital funds in these pools make it possible for users to buy, sell, borrow, lend, and swap tokens with one another with ease.
- The LPs are the investors who put their money in the liquidity pool and get rewarded for doing so.
Yield farming is also a lifeline for tokens with low open market trading volume, allowing them to be traded with ease.
Risks with Yield Farming
Only by being aware of the risks associated with each type of investment can one gain a deeper grasp of their differences. Investing in yield generation might be risky, but it can also be rewarding. Permanent loss, smart contract risk, composability risk, and liquidation risk are some of the prominent risks associated with yield farming.
Then there’s the issue of token volatility. In the past, the price of cryptocurrencies has been known to fluctuate. When a token is locked in a liquidity pool, its price may soar or fall in short bursts, depending on how volatile the market is. Because of this, it’s possible that you’ll end up worse off than if you’d kept your coins readily available for trade.
Why should you Yield Farm?
To put it plainly, yield farming is all about hefty profits. As an example, early adopters of new projects could earn tokens that could quickly rise in value. You can either reinvest the money or use it to reward yourself.
There are advantages and disadvantages to both yield farming and regular banking at the moment. Interest rates can fluctuate, making it difficult to forecast what your returns will be over the next year—not to forget that DeFi is a riskier environment in which you can put your money. However, if you aren’t looking to get stressed out over day trading, Yield farming is the way to go.
Staking – The Future of Consensus Protocols
Staking is a term used in the crypto economy to describe putting your crypto assets up as collateral for blockchain networks using the PoS (Proof of Stake) consensus mechanism. To validate transactions on Proof-of-Stake (PoS) blockchains, stakers are selected similarly to how mining facilitates consensus in PoW (Proof of Work) blockchains.
PoS is often chosen over PoW because it is more scalable and energy-efficient. Stakeholders can benefit from PoS by earning rewards. The more coins a staker has, the more likely they are to produce a block in PoS.
As a result, the more stake you have, the bigger the network’s reward for staking. If you stake your cryptocurrency, you will receive fresh tokens of that currency whenever a block of that currency is validated. Staking, rather than mining, is a more practical technique of achieving consensus. Miners need no expensive equipment to create the computing power they need. In addition, staking platforms make the practice of staking more convenient.
When it comes to passive investments like yield farming, staking has a reduced risk factor. The safety of staked tokens is identical to the safety of the protocol itself.
Risks with Staking
One of the most important considerations in debates about whether to stake, farm, or mine is the risk involved with Proof-of-Stake procedures. Staking has a lower risk than other passive investment methods, which is an interesting fact to consider. There is a clear correlation between the safety of the protocol and that of the staked tokens.
However, there are still risks associated with staking cryptocurrencies, such as slashing, volatility, validator, and server risks. In addition, you may have to deal with difficulties such as the theft or loss of funds, waiting periods for incentives, project failure, liquidity risks, minimum holdings, and extended lock-up periods.
Why Stake your crypto?
To begin with, staking is a great way to earn more cryptocurrency, and interest rates can be extremely high. You may be able to earn more than 10% or 20% every year in some instances. It has the potential to be a very lucrative investment strategy. Furthermore, the proof-of-stake model of cryptography is all that is required.
The blockchain of the cryptocurrency you’re investing in can also benefit from staking. To authenticate transactions and keep the network working efficiently, many cryptocurrencies rely on staking by holders.
Liquidity Mining – The life force behind DeFi
There is no DeFi project without liquidity mining. Its primary goal is to provide liquidity to the DeFi protocol. Participants in this investment method contribute their crypto-assets (such as ETH/USDT trading pairs) to the DeFi protocols’ liquidity pool for crypto trading (not for crypto lending and borrowing). The Liquidity Provider Token (LP) is given in exchange for the trading pair. This, in turn, is used for the final redemption.
For as long as the user’s tokens are still in the liquidity pool, the protocol compensates them with native tokens (or governance tokens, GOV) that are “mined” in each block in addition to the LP they already earned. Based on their portion of the pool’s liquidity, they receive a reward percentage. In addition to giving liquidity miners access to the project’s leadership, these newly generated tokens can also be swapped for better rewards or other digital currencies.
Understanding Liquidity Mining
Liquidity mining differs from other crypto investment techniques. It hinges on an understanding of how it works. In return for the tokens they put in the liquidity pool, investors would be rewarded by the protocol. The native governance tokens that are mined at the end of each block are the rewards for liquidity mining.
In the first stage of locking in the crypto assets, investors receive the LP token as a bonus. Liquidity mining rewards are directly proportional to the amount of total pool liquidity, which should not be underestimated. Newly issued tokens could potentially provide access to a project’s governance, as well as the opportunity to exchange them for other cryptocurrencies or higher benefits.
Risks with Liquidity Mining
Staking, yield farming, and liquidity mining all have their own unique set of risks, and it’s important to know what those risks are. Like the other two methodologies, Liquidity mining has some major drawbacks, including the possibility of impermanent loss, smart contract risks, and potential project risks. The rug pull effect can also affect liquidity miners, which makes them vulnerable.
Why should you opt for Liquidity Mining?
With liquidity mining, your return is directly correlated to the level of risk you’re willing to assume, so investing may be as risky or as safe as you want it to be. Beginners will have no problem getting started with this investment plan because of how simple it is to get started.
Although liquidity mining is a relatively new investment technique for crypto assets, it appears that it will be around for a long time to come. Liquidity mining may be a good option for you if you’re looking for an investment strategy that will serve you well in 2022 and beyond.
To sum it up, here’s a quick comparison chart:
Data collected from blockchain-council.org
Closing thoughts
Ultimately, liquidity mining is a component of yield farming, which is, in turn, a component of staking, and so forth. You can put your crypto assets to good use in any of these three ways. Liquidity mining helps the DeFi protocol by providing liquidity, whereas yield farming attempts to maximize yield, and staking aims to maintain the security of a blockchain network. In the end, it’s all up to you. However, whichever path you walk on, make sure you are prepared with the proper understanding of the approach. DYOR is the mantra.
Disclaimer: Cryptocurrency is not a legal tender and is currently unregulated. Kindly ensure that you undertake sufficient risk assessment when trading cryptocurrencies as they are often subject to high price volatility. The information provided in this section doesn't represent any investment advice or WazirX's official position. WazirX reserves the right in its sole discretion to amend or change this blog post at any time and for any reasons without prior notice.
