Everything has a beginning. And this is the beginning of yield farming. So before yield farming, there was staking, and before staking, there was mining. As the years pass by, blockchain developers find new ways of providing passive income opportunities where users can use existing capital to gain more crypto assets.
In 2020, yield farming became a special hit that thrived along with DeFi and all of its glamorous new features. Since providing liquidity to DEXs is multiple times more profitable compared to staking, crypto investors have naturally completely forgotten about staking.
But what about the risks of yield farming? Are higher APY rates enough for the community to ignore all the safety hazards that unsecured liquidity pools offer?
Perhaps staking is better, or perhaps it is not. Let have a look at it.
What is yield farming?
Yield farming, alternatively known as liquidity mining, is a method of earning cryptocurrencies by temporarily lending crypto assets to DeFi platforms in a permissionless environment.
Decentralized exchanges are the main product of the DeFi market, and to facilitate trades, they rely on investors who are willing to assist them in this matter. When a yield farmer provides liquidity to a DEX like Uniswap he earns a portion of the platform’s fees, which are paid for by token swappers who access the liquidity.
Yield farmers contribute their assets for as long as they want. For the period, which can last as short as a few days or as long as a couple of months, the user will earn fees daily. The more he lends, the higher the rewards are.
As a result of their high yield rates (APY), yield farming pools are highly competitive. Rates change all the time, which forces liquidity farmers to switch back and forth between platforms. The downside to this is that the farmer pays gas fees every time he leaves or enters a liquidity pool. During times of high network congestion on the Ethereum network, hunting for high-APY LPs is almost completely inefficient.
Certain platforms like Yearn Finance combat this issue through the use of ‘Vaults,’ a feature that implements automated yield farming strategies. After depositing his assets to a vault on Yearn Finance, the vault will constantly rebalance its assets across all of DeFi’s LPs to participate in the very best yield farming opportunities. The vault also reinvests the profits to increase its size, which naturally leads to higher profits for upcoming yield farming opportunities.
Decentralized Finance is, similarly to ICOs, given the moniker of crypto’s wild west. Because DeFi protocols are decentralized and are managed completely by smart contracts, there are a lot more risks involved compared to centralized solutions.
Security is the first risk. Smart contracts tend to be poorly coded by inexperienced teams, which results in security vulnerabilities that are exploited by ‘hackers.’ If you provide liquidity to any DeFi platform and the project suffers a loss of funds, your funds will be gone forever.
Insurance coverage platforms like Nexus Mutual help yield farmers and other DeFi participants with securing their assets in such events. However, users end up spending a good portion of their capital to protect themselves from such exploits.
Secondly, we have the issue of impermanent loss. While hard to grasp, we’ll attempt to explain it in the simplest terms possible.
Impermanent loss occurs exclusively when one deposits his assets to a liquidity pool, and the cryptocurrency in question suddenly faces a large spike in volatility. If the asset goes up, you will end up making less money than if you were just to hold the asset in your wallet. Likewise, you will also suffer impermanent loss if the asset loses its value.
There is practically no way to defend yourself against impermanent loss. The only solution here is to monitor markets and yield farms only when altcoins range.
What is staking?
Staking is a mechanism derived from the Proof of Stake consensus model, an alternative to the energy-fueled Proof-of-Work model where users mine cryptocurrencies.
Rather than spending electricity and hardware power to solve complex mathematical problems and confirm transactions, stakers lock up their assets to act as nodes and confirm blocks.
Traditionally, stakers are users who set up a node on their own and join any PoS network to support them as a node validator. However, this is not always the case.
Centralized and decentralized exchanges alike (or any platform where assets can be stored for any reason) offer their users to stake their assets without having to deal with the technicalities of setting up a node. The exchange in question will handle the validating part of the process on its own, while the staker’s only job is to provide the assets.
This way, the user can stake multiple assets just from one place. Moreover, he will not have to suffer the effects of slashing, a mechanism that cuts down a user’s assets whenever he acts maliciously.
To summarize, the main goal of staking is not to provide liquidity to a platform but to secure a blockchain network by improving its safety. The more users stake, the more decentralized the blockchain is, and hence, it is harder to attack.
The only bad aspect is that staking does not offer such a good deal compared to yield farming. APY rates payout every year, and they range between 5% to 15%. On the other hand, yield rates in LPs can go higher than 100% in some cases.
Overall, yield farming might be the most profitable option for passive investments, but it is also highly risky, especially if markets turn violently bearish or bullish, the rate of profitability will drastically drop due to impermanent loss.
Security-wise, yield farming on newer projects might result in a complete loss as developers tend to create so-called rug pull projects. After listing a new token and allowing users to deposit funds into liquidity pools, the project’s creator will shut down the project and disappear with the funds.
Even if the developer acts in good faith and works on a serious project, he might end up unintentionally creating a hole in a smart contract’s code that makes it possible for a hacker to exploit it. This is common in projects that feature both flash loans and yield farming. Once an LP is drained, the assets are forever gone, and there is no central entity that can return them.
When it comes to staking, there are two main disadvantages: low APY rates and timelocks.
Validating transactions on a PoS-based blockchain network does not reap the same rewards as yield farming. As previously mentioned, yields range from 5% to 15%, and they do not go higher than that.
Secondly, certain projects enforce timelocks. A staker might be forced to lock his assets for an entire year. During that time, he cannot move or sell his assets. If a bull market suddenly turns into a bear market, the investor will suffer greater losses than what he has gained from staking.
But how do you decide between yield farming and staking? Your taste for risk should be the sole determining factor. If you are confident in your skills and believe that gaining more money in a short period is worth the risk, yield farming is naturally the right choice.
Want to start yield farming? Go to https://master.coinswap.space/farm.