The development of DeFi has ushered in a global revolution in the world of cryptocurrencies in particular and financial markets in general. DeFi provides decentralized finance solutions that help businesses and individual investors easily access and manage digital assets, thereby optimizing portfolios and returns.
Legendary investor Warren Buffett once said:
“If you don’t find a way to make money even when you’re sleeping, you’re going to have to work until you die.”
Understanding that philosophy, earning passive income from crypto assets is of great interest to crypto investors.
When it comes to DeFi trading, investors often fret between staking, Yield farming and liquidity mining options. The three DeFi passive income generation strategies all require participants to pledge crypto assets to support a decentralized protocol or application. However, the nature of each of these methods is always different.
Besides, the underlying technology also helps to distinguish the differences of these three approaches. You can learn more about DeFi’s three main approaches to generating profits from crypto assets or learn about yield farming and at the same time the other two strategies to determine the differences between them.
Understanding exactly where their profits come from helps investors understand the nature of the problem and have a reasonable plan to weigh the opportunity and risk.
Decentralized exchanges (DEXs) are automated applications that help users trade cryptocurrency freely 24/7. DEXs operating under the AMM model need liquidity pools . Users can exchange back and forth between assets contained in the liquidity pool, and liquidity providers receive a portion of the transaction fees.
Yield Farming is a way to make a passive profit from depositing cryptocurrency into a liquidity pool to earn the profit of that transaction fee.
Yield Farming Explained
To replace the traditional order book, yield farming relies on automated market makers (AMMs). AMMs are smart contracts that use mathematical algorithms to trade digital assets. Transactions take place between the user and the contract, not through a direct counterparty, so consistent liquidity is maintained.
Staking is a term used in the cryptocurrency economy to describe the collateralization of crypto assets on blockchain networks using a PoS (Proof of Stake) consensus mechanism. The choice of staking to validate transactions on the Proof-Of-Stake (PoS) blockchain is similar to how to exploit consensus mechanisms in the PoW blockchain.
With scalability and energy savings, PoS is a more optimal choice than PoW. Stakeholders can benefit from PoS by earning rewards. The more coins a staker bets, the more likely they are to create a block in PoS.
Therefore, the more you stake, the greater the reward of the network. If you stake coins, you will receive the network’s newly born coins whenever a block is validated. Staking, rather than mining, is a more practical technique for reaching consensus. Miners don’t need expensive equipment to generate algorithmic power.
In addition, staking platforms make staking implementation more convenient. When it comes to passive investments like yield farming, staking reduces the risk factor. The safety of the staked tokens is equivalent to the safety of the protocol itself.
You can understand what Liquidity Mining is through the formula: Liquidity mining = Yield farming + Staking
Dapps at birth will encounter the problem of a pre-existing egg or a chicken with first: Liquidity grantor first or User with first?
There is no DeFi project that does not need liquidity. If there is no liquidity, how can users trade? If there are no trading users, what are the fees to pay for liquidity grantors?
Therefore, to encourage early users to participate in liquidity levels for the protocol, projects will allocate 1 token fund of the project itself to those who deposit their coin pairs into liquidity pools.
It’s as simple as: If you yield farming on our platform, we will pay 1 part of our tokens to you.
This token can be an administration token or a utility token of the project, depending on the tokenomics.
Liquidity Mining Explained
Unlike other cryptocurrency investment techniques, liquidity mining requires investors to have an understanding of how it works. Investors put tokens into the liquidity pool, in return they will receive rewards according to the protocol. The native governance tokens mined at the end of each block are a reward for liquidity mining.
In the first stage of locking crypto assets, investors receive LP tokens as bonuses. The liquidity mining reward is directly proportional to the total pool liquidity, so investors should not underestimate this. Newly issued tokens are capable of providing access to the administration of the project, as well as the opportunity to exchange them for other cryptocurrencies or higher benefits.
Difference between Yield Farming, Staking and Liquidity Mining
|It is the locking of coins into the blockchain platform to validate transactions in order to receive a reward of tokens generated after each new block.
|It is the locking of coins into liquidity pools to provide liquidity for DeFi protocols in order to receive the reward of user transaction fees.
|It is the locking of coins into liquidity pools to provide liquidity for new DeFi protocols, in return for rewards in the form of the protocol’s native tokens.
|Rewards are new tokens of that currency when a block is validated
|Yield farmers typically make a profit as a percentage of APY
|Native tokens or governance rights
|Proof-of-Stake Consensus Mechanism
|Investors place assets into a lending protocol through a Decentralized Application or DApp, also known as liquidity farming.
|Based on decentralized finance, liquidity provider and smart contracts
|Works on both centralized (Nexo, Coinbase, and BlockFi) and decentralized (CertiKShield) platforms
|AMM Platform (Uniswap)
>>> Related: What is Impermanent loss?
Liquidity mining is part of yield farming, while yield farming is a component of staking strategy. Investors can take advantage of these forms of investment to optimize profits and diversify their portfolios. Liquidity mining helps provide liquidity to the DeFi protocol, while yield farming aims to maximize profits and staking maintains the security of the blockchain network.
However, whatever form you invest in, make sure you are prepared and knowledgeable about the approaches to building an effective investment strategy that aligns with your goals and risk appetite.
F.A.Q – Frequently Asked Questions about yield farming, staking and liquidity mining
Risks of Yield Farming
Only by being aware of the risks of each type of investment can one gain a deeper understanding of the differences between them. Yield farming is a tool to help investors make passive profits but also potentially many risks. Some of the risks include permanent loss, Smart contract risk, solvency risk, and liquidity risk.
Besides, there is the volatility of tokens. In the past, the price of cryptocurrencies has always fluctuated. When a token is locked in a liquidity pool, its price can go high or fall during short bursts, depending on how volatile the market is. That makes it more difficult for investors than keeping money ready to trade.
Why Yield Farming?
Yield farming is a useful tool to help investors find huge profits. For example, those who first find new projects will own tokens that can quickly rise in price in the future. You can use that money to reinvest or use it as a way to reward yourself.
Risks of staking
One of the most important issues to consider in debates about whether to staking or not is the farm or mining risks associated with the Proof-of-Stake process. In fact, staking carries a lower risk than other passive investment methods. The security of the protocol is correlated with the safety of the staked tokens.
However, staking still carries risks such as price drops, volatility, validators, and server risks. Besides, you may face problems such as theft or loss of funds, incentive waiting periods, failed projects, liquidity risks, minimum funds, and extended lock-in periods.
Staking is a highly profitable investment strategy that helps investors earn passive income and enjoy interest rates. You will have the opportunity to earn more than 10% or 20% annually. Besides, the proof-of-stake cryptocurrency model is all required when participating in staking.
The cryptocurrency blockchain you are investing in also benefits from staking. To validate transactions and keep the network running efficiently, many cryptocurrencies rely on the staking of their owners.
Risks of Liquidity Mining
Staking, yield farming and liquidity mining all carry their own risks and it is important for investors to know what those risks are. Like the above two forms of investment, liquidity mining has some major disadvantages such as temporary losses, smart contract risks and potential project risks. The rug pull effect can also affect liquidity mining instruments.
Why Liquidity Mining
With liquidity mining, the return is directly correlated with the level of risk you are willing to take, so the level of safety or risk depends on how you invest. Liquidity mining is simple and easy to use for new investors.
While liquidity mining is a relatively new investment technique for crypto assets, it will be a potential strategy investors can leverage to optimize returns.