Crypto investors constantly search for ways to increase their portfolios and earn bigger. One notable way is through passive income. There are different passive crypto earning methods, but the two common ones are staking and yield farming.
Pro traders and investors are aware of these terminologies and how they operate. However, anyone new to the game should learn about these forms of passive income.
If you are here, it means you are interested in making your crypto tokens work for you. Well, we have got you covered. Our guide has been expertly crafted to uncover the intricacies of passive income crypto. Yield farming vs Staking? Which is the best for you? Take a seat, relax, and read on!
What is Yield Farming?
Crypto yield Farming follows the pattern of traditional farming, which involves planting seeds into fertile soil for a set period to yield a crop. In this case, your seed is your crypto token, the fertile soil is a DeFi platform, and the crop that gets harvested is also a cryptocurrency.
How does this work?
A crypto user deposits and locks a certain amount of tokens into a decentralized finance (DeFi) platform to earn rewards. However, we must notify you that this is a high-risk and volatile investment strategy.
For example, rather than leaving ETH in your wallet to be affected by price fluctuations, you can lock it on any DeFi platform for a specified time. In return, the platform pays based on a fixed ROI, usually in more cryptocurrency.
How to go about Yield Farming
To get started, all you need is a cryptocurrency wallet. Then, you select a method of yield farming. These are;
- Lending: This is mostly user-to-user rather than user-to-platform. Here, you lend a trader some crypto to run their trades with an agreed-upon interest rate. The trader is obliged to pay whether he wins or loses.
- Liquidity provision: DeFi platforms often need extra funds to facilitate transactions. So, they create a pool in which users can loan them crypto. In addition to being paid back in crypto (interest inclusive), users enjoy other perks (such as exclusive and priority access to NFTs and Initial Decentralized Offerings).
What is Crypto Staking?
Crypto staking is usually mistaken for yield farming. Although they both involve crypto assets locking for a set period, staking is majorly done to support the operation of a blockchain. Does this mean that people who stake cryptos are not rewarded? No, they also earn cryptocurrency returns.
How does staking work?
Blockchain technology is at the heart of crypto transactions. Many of these blockchains use a consensus mechanism called "proof-of-stake."
Just like houses of parliament have members that vote to validate laws, this mechanism has network participants. Their work is to validate new transactions and add new blocks. However, they must "stake" a certain amount of cryptocurrency to do this.
The money deposited is a form of insurance. If the participant validates a wrong transaction and the blockchain is hacked, they lose the deposited funds as a penalty. However, if they secure the chain by validating legitimate blocks, they earn more crypto as a reward.
Typically, the bigger the stake, the greater the chance of a participant validating new blocks. The amount of stake a validator holds also proves their trustworthiness. This, in turn, means they become the platform's priority and are paid better.
Comparing Staking and Yield Farming
So far, we’ve defined both terminologies and peeked into their operations. Now, let’s compare both forms of passive earning. First, we would look at their similarities and then their differences.
Similarities between staking and yield farming
Here are two ways in which both staking and yield farming are similar;
- Passive Income
Here’s the main underlying similarity between staking and yield farming. Passive income is acquired with little to no labor. Typically, it involves getting your money to work for you. Staking and yield farming are great ways for people who do not wish to trade crypto but want to generate another source of income.
- Volatility risk
Although there is a fixed ROI or payment plan to yield farming and staking, they are still subjected to the volatile movement of the markets. Tokens stored in staking and liquidity pools could rise or plunge in value by the due date. If the latter happens, yield farmers and stakers will lose their money. Furthermore, yield farmers are prone to liquidation by the DeFi platform, which occurs when their collateral depreciates.
Differences between staking and yield farming
Having gone over the similarities, here are their major differences;
- Complexity levels
Yield farming and staking have distinct levels of accessibility and complexity. Yield farming is generally more challenging and requires a steeper learning curve. Why? It requires thorough research to uncover lucrative liquidity pools and navigate intricate DeFi strategies. You’ll have to find a liquidity pool with an ROI that matches your expectations.
Staking, on the other hand, doesn’t require you to do much prior assessment to earn from it. Its complexity level is ranked from low to minimum, as it requires little to no effort. Therefore, it is a more accessible option for newbies. All that is needed is to select a staking pool in a Proof of Stake network to stake crypto.
- Token requirements
To participate in yield farming, you are expected to use crypto pairs. Examples of crypto pairs include ETH-LTC, DOGE-USDT, and ETH-USDC. For a customizable liquidity pool, yield farmers can be flexible about the deposits, e.g., 70% Token A and 30% Token B. However, for an equilibrium pool, you must add an equal amount of Token A and Token B (50% each).
For staking, you only need one token. This token is expected to have been created using the blockchain protocol you are trying to validate, making staking a more cost-effective option. However, you should be aware that certain platforms require a validator to commit a specific amount, which is like a minimum deposit.
- Deposit periods
Although it's more lucrative to lock your crypto funds for a set period, it's not compulsory on yield farming platforms. As a liquidity provider, you have the liberty of withdrawing your tokens at any time - only if the platform has that clause. If there is no time limit, you can transfer your funds from one DeFi pool to another.
Staking requires locking up funds for a fixed period (days to months), depending on network traffic. Smart contracts enforce this, preventing withdrawals until the agreed period ends. Regardless of market conditions, users cannot unstake their crypto until the specified period ends, ensuring a committed stake.
- Transaction fees
Like traditional banking, cryptocurrencies attract transaction fees, termed gas fees, on the Ethereum blockchain platform. Transaction fees can significantly affect how much you make off any passive income method. So, you have to consider it.
Crypto yield farming transaction fees could be on the high side, especially for those who transfer funds from one pool to another. This will be particularly high if you are dealing with an ERC-20 pair. Staking, on the other hand, requires no transfer fee. Since your assets will be locked up for a certain period, the only price effect will be volatility.
- Impermanent loss and slashing
As a farmer, when you add funds to a liquidity pool, you might face "impermanent loss" if the token prices change. It happens when the pool adjusts to market fluctuations. The temporary loss becomes permanent if you withdraw your funds when prices have shifted. It's essential to understand this risk before providing liquidity.
Staking doesn't carry the risk of impermanent loss like liquidity pools do. However, if the market declines, the value of your staked assets might drop. Additionally, stakers risk "slashing" if they validate incorrectly or harm the network, resulting in a penalty that reduces their staked tokens.
Strategies for Maximizing Returns
The goal of making passive income is to generate as much cash inflow as possible. If you go about it wrong, your income will stagnate. For crypto methods such as yield farming and staking, the right approach is to employ a combination of strategies to mitigate risks and optimize rewards.
Here are seven tips to follow to ensure that you maximize returns on money invested or staked;
Research and Choose the Right Projects
The crypto market is vast and open to many projects. There is a high chance you can invest with scammers, which is why due diligence is essential. Whatever passive income method you choose, the first thing to do is thoroughly research the project's team, security audits, and community feedback. If any ticks your boxes for positive features, you may then go ahead and invest.
A reliable platform that we found which aggregates staking rewards across the market is Staking Rewards, that you can use to find necessary and useful information to get started.
Diversify Your Portfolio
We have mentioned a couple of times in this guide how volatile the crypto market can be. For this reason, it is wise and safe to avoid investing all your funds into a single project. Diversify across multiple platforms to reduce risk. You can also use passive income means (yield farming and staking) to balance risk and return.
Utilize Stablecoins
Using a stablecoin for yield farming and taking is advisable. Typically, stablecoins can provide some protection if yield farming requires a crypto pair or staking that requires just one token. These coins are pegged to fiat currencies such as the USD, which means price volatility does not affect them. Although a bullish market would not be rewarding, your money will be safe during bearish periods.
Stay Updated on Protocol Changes
"Information is power," they say, and this stands true when trying to maximize returns. The crypto industry doesn't sleep, changing by the second. This dynamism is why you should participate in or closely follow proposals that may impact yield rates or staking conditions. Additionally, monitor announcements from invested projects to anticipate and adapt to changes. This way, you ensure that you are always positioned for optimal returns.
Understand Lock-Up Periods
Before locking your funds, you must understand the potential interest and how long it will take to achieve it. If investing in a staking pool, you would have liquidity constraints associated with the lock-up periods. For yield farming, your focus should be on the cost of transferring from one liquidity to another. Whichever option you pick, ensure the terms match your investment horizon.
Leverage Auto-Compounding
You can maximize returns with auto-compounding features on yield farming protocols and staking platforms. The auto-compounding tool helps investors reinvest a percentage of their earnings, maximizing compound interest. If this tool is unavailable, use manual compounding to reinvest rewards regularly. Regular reinvestment optimizes growth and boosts returns. This simple strategy enhances yield farming and staking rewards over time.
Risk Management
Effective risk management is one of the best strategies for success in the crypto market. You must be aware that certain risks are associated with crypto passive income. Insurance products are used for hedging to mitigate some risks. However, as commonly said, "Do not invest what you cannot afford to lose."
Understanding the Risks
Crypto staking and yield farming can be lucrative but comes with significant risks. One primary risk is smart contract vulnerabilities. Smart contracts are susceptible to hacks and breaches, as bugs are implanted into underlying codes. Despite audits, no system is entirely foolproof.
Another concern is market volatility. Cryptocurrencies are highly volatile, and price fluctuations can negatively affect the value of your investment, leading to potential losses. Additionally, yield farming often involves impermanent loss. It occurs when liquidity pool assets' value diverges from their initial deposit value, potentially reducing returns.
Crypto trading is relatively new in several parts of the world. Consequently, this has led to regulatory concerns, as governments either restrict or monitor its operations or ban it outright. Before staking or participating in a liquidity pool, ensure it is legal in your jurisdiction. If the laws are still under review, you have to be careful because a ban while your money is still locked would most likely lead to loss of funds.
Lastly, project-specific risks such as poor management, fraudulent activities, or unsustainable reward models can lead to the collapse of a project. Dead projects result in a total loss of invested capital. This is why the first suggested strategy for maximizing returns is "Research and Choose the Right Projects," and the next is "Diversify Your Portfolio" to mitigate these risks.
Conclusion: Balancing Risk and Reward in Crypto Investments
In summary, yield farming is perfect for traders and investors with high-risk tolerance. Although the rewards are huge and juicy, there is a high chance of losing your initial investment. If you want to play it safe, then try staking. Staking is a predictable way to earn passive income by validating crypto transactions and ensuring transaction throughput.
Yield farming vs staking? Now that you have completed the guide, can you answer which is right for you? Both forms of passive income offer differing risk-reward profiles. However, the choice is yours, and our guide is here to help make your decision easier.