Yield Farming vs. Staking: Which Passive Income Strategy Is Better?

As major cryptocurrencies have flirted with all-time highs this year, investors have looked toward passive income strategies as opposed to active trading. Sone example of such strategies include debating between the merits of yield farming vs. staking. Spurred in part by low interest rates in other markets, and in reaction to the risks of active trading, yield farming and staking are becoming more popular as ways to reward investors when they HODL their favorite tokens and coins.

Not satisfied with just storing their digital assets and hoping that the value will appreciate, investors have found ways to put their crypto to work. Of all the various ways of earning passive income on your crypto assets, yield farming and staking are taking center stage. Between the two strategies, which one will work best for you?

In this article, we’ll look at yield farming vs. staking in order to better understand how they work, their associated risks and benefits, and which strategy could better fit your goals.

What Is Yield Farming?

Yield farming is a method of generating cryptocurrency from your crypto holdings. It has drawn analogies to farming because it’s an innovative way to “grow your own cryptocurrency.” The process involves lending crypto assets for interest to DeFi platforms, who lock them up in a liquidity pool, essentially a smart contract for holding funds.

The funds locked in the liquidity pool provide liquidity to a DeFi protocol, where they’re used to facilitate trading, lending and borrowing. By providing liquidity, the platform earns fees that are paid out to investors according to their share of the liquidity pool. Yield farming is also known as liquidity mining.

Liquidity pools are essential for AMMs, or automated market makers. AMMs offer permissionless and automated trading using liquidity pools instead of a traditional system of sellers and buyers. Liquidity provider tokens, or LP tokens, are issued to liquidity providers to track their individual contributions to the liquidity pool. 

For example, if a trader wants to exchange Ethereum (ETH) for Dai (DAI), they pay a fee. This fee is paid to the liquidity providers in proportion to the amount of liquidity they add to the pool. The more capital provided to the liquidity pool, the higher the rewards.

Yield Farming: Advantages

As a yield farmer, you might lend digital assets such as Dai through a DApp, such as Compound (COMP), which then lends coins to borrowers. Interest rates change depending on how high demand is. The interest earned accrues daily, and you get paid in new COMP coins, which can also appreciate in value. Compound (COMP) and Aave (AAVE) are a couple of the most popular DeFi protocols for yield farming which have helped popularize this section of the DeFi market.

Instead of just having your cryptocurrency stored in a wallet, you can effectively earn more crypto by yield farming. Yield farmers can earn from transaction fees, token rewards, interest, and price appreciation. Yield farming is also an inexpensive alternative to mining — since you don’t have to purchase expensive mining equipment or pay for electricity. 

More sophisticated yield farming strategies can be executed using smart contracts, or by depositing a few different tokens onto a crypto platform. A yield farming protocol typically focuses on maximizing returns, while at the same time taking liquidity and security into consideration.

What Is Staking?

Staking is the process of supporting a blockchain network and participating in transaction validation by committing your crypto assets to that network. It’s used by blockchain networks which use the proof of stake (PoS) consensus mechanism. Investors earn interest on their investments while they wait for block rewards to be released.

PoS blockchains are less energy intensive than proof of work (PoW) blockchains, such as Bitcoin, because unlike PoW networks, they don’t require massive computing power to validate new blocks. Instead, nodes — servers that process transactions — on a PoS blockchain are used to validate transactions and act as checkpoints. “Validators” are users on the network who set up nodes, are randomly chosen to sign blocks, and receive rewards for doing so. 

You might not even have to understand the technicalities of setting up a node, because crypto exchanges often allow investors to provide their crypto assets, and then the network handles the node setup and validation process. For instance, brokerages such as Binance, Coinbase and Kraken offer this service. Kraken reported in January that its customers already have more than $1 billion worth of crypto assets staked on the platform.

Since PoS consensus is based on ownership, it requires an initial setup to distribute coins fairly among the validators in order for the protocol to work correctly. This can be done through a trusted source, or via proof of burn. Once the staking has started up, and all nodes are synced with the blockchain, proof of stake becomes secure and fully decentralized.

Staking ensures a blockchain network is secure against attacks. The more stakes that are on a blockchain network, the more decentralized and secure it will be. Since stakers are rewarded for maintaining the integrity of the network, it’s possible for them to earn higher returns than those who invest in other financial markets. However, there are also risks involved in staking, since the stability of networks may fluctuate over time.

How DeFi Impacts Staking

DeFi stands for decentralized finance, which is an umbrella term for financial applications using blockchain networks to obviate the use of intermediaries in transactions.

For example, if you take out a bank loan now, the bank acts as an intermediary by issuing a loan. DeFi aims to remove the need to rely on such an intermediary through the use of smart contracts, which are essentially computer code that executes based on predetermined conditions. The overall goal is to reduce costs and transaction fees associated with financial products like lending, borrowing and saving. 

When it comes to staking, there are a few extra measures investors should take into account, as they’re engaging in DeFi. These include:

• Considering the security of the DeFi platform
• Evaluating the liquidity of staking tokens
• Looking into whether or not rewards are inflationary
• Diversifying into other staking projects and platforms

DeFi platforms are often more secure than traditional finance applications because they’re decentralized — and therefore less susceptible to security breaches. You can stake tokens with a variety of already established projects, such as Polkadot and The Graph. Ethereum is also transitioning from PoW to PoS validation, which means network transactions will be entirely confirmed by staking.

Yield Farming vs. Staking: What’s the Difference?

Curious about which is better suited for the average investor when deciding between yield farming vs. staking? Yield farming is very similar to staking because both require holding some amount of crypto assets to generate profits. 

Some investors consider staking to be a part of yield farming. While the terms “yield farming” and “staking” are sometimes used interchangeably, there are distinct ways in which they differ. Here are the key differences.

Complexity

When looking at yield farming vs. staking, staking is often the simpler strategy for earning passive income, because investors simply decide on the staking pool and then lock in their crypto. Yield farming, on the other hand, can require a bit of work — as investors choose which tokens to lend and on which platform, with the possibility of continuously switching platforms or tokens.

Providing liquidity as a yield farmer on a decentralized exchange (DEX) may require depositing a pair of coins in sufficient quantities. These can range from niche altcoins to high volume stablecoins. Rewards are then paid based on the amount of liquidity deposited. It often pays well to switch between yield farming pools constantly, though this also requires paying additional gas fees. As a result, yield farming can benefit more than staking from active management. This is how the top yield farmers go about achieving the highest possible returns. 

Ultimately, yield farming is more complex than staking — but it may also yield higher returns if you have the time, wherewithal and know-how to manage it.

Risk Levels

Yield farming is often practiced on newly created DeFi projects, which can be highly risky if “rug pulls” occur. This term refers to shady developers intentionally draining assets from liquidity pools.

Even smart contracts built by high-quality developers can have weaknesses or bugs, which is always a risk. According to a survey, 40% of yield farmers don’t know how to read smart contracts — and don’t understand the associated risks.

Staking can be done with minimal initial investment, which can make staking an attractive option for users who are new to DeFi. Rug pulls are also less likely on an established PoS network.

Volatility risk is common to both yield farming and staking. Yield farmers and stakers alike can lose money when tokens suddenly drop in value. Liquidation risk also occurs when your collateral is no longer enough to cover your investment.

While yield farming offers a better yield than staking, risk-averse investors might be more inclined to consider staking when weighing yield farming vs. staking strategies. The risks can be higher since transaction fees can add up and detract from returns. The risk of asset depreciation applies to both strategies: you can lose your money if the market turns unexpectedly bearish. 

Impermanent Loss

Yield farming exposes investors to impermanent loss due to fluctuations in prices from when the crypto was initially deposited. For example, if you deposit funds into a liquidity pool and then that crypto spikes in value, you would have been better off holding those tokens — rather than depositing them into the pool. You can also experience this loss if the crypto that you’re holding drops in value. Conversely, impermanent loss does not apply to staking.

Profitability

Wherever there’s a risk, there can also be a reward. Just as jumping off the Eiffel Tower for that adrenaline rush might not be a good trade-off — at least, not without a parachute and a good lawyer — weighing risk and reward in financial investments is critical.

The main comparison for yield farming vs. staking is the passive income investors can gain from staying invested. The more returns received, the more that can be reinvested and grown. Albert Einstein once called compound interest the “eighth wonder of the world” because of the potential for outsized gains from this phenomenon. 

A common measure of returns is annual percentage yield, or APY. Traditional staking on exchanges tends to have steadier APY returns when compared to yield farming. Typically, staking rewards are in the range of 5%–14%.

For example, yield farmers who get involved early with a new project or strategy can reap sizable profits. Returns can range from 1% to 1,000% APY, according to CoinGecko. However, these strategies bear higher risk. 

Duration

For investors seeking liquidity when comparing yield farming vs. staking, the winning strategy is clear. Staking offers increased returns (or APY) when investors choose to lock in their funds for prolonged periods. Yield farming, however, doesn’t require investors to lock in their funds.

Inflation

PoS tokens are inflationary assets, and any yield paid to stakers is made up of new token supply. By staking your tokens, you can at least receive rewards in line with inflation, proportional to the amount staked. If you miss out on staking, the value of your existing holdings decreases — from inflation. 

Transaction Fees

For the unaware comparing yield farming vs. staking, gas fees can certainly be a significant concern for yield farmers who are free to switch between liquidity pools, but have to pay transaction fees in the process. Yield farmers need to factor in any switching costs, even if they spot a higher return on another platform.

Stakers on a network don’t have to solve computationally difficult math problems to mine rewards, as they would in a PoW blockchain network. Hence, the costs of staking upfront and maintenance are also lower.

Security

Yield farming based on newer DeFi protocols may be more vulnerable to hackers, especially if there are glitches in a smart contract’s programming. Staking is generally more secure because stakers are participating in the underlying blockchain’s strict consensus method. Any attempt to trick the system may actually result in the perpetrators losing their staked funds.

Yield Farming vs. Staking: Which Is the Better Short-Term Investment?

For investors with a shorter time horizon and are stuck in deciding between yield farming vs. staking, both strategies have their own unique benefits.

Staking allows investors to generate rewards immediately during transaction validation. As a result, it can be a good short-term investment which reaps steady profits. For example, a staking strategy can be used for mining a PoS coin like Cardano ADA. Staking ADA offers no additional risk beyond owning Cardano.

However, the expected return and risk may be lower than with an active yield farming strategy.

On the other hand, if you need liquidity for a short-term strategy, yield farming doesn’t require a lockup of funds. You can try to generate high returns on platforms offering a high APY. As with any investment strategy, execution matters — and a bit of luck helps, too.

Yield Farming vs. Staking: Which Is the Better Long-Term Investment?

You can also use yield farming and staking as longer-term strategies to earn more income from crypto.

First, let’s take a look at yield farming, which is basically reinvesting profits back into crypto to generate interest in the form of more crypto. While yield farming may not always offer an immediate return on investment (ROI), it  doesn’t require you to lock up your money, as staking does. 

Despite the lack of an immediate payout, yield farming has the potential to be fairly lucrative over the long term. Why? Because without a lockup, you can try to jump between platforms and tokens to find the best yield. You just need to trust the network and DApp you’re using. As such, yield farming could prove to be a great way to diversify your portfolio.

Staking can be a reliable source of returns over the long term as well, especially if you’re committed to HODLing and therefore plan to keep your coins for the long haul. Whether you decide to stake or yield farm over time may depend more on how actively you’d like to manage your investments. While staking returns could turn out to be less profitable, it trumps the yield farming vs. staking comparison because the associated long-term risks are fewer. This ultimately makes the returns more stable.

The Bottom Line

Overall, we hope this comparison for yield farming vs. staking has been useful for you. Staking and yield farming are still relatively new passive income strategies when compared to approaches used in other financial markets. At times, the terms are used interchangeably, and staking may even be considered a subset of yield farming. Both approaches to earning passive income rely on holding crypto assets to earn rewards, and each strategy allows investors to share in the value of the decentralized financial ecosystem.

Staking may be more of an intuitive concept to understand, whereas yield farming can require a bit of strategic maneuvering to reap higher profits. Both products offer rates of return that can be highly attractive. Deciding between yield farming and staking depends on your level of investor sophistication, and what’s right for your portfolio.