Staking, yield farming, and liquidity mining are all terms you’re likely to come across during your journey through the DeFi metaverse.
These concepts have a lot in common. They all refer to the act of a user providing their assets in support of a blockchain, decentralized exchange (DEX), mutual insurance alternatives, or any other application or function that requires capital.
While these terms are sometimes used interchangeably, there are a number of important differences. Let’s define each term and break down the differences between staking, yield farming, and liquidity mining.
Staking is the broadest of the three terms. Ulike yield farming and liquidity mining — it also has a number of non-crypto definitions. These can help illuminate what it is you’re actually doing when you stake assets in a crypto network.
People often refer to staking their reputation on something. This means that they are putting their personal integrity on the line in support of something they believe in. A stakeholder is anyone that has an interest in a company or operation. This can be any party from shareholders, employees, or even customers — anyone who stands to gain or lose from the enterprise’s performance.
In crypto, staking refers to the act of putting up collateral to serve as proof of a party’s skin in the game. This demonstrated financial interest in the continued success of the protocol they’re supporting is an indicator of the staker’s actions being in good faith.
There are a number of ways that staking supports various crypto and DeFi protocols. Ethereum 2.0 is notably transitioning from a Proof of Work (PoW) model to Proof of Stake (PoS). Instead of providing hashing power to the network, validators will instead need to stake parcels of 32 ETH in order to verify transactions on the Ethereum network and receive block rewards.
Networks such as Polkadot allow DOT holders to stake their tokens and nominate validator nodes in their Nominated Proof of Stake (NPoS) consensus mechanism, earning annual percentage yield (APY) in return. Other protocols require tokens to be staked in order for users to participate and vote on governance decisions.
Centralized platforms such as Coinbase, Nexo, and BlockFi also allow users to stake their digital assets. These entities work similarly to commercial banks, which take customer deposits and lend them out to those seeking credit. Creditors pay interest, depositors receive a certain proportion of that, and the bank takes the rest.
It’s important for prospective stakers to consider why their tokens need to be staked. Some protocols inherently require staking for proving a user’s skin in the game or enabling important financial functions, while others use staking simply as a way of drying up circulating supply in order to pump the price.
CertiKShield — a decentralized insurance alternative — allows CTK holders to earn up to 30% APY by providing liquidity to the collateral pool. These tokens perform an important economic function: they underwrite the coverage taken out by other users who are looking to protect their assets in the event of a protocol hack or malfunction.
CertiKShield’s model functions differently to other applications of staking such as Proof of Stake or centralized credit provision. It combines the openness of DeFi with the reputation of the market’s leading security firm and enables a whole new crypto industry: decentralized on-chain protection from hacks or losses. CTK stakers make the platform work and earn rewards for the value they provide to the network.
Yield farming is a newer concept than staking, though the two share many similarities. While staking can refer to actions such as locking up 32 ETH to become a validator node on the upcoming Ethereum 2.0 network, yield farming refers more exclusively to providing liquidity to a DeFi protocol in return for yield. Farmers are those who actively seek out the highest yield on their assets, rotating between pools to maximize their returns.
Providing liquidity to an Automated Market Maker (AMM) pool such as Uniswap is one example of yield farming. Liquidity providers deposit two tokens — Token A and Token B, with Token B usually being ETH or a stablecoin such as USDC or DAI — and in return they collect a proportion of the fees paid by users who use that pool to swap between tokens. A depositor’s returns are calculated off the percentage of the pool that their deposit makes up. If their deposit makes up 1% of the pool’s depth, they’ll collect 1% of the total fees generated by that pool.
One risk of yield farming in double-sided liquidity pools is impermanent loss. Take the case of an ETH/DAI pool. DAI is a stablecoin, so its value hovers around parity with the U.S. dollar. But ETH has unlimited upside potential. As ETH appreciates in value, the AMM adjusts the ratio of the depositor’s two assets to ensure that the value of the two remains constant. This is where impermanent loss can occur: with the disconnect between the value and the number of tokensdeposited. As ETH appreciates, the number of Ether equal in value to the initial DAI deposit decreases.
This impermanent loss becomes permanent when the depositor removes their liquidity from the pool. Impermanent loss can mean that a liquidity provider would have been better off holding their tokens rather than depositing them to a pool, if the impermanent loss they suffer is greater than the fees they accrue.
There are AMMs such as Bancor that offer single-sided deposits with impermanent loss protection. There are also other yield farming and interest bearing products such as CertiKShield that by design cannot create impermanent loss.
Yield farming can be extremely lucrative, especially in the early days of a project when your deposit is likely to make up a large proportion of the pool. However, crypto’s inherent volatility and the innovative design of new financial products means that there can be new risks to think through before setting out to harvest the fields of yield.
Just as yield farming is a form of staking, liquidity mining is a subset of yield farming. The main difference is that liquidity providers are compensated not just with fee revenue but also the platform’s own token.
Compound was the first to introduce this incentive scheme when it began rewarding users with its governance token COMP. For liquidity providers, this additional source of income can offset some or all of the impermanent loss risk they take on.
However, COMP tokens flowed not just to the liquidity providers but also to those taking out debt. Thanks to liquidity mining incentives, for the first time ever a borrower can earn a yield on the loan they’re taking out. This flips the traditional finance model on its head. It rewards all Compound users and gives them a stake in the governance of the protocol.
Other liquidity mining programs only pay out to liquidity providers (LPs). There are often pools where LPs can stake the tokens they earn, receiving yield not just on their initial deposit but also on the rewards they earn.
Liquidity mining has proven to be a successful way to attract liquidity to a DeFi platform. While token rewards are usually inflationary — which dilutes hodlers — liquidity mining programs are often limited to a defined period of months or years: enough time to bootstrap the protocol.
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Staking, yield farming, and liquidity mining are all ways of putting idle digital assets to work. DeFi users can choose to act as underwriters in decentralized mutual insurance pools, provide liquidity to AMMs, or serve as creditors and earn governance tokens in the process.
The APYs are often lucrative and there are hundreds of different options out there. There are risks to consider and it’s always worth asking why your tokens are needed and how the yield is generated.
If you find an audited platform where rewards are paid out from real economic value enabled by your liquidity, then congratulations, go ahead and make the most of it!