Cryptocurrencies have created a means for an alternative source of income and wealth creation for many investors and blockchain enthusiast alike. So today we would be doing a comparison on two famous passive income strategies for crypto investors, yield farming and staking. Both have become incredibly popular with the rise of decentralized finance, but due to how fast the new market evolved, most of us did not have enough time to catch up with these concepts, like yield farming, impermanent loss, staking and slashing. In this write-up, we would explore all of these concepts and talk about their risks in order to help you get a better sense of which strategy works best for you.
So first, let’s start with the newest and most confusing method, yield farming. Yield farming is a method of acquiring more cryptocurrencies, by temporarily lending existing assets to a DEFI platform like a decentralized exchange or lending protocol in return users earn the platform fees along with special liquidity pool tokens. As long as the yield farming process is active users will accumulate fees. The exact rewards are determined by a liquidity pools APY; an interest rate that changes along with the pools activity and token value. From the perspective of DEFI platforms and applications the main objective of yield farming is to attract liquidity by rewarding investors who are willing to lend their assets by doing so the platform can redistribute those crypto assets to farmers who are interested in using their products and services. In the end a portion of the fees gained from user transactions is used to repay yield farmers. Since DEFI is decentralized, services like yield farming are automated via smart contracts which means that there’s almost no risk of losing your assets since developers can’t manually steal your crypto or transfer them without your permission. There are still safety issues of course and they primarily stem from poor smart contract coding practices. If a project is not audited or if a team member unintentionally creates an exploitable smart contract, anyone with sufficient technical knowledge can steal funds. For example, a lending protocol might use its user funds to fund flash loan services. If the flash loan smart contract has an exploitable attack vector, a hacker can effectively create loans and not repay them. Millions of dollars can be drained from liquidity pools within minutes unless a developer notices the exploit early on, and the team will be unable to recover funds which may include assets that are provided by a yield farmer. Since no one can predict whether an exploit will occur or not, yield farmers are constantly exposed to this form of risk.
Impermanent loss is another risk unique for yield farming, but in this case, the risk isn’t tied to security. Impermanent loss occurs when a cryptocurrency suddenly experiences a gigantic spike in volatility, if the asset rises in value, the yield farmer would have made more money by simply holding the token. Likewise, loss is also suffered if an asset declines in value because the yield rate is not high enough to offset the losses. Impermanent loss is very similar to the concept of opportunity cost although yield farming generates passive income, users who farm must always think about whether it’s a better idea to sell the asset or store it for speculative purposes in order to stay profitable. If you’ve managed to wrap your head around yield farming, understanding staking will be a piece of cake, not only is staking easier to do, but it has a lower risk level as well.
Essentially staking is a mechanism used by proof of stake blockchain networks to ensure that node validators act in good faith. Since validators must provide a stake to earn rewards, just like yield farmers their assets can be taken away when these users stop confirming transactions or conduct other malicious activities. You can think of staking as an upgraded version of mining, except that in this case miners don’t waste electricity and computing power to support a blockchain network. So besides gaining monetary rewards users who stake also have a role in fueling a network and helping out other members with successfully transferring assets. The assets are locked into the network and cannot be transferred for as long as the node operator wishes to support the blockchain. If the operator does a bad job or spams the network with fake transactions the network will take his assets away. Unlike yield farming staking only offers risk in one key area, speculation. Certain proof of stake blockchains enforce a rule where a staker must lock his tokens for a fixed period of time, for example users have to stake for at least an entire year during this period the assets cannot be transferred or sold. If the staked cryptocurrency drastically drops in value or the entire industry enters a bear market users who stake are exposed to massive risk. There is no way to offset your losses by selling out for ten percent lower price, which would be beneficial if you think that the asset will at least lose half of its value. No matter how high the yield rates are the rewards won’t negate the massive losses suffered at the hands of volatility. So as long as there is a possibility for the market to experience downside for the next year, staking is a high-risk option. The only way to go around this is by exclusively targeting blockchain networks that do not enforce time locks. This way, you’ll be able to unstake your assets anytime and sell them on the market if you believe that prices will drop.
Now that we understand how both these passive income strategies work and what risks they offer. It’s time to compare yield farming with staking and choose the winner. Yield farming is objectively a more complicated method that reaps higher rewards but comes at a high price due to its major safety risks. Yield farming also requires the user to constantly hunt liquidity pools with the best yield rates which may be exhausting for the average market participant. On the other hand, it’s taking does feature a lower rewards which usually 3 percent to 18 percent but there’s almost no security risk involved stakers often suffer losses if they engage with time locks but rarely any respectable project enforces such a rule in 2021. The incredible difference in yield rates might still make the final result uncertain but we offer one more factor that is a deal-breaker for many yield farmers, gas fees. Yield farming involves jumping from one liquidity pool to another, and every transfer involves at least two transactions, a deposit and withdrawal. Yield farmers have to use a portion of their assets to pay for gas fees. Since the ETHEREUM network is not scalable yet the gas fees can sometimes cost more than $100 for a single transaction, such high gas fees can last up to a month if not more. Those who don’t have a sizable portfolio can’t profit from yield farming since the fees alone eat up all the newly gained rewards. After considering all of these factors it becomes clear that staking is the winner for a majority of people at least, yield farming is still a sensible option but we only recommend it if you have enough money to earn plenty of cryptocurrencies and negate the losses incurred by gas fees and impermanent loss.