What is Staking and Farming in Crypto?
Staking is a way to earn passive income from cryptocurrencies. It operates on the Proof-of-Stake (PoS) consensus algorithm and its variants, and the yield on some coins exceeds 50% annually. To explore potential opportunities you can:
- check the current staking yields for various coins via this link
- get a staking calculator from a prominent crypto wallet and;
- find staking statistics here.
The essence of staking is locking a certain amount of coins in a wallet to gain the right to participate, either directly or through intermediaries, in maintaining the blockchain's functionality and receiving rewards for doing so. Staking plays a similar role in PoS blockchains as mining does in the Bitcoin network.
Staking is presented as a profitable alternative to simply holding cryptocurrencies in a wallet, serving as an analog to a bank deposit in the crypto industry. The yield from staking varies depending on the blockchain and can reach tens of percentages or more annually.
How is Staking Different from Mining?
Mining is the process that ensures the functionality of blockchains operating on the Proof of Work (PoW) algorithm. Bitcoin, the first cryptocurrency, operates on this algorithm. Miners use computational power to maintain the network and process transactions, for which they receive rewards. If mining can be called a competition of computational power, staking is a competition of coin holders in a particular blockchain. The main difference between staking and mining is that staking does not require significant computational power, the purchase of graphics cards, or application-specific integrated circuit (ASIC) miners. Consequently, staking is a more environmentally friendly and energy-efficient way to create new blocks in a blockchain. Another advantage of staking is that the cryptocurrency owner does not need to have the required technical skills to run and maintain a computational machine.
Mining requires more involvement in the process; one must constantly stay on top of things. In contrast, staking is simplified and open to a larger number of blockchain community members, and the entry barrier for staking is lower than it is for mining.
Types of Staking
In principle, staking resembles a bank deposit – the user transfers funds to an account, leaves them untouched, and earns passive income. The more funds in the account, the higher the profit.
In addition to this basic scheme, individual blockchains may have their own conditions for staking.
1. Fixed Staking (Locked Staking)
This approach requires the user to specify the period they intend to keep their assets deposited in advance. The token owner can choose a convenient term but cannot change it later. For example, if it’s set for three months, the coins cannot be withdrawn earlier.
With this type of staking, users receive a fixed fee. Such contracts usually offer higher interest rates, making this option attractive to those who want to earn more money.
An example is ETH 2.0 staking. To become a validator, one needs to deposit at least 32 ETH. The annual interest rate ranges from 2% to 20%, depending on the total amount of coins locked for staking. This is a case where the entry threshold for staking is significantly higher compared to traditional mining.
2. Flexible Staking
With this type of staking, no end date is specified for holding the coins. The user can stop participating in the validation process whenever they see fit. Interest will accrue until the participant withdraws their tokens or places an order to sell them.
In most cases, rewards start accruing within a day of opening a flexible contract. However, payments are not made daily. The most common option is monthly payouts.
Flexible staking suits those who do not like to lock up their digital funds for long periods and prefer flexible asset management. Coins placed in such a wallet generate passive income and can be withdrawn at any time.
3. DeFi Staking
DeFi stands for Decentralised Finance. These are various services operating on a blockchain which may include lending, insurance, prediction, etc.
DeFi projects are based on smart contracts, which are beneficial because they ensure the automatic execution of transactions under pre-set conditions.
DeFi staking differs from regular staking in that third parties are involved in the process. For example, these could be organisations or individual users who borrow coins from the owner with interest. In other words, they are being lent funds.
The system is designed to accurately and efficiently control transaction execution. However, it is recommended that you always check the efficiency of individual smart contracts. Theoretically, they may contain vulnerabilities.
Facts About Staking:
- Staking is considered an eco-friendly alternative to mining.
- Sometimes, the entry cost for staking can be high. For instance, activating Ethereum validator software requires 32 ETH.
Crypto Farming is a passive way to earn cryptocurrency by providing crypto assets to a liquidity pool. Annual yields can range from 4% to 1000% or more. Annual Percentage Yield (APY) can be checked on the CoinMarketCap platform while statistics on locked assets for various DeFi protocols can be found on DappRadar.
Liquidity pools are used to facilitate decentralised trading and lending in the DeFi space. Users who deposit their assets into a pool are called liquidity providers. In exchange for providing their assets to a DeFi protocol, they receive rewards that can be paid in the provided cryptocurrencies or the platform's tokens.
Facts About Farming:
- Farming emerged in June 2020 when the decentralised finance platform, Compound, started distributing its COMP tokens to users.
- People who engage in farming are called farmers or yield farmers.
What is the Difference Between Staking and Farming?
Staking involves maintaining the blockchain's operation using its native coins. Farming, on the other hand, involves earning fees in the liquidity pool of a decentralised exchange, which is an application built on a blockchain.
What Are the Pitfalls of Staking and Farming?
Staking:
- Price Drop: The main risk of losing funds in staking, even in a stable project, is the drop in the token's value, which could outweigh the staking rewards. This can happen due to token inflation or market cycles.
The cryptocurrency market is volatile, as any change in the valuation of crypto assets can harm your share in the platform's protocol. If the price of the crypto asset you staked drops, say by 50% over a year, you will incur a loss. Participants are advised to be cautious when choosing an asset for staking, and it should not be based solely on APY figures, as capital losses may exceed the expected staking rewards.
- Fraud: Tokens can be lost, frozen, or stolen. According to a Bloomberg article in 2021, over $200 million worth of cryptocurrency was lost due to fraudulent activities. When you stake your cryptocurrencies, you are delegating your assets to the platform in exchange for rewards and since you would leave them there for a long period, there is a chance of forgetting your private keys, leading to the loss of funds if you are using a decentralised platform.
- Other Risks:
- Theft of funds from the wallet and;
- System errors.
Farming:
- Impermanent Loss: You deposit 100 DAI stablecoins and 100 Token #1 into a specific liquidity pool. This is how most automated market makers (AMM) exchanges work. And you expect a certain reward over time. When the time comes (say, some funds were borrowed and need to be returned), it turns out that you did receive the fee, but the price of the internal token in which the reward was paid has dropped – first. Second, due to internal regulation mechanisms, you can only withdraw 50 stablecoins and 50 Token #1. This second situation is exactly what "impermanent loss" is. If you wait a bit, the situation should normalise, but traders usually cannot wait.
- Payment Delays: Similar to what happens with staking. You cannot immediately withdraw the deposited amount. And it cannot immediately start generating income after you deposit. You will have to wait for some time (each project has its own timeframe). The time during which the assets do not generate profit is a loss.
- Collateral Issues: Only large whales can immediately deposit a large sum in the required stablecoins. They are not afraid of transaction costs or slippage and do not face exchange problems. Smaller players have to borrow the necessary crypto assets and since DeFi is considered an unstable space by most lenders, you will have to deal with so-called "collateral." Simply put, if you need 50 specific tokens to deposit into a pool, you will have to pay for 100, receive 50, and then return them on time. And the higher the market volatility where you plan to work, the more "collateral" will be required.
- Smart Contract Errors: The automation is not perfect. Smart contracts may contain errors from creation, and many projects do not have the resources to attract external auditors. In addition, keep in mind that we are talking about decentralised finance. If something goes wrong – all transactions are irreversible – no one will return anything to you. And this is perhaps the main risk, especially when dealing with new "promising" projects.
- Compatibility Issues: The main advantage of DeFi is compatibility between various projects, which can also be a disadvantage. For instance, the abovementioned investment of 100 stablecoins and 100 tokens. If the project turns out to be unreliable, you will lose everything invested in it. It's good if the project’s failure will not lead to a loss of the initial 100 stablecoins (since the loss of the project’s tokens may indicate ownership rights on co-invested stablecoins). Therefore, if you have to work with multiple projects, it is better to make sure in advance that all of them are reliable.
- Strategy Complexity: Experienced farmers differ from beginners in that they constantly look for more efficient ways to invest assets. Why? Here is an example: you deposit 1000 stablecoins into a new project, which will make up 5% of the total liquidity pool and give you the right to 5% of all fees. If the project does not gain popularity, this will be a negligible amount. In addition, if the total liquidity pool drops, your stablecoins will also decrease 5%, and you will incur losses. Therefore, experienced farmers closely monitor market situations and are ready to withdraw their assets from projects that do not meet expectations at any moment. You can add classic "diversification of the investment portfolio", but you would have to monitor several projects. A separate problem is that no one wants to reveal their investment strategies, as the fewer people use them, the more effective they are.
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