Traditional investors regularly invest in companies and assets such as bonds and real estate in search for inflation beating yield. However, in troubling economic times with inflation running at 10% and the possibility that companies may cut dividends to preserve cash buffers, risk-adjusted yield is not easy to come by unless one is happy to receive a nominal 3–5% in traditional markets.
The blockchain sector does offer certain yield solutions but they suffer from management opacity, improper security measures and in general, poor regulatory oversight. In this article (sourced from ByBit), we outline the differences between yield farming and staking and how Phoenix, a revolutionary yield product created by a company Hatchworks advises, offers one of the best risk-adjusted ways to generate healthy cash yield in the blockchain space.
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 providing 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 (automated market makers) or dexes that offer permissionless and automated trading using liquidity pools instead of a traditional system of sellers and buyers. Often, but not always, 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: Perceived 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. Other protocols focused on lending, such as Euler, also allow for interest to be earned by those who lend capital.
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. However, that being said, most protocols are controlled by unknown management teams and developers with moral hazard being a significant problem. Yields are rarely sustainable.
Yield Farming: Disadvantages
A yield farming protocol is only as sustainable as the tokens of the project one is getting paid in, for providing liquidity. Yield farmers can earn from transaction fees, token rewards, interest, and price appreciation, as stated earlier. Transaction fees are dependent on volumes and volumes are a function of newsflow in a project. Most projects in crypto are hype fests with little real newsflow of economic substance. Over time, as the project fails to deliver real traction (real concurrent users, real cashflows), the newsflow cycle ebbs and volume tends to dry up. Token rewards are only worth receiving if the token price isn’t in a death spiral and unfortunately, as defi protocols eventually fail to deliver, their tokens which are usually inflationary, also trend south over time. This leaves interest on lending or other actual activities of real value, as the only ‘real’ income stream.
Phoenix, the app, installs your liquidity on a global dex liquidity frontier but focuses yield farming efforts on only the highest value and relatively stable digital assets such as Bitcoin, Ethereum and certain stables.
There are no other payouts in the form of inflationary tokens of a startup project — which we feel is gimmicky and unsustainable — and the app, because of natural hedges inbuilt in the way liquidity is installed, limits impermanent loss significantly, with gearing to crypto prices falling in the 0.1–0.5x range.
APYs are earned minutely, paid out in USDC and capital is never locked up. APYs tend to range in the 7–20%+ range depending on which risk tier one selects. In periods of newsflow, APYs typically rocket to 50–100% but can also drop as low as 3–5% on weekends and quiet periods.
The team is fully doxxed and regulatory licenses are in place. The risk of rug pull or contract-flaw-based hack does not exist when using Phoenix as all smart contracts used are those of reputable decentralised exchanges who have been heavily audited.
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.
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 but this is rare. Staking returns, for example, on Ethereum are around 5% gross. In addition, 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
In theory, DeFi platforms are often more secure than traditional finance applications because they’re decentralized — and therefore less susceptible to security breaches. In reality, defi platforms often lack the appropriate code checks and can be hacked and drained resulting in total wipeout, as we saw with Euler earlier this year.
Yield Farming vs. Staking: What’s the Difference?
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. Additionally, managing protocol risk, ensuring the underlying liquidity pool doesn’t consist of tokens of a low quality project and overall impermanent loss management makes yield farming arduous.
This is why Phoenix, for the reasons mentioned earlier, does all of this but on autopilot.