Staking vs Farming
Perhaps the most foundational investment strategies in DeFi, staking and farming are similar in many ways but also different. Investors, deciding between whether to stake or farm, need to understand their characteristics and risk/return differences. Staking simply refers to staking a single asset or token into a yield-generating pool, while farming tends to be associated with staking liquidity pool tokens (LPs) to similar pools. Therefore, the underlying risk and return structures have to do with holding single assets vs. LP tokens and the APY differences between the two options.
Single Assets - Single Asset refers to plain-vanilla tokens; it isn't a derivative of any other token or represents deposited funds; it just is.
Liquidity Pool Tokens - Also known as LPs, they are receipt tokens representing deposits within liquidity pools, typically two-sided. In the case of the traditional two-token liquidity pool, LPs are essentially equal-weighted index funds of two tokens with passive auto-compounded returns being generated from trading fees within those liquidity pools. However, LPs tokens with more than two underlying tokens exist too; they're typically referred to as Balancer LPs (after the original inventor of the strategy).
Staking was originally referred to as a less-capital intensive system of mining (supporting blockchain validation) through a process called Proof of Stake (PoS). It involves cryptocurrency holders depositing or locking up their tokens inside a pool to support the mining process. Stakers, as compensation for doing so, receive rewards in more tokens.
DeFi projects, especially those in the lending or levered trading/farming sectors, need pools of capital to provide those services. One way to achieve this is by incentivizing investors to provide that liquidity through various forms of incentives. These could be perks on the protocol, voting rights, and/or rewards distribution. The source of funding for rewards can either be from protocol revenues or simply new emissions; this topic is referred to as project Tokenomics.
A great example of how this works is PancakeSwap's staking pool. It allows $CAKE stakers to earn rewards in CAKE, or other tokens sponsored by partners. Feeder Finance's staking pool also incentivizes Feeders to stake, initially with rewards coming from emissions, but eventually solely funded by platform fees.
Investors hoping to earn rewards from staking simply have to buy a token they wish to stake and deposit them into available pools. Most tokens have a staking pool on their respective protocol DApps. However, investors are usually required to "harvest" those rewards. Rewarded tokens do not automatically get sent to the depositors' wallets; they must be manually collected ("harvested").
While staking cryptocurrencies or protocol tokens has the potential for high returns, investors need to be aware that they are receiving rewards typically in those same tokens. Therefore the actual fiat returns will be subject to the price of these tokens when/if they are sold. Staking early when projects are young and highly inflationary could mean investors can collect a significant amount of these tokens. As emissions slow down or run out, and prices rise, this could result in handsome returns on investment for early investors. Nonetheless, new projects do come with more risk as prospects are still unclear.
Yield Farming generally refers to all aspects of DeFi yield generation; however, the term "farming" has come to differentiate yield-farming of single assets from that of LP tokens. So while staking refers to single asset deposits for rewards, "farming" is typically used to refer to staking LP tokens for rewards.
The motivation behind projects launching farming pools is usually no different from staking pools. There is a need for liquidity, in this case, two or more sided liquidity in the forms of LPs, and they're willing to reward liquidity providers for the privilege of renting that for some time.
PancakeSwap has made this their business model. To attract large pools of capital to their most popular AMM pairs, they allow those liquidity providers to deposit LP tokens and earn $CAKE.
Finally, investors will find that not only do most projects have a staking pool, but they also come with a farming pool, regardless of whether their products or services need LPs to function. This, primarily, is because those farming pools are specifically for the project's own native token LP. In order to allow a smooth swapping experience with low slippages, liquidity pools need to be sufficiently well funded. Achieving this requires more investors to provide liquidity. Projects typically reward liquidity providers with their tokens as an incentive. Feeder Finance's farming pool is doing precisely this.
Investors hoping to earn rewards from farming will have to go through a couple of extra steps from a simple staking investment. In a traditional two-token liquidity pool farming, investors would need to
- 1.Own the specified two tokens (eg.: BNB-CAKE)
- 2.Provide liquidity by depositing both tokens in the same value
- 1.Once liquidity has been provided, LP tokens will be sent to the wallet as a receipt (it represents the share of the investors' liquidity inside the liquidity pool)
- 3.Deposit LP token into a farm
Like the staking pool, investors are usually required to harvest rewards accumulated while the LP tokens are deposited within the farm.
Farming is one of the best ways to earn relatively stable returns on DeFi; predominantly because of the beauty of LP tokens.
More Stable APY
While staking is entirely dependent on token rewards, two components drive farming returns: 1) Trading Fees and 2) Rewards.
Even if the tokens rewarded experience price volatility, holding constant a stable trading activity in the liquidity pool, trading fees would remain a driver of returns and would lower the volatility of the overall returns.
Lower Price Volatility
Staking is a 100% speculative investment on that one particular token; its price return will be a major component of overall return. However, LPs are essentially equal-weighted funds of two tokens. As one side of the equation rises in value, it gets sold to buy the other, and vice versa; keeping a balance of 50/50 in value on both sides at all times. Typically speculative tokens are paired with a native blockchain cryptocurrency or a stablecoin, thus forcing at least half of the price component to tilt towards more stability.
What is Impermanent Loss
While this article will not dive into the details, investors need to be mindful of what the industry terms as "Impermanent Loss". This is, in simple terms, the difference between holding one (or both) of those tokens in isolation versus holding both as an LP Token together. The rebalancing mechanism dictates that price returns will not move in a one-to-one fashion with either token, and that discrepancy is what's known as "Impermanent Loss".
Disclaimer: Nothing written here should be considered investment advice. The article is intended for informational purposes to guide investors only. For investment advice, please consult a licensed professional.