DeFi exploded onto the scene in 2020, providing cryptocurrencies with a new use case and giving people greater control over their money.
The total value locked in DeFi protocols rose from nearly nothing in early 2020 to $202.2 by late January 2022 (DefiLlama).
It’s easy to see why DeFi has become so popular. It’s because DeFi has enabled capital efficiencies, with people able to put their money to work in a myriad of ways.
In this article, we’ll discuss what DeFi is and then explore the different types of DeFi activities.
What Is DeFi?
DeFi stands for decentralized finance. Blockchain-based and permissionless, DeFi offers financial products similar to what you’d see at banks, but without the need for an intermediary.
Most people use DeFi platforms to put their crypto capital to work to earn more money. By putting your crypto to work, you can maximize your returns on holdings. It’s similar to earning interest at a bank — but potentially much more lucrative.
While some banks in certain countries offer 0.025% on your savings, most DeFi platforms offer double-digit APYs on most products, even stablecoins. You can even earn yield on top of what your original capital generates.
For instance, on TraderJoe, a one-stop decentralized trading platform on the Avalanche network, you can farm tokens by providing liquidity for an exchange pair. In return, you get JOE tokens. You can then stake those JOE tokens to generate further yield.
So, as an educational article for our community, we thought it would be interesting to cover the main types of DeFi activities: yield farming, liquidity providing and staking.
Liquidity Pools and Providers
Liquidity providing falls under the umbrella of yield farming.
Let’s say you went on a trip to Europe and you went to the local fiat currency exchange to exchange American Dollars for Euros. Obviously, you would have to have some American Dollars. The exchange would also have to have some Euros.
The same is true for centralized crypto exchanges, like Coinbase and Binance. If you want to trade BTC for ETH, the exchange needs to have both tokens.
But what if there aren’t enough tokens or the bidders and sellers can’t agree on the exchange rate? That’s where market makers come in.
Market makers provide liquidity to the market and facilitate trades, enabling people to exchange currencies at almost any time — even if no other individual is there to accept the requested exchange rate. Market makers typically make money from the bid-ask spread difference.
In the DeFi world, these protocols are what’s called automated market makers (AMMs). Automated market makers rely on users to provide liquidity by holding tokens on the platform.
Here’s a quick overview of how AMMs differ from traditional exchanges:
- On traditional exchanges, prices are determined by the order book.
- On AMMs, there’s an underlying algorithm that provides asset prices (it’s near what you find on sites like CoinGecko).
As mentioned, AMMs need users to serve as liquidity providers (LP). But what’s in it for them?
- Each time there is a successful trade with that currency pair, the liquidity pool providers earn a fee, usually the LP token (liquidity provider token). That fee is distributed proportionally to the amount of liquidity each LP has deposited into the pool. It can be a powerful way to earn passive income.
- When liquidity providers deposit a token pair into the pool, they get the exchange’s LP token as the reward. For instance, on PancakeSwap, you earn the native CAKE token as a reward for providing liquidity.
- You can also farm the liquidity provider token to earn more income.
Staking
The reason why providing liquidity is so similar to staking is because liquidity providing IS a form of staking. But here’s the difference:
- In liquidity pools, the providers deposit some “third-party” token pair
- In staking pools, those who stake deposit just one currency and earn yield. The token they stake is often the platform’s native token. For example, on PancakeSwap, a decentralized exchange on the Binance Smart Chain, you earn the native CAKE token as a reward for providing liquidity.
So, why would anyone want to stake tokens and not provide liquidity?
Well, we don’t wish to bore you with how blockchain works and how new blocks are created, but there are two major ways that’s done: proof of work and proof of stake. At Elite Mining Inc, we do proof of work mining, as that’s what creates new blocks on the Bitcoin blockchain.
With proof of stake blockchains, those who stake more and for a longer period are more likely to validate a new block on the blockchain and earn rewards. The reason they’d want to do that is because, by increasing the size of the blockchain, the entire network becomes more secure and efficient. Staking also doesn’t require expensive equipment, like Bitcoin mining does (proof of work).
Another reason to choose staking over liquidity providing is that staking is generally (but not always) less risky than liquidity providing. Participating in liquidity pools exposes you to what’s called impermanent loss. Impermanent loss is a bit complicated, but the gist is this:
- When you provide liquidity with a coin pair, you must maintain a 50:50 ratio between the coins.
- If one token’s price moves up or down and the platform must rebalance your amount, then there’s a chance that you would’ve made more money if you had just HODLed.
- Example: You provide liquidity for ETH:USDC pair. The price of ETH goes up a lot, but the farm must reconfigure your balance so that you have the same amount of ETH and USDC. This means you miss out on some gains of ETH.
Staking simply doesn’t involve impermanent loss, as it only deals with one token.
However, staking does involve some risks:
- The token’s value could decrease
- When you stake tokens, they’re locked on the platform (you can’t use them for other activities)
- Some platforms require you to stake for a certain period to earn better rewards.
Yield Farming
Broadly speaking, yield farming is putting your crypto assets to work to earn returns. Also known as yield farming or liquidity mining, farming sits somewhere in between liquidity providing and staking.
Some examples of yield farming include:
- Lending crypto assets
- Staking your LP tokens (more on this below)
- Providing liquidity to a DEX in exchange for fees
Final Thoughts
To make things easier, we’ve provided a table that summarizes the main three ways of generating passive income with yield farming:
| Farming | Liquidity Pools | Staking |
Token locked | “third-party” pair | “third-party” pair | Native token |
Rewarded with | “third-party” pair which you locked, or another coin | Native or governance token | Token which you staked |
Risks | Impermanent loss, Token value drop | Impermanent loss, Token value drop | Token value drop, Assets locked, Unstaking period |
Benefits | Passive income, Potential greater value of the locked token | Passive income, Potential greater value of the native token | Passive income, Potential greater value of the native token, No impermanent loss |
Now, DeFi is new, and not without risk. Only farm on reputable platforms and make sure to do research!
Also, remember this: There may be many ways to invest in the crypto revolution. DeFi, NFTs, the metaverse and other popular trends may catch your eyes. But don’t forget Bitcoin and cryptocurrency mining and that it remains important to the cryptocurrency industry.
If you want to know more about Bitcoin and cryptocurrency mining, stay tuned to what we’re doing at Elite Mining Inc. We’re mining Bitcoin at scale by using clean energy solutions. And you can be a part of it, join us now on Telegram!
*This article is for informational purposes only, and should not be considered financial advice. Understand that rewards vary based on network, overall participation, and other factors. Do your research and consult with a financial advisor before deciding to provide liquidity, stake or farm tokens.