Since the summer of 2020, DeFi has been on fire. And many investors have turned to yield farming as a way to make even more capital with their capital. Now, many people use terms like yield farming, liquidity providing, and staking interchangeably, but there are differences in what they mean and how much money you can make. Staking refers broadly to the rewards that you get through the validation process of a proof-of-stake blockchain. Staking and yield farming are similar in the sense that they allow investors to earn return on their assets. But yield farming is a bit more intense, which means the potential for a higher return for an educated investor. So let's do some defining. Staking versus Yield farming – what's the difference? Starting with the more simple one: Staking. All cryptocurrencies have a consensus mechanism, which basically means they have a system that verifies transactions on their ledger.
Those who verify transactions are paid for their efforts in crypto. The thing about verifying transactions is you can't make it easy to do. Otherwise, bad actors can come in and attack the system. So a good way to make it difficult to verify transactions is by requiring resources to do the verification. This can be done through mining a cryptocurrency like Bitcoin does, which needs a lot of electricity and powerful computers to verify transactions, or through staking your cryptocurrency. Now, Staking allows you to verify transactions by essentially locking up or staking that currency with a validator.
The model basically says, if you have money in the system, you're unlikely to be a bad actor, so you can be paid staking rewards for locking up your currency and helping to facilitate the system. The rewards are paid in proportion to how much of that crypto you hold. So if you hold 100 coins, you'll receive ten times more Staking rewards than someone who holds 10 coins. Staking rewards are typically around 4% to 10% annually, but some reach as high as 100% or more. Now, usually on the higher end, those are temporary rewards. Now, how do you stake your crypto? Unfortunately, each crypto is slightly different, but the most user-friendly way is by going through an exchange like Exodus or Binance who offers fairly good staking rewards. Otherwise, you can stake directly from your crypto wallet to what's called a stake pool. Now, this generally gets you the highest possible rewards. Staking is a great option if you plan on holding a crypto long term. Now, Yield farming. Yield farming takes a bit more effort and deeper understanding of cryptocurrencies and the risks involved. So buckle in. You're doing more than just putting your held coins in a stake pool to help facilitate transactions.
Instead, you're allowing your coins to be used to facilitate transactions in a decentralized exchange, something like Uniswap or PancakeSwap. This is called providing liquidity in a liquidity pool, so your coins are used by a decentralized exchange to let other users borrow or trade cryptos through swaps. Now, swaps are literally swapping one coin for another. So swapping like Ethereum for Chainlink. I like to think of providing liquidity as a small business because you lock up your crypto in these liquidity pools and you're paid a percentage of all the transaction fees that that pool earns. So if you're providing 50% of liquidity in a pool, meaning 50% of the currency in that pool is your currency, you get paid 50% of the rewards, which means 50% of the fees generated you receive, which can be a lot of money.
Now there's another layer to this comparison, and that's called liquidity mining. I know, stick with me here, I promise it will all makes sense. With liquidity mining, you're still allowing your coins to be used in a liquidity pool, and you're still earning a portion of the transaction fees. But on top of this, you also receive additional tokens, which you can trade on exchanges for additional cash. So let's do an example. You provide liquidity for an Ethereum-LINK swap, meaning you hold both of those cryptos and you're locking them up with the liquidity pool. With regular liquidity providing, you get paid your transaction fee rewards in Ethereum. With liquidity mining, you get your transaction fee rewards and additional tokens from the exchange. Let's call it token X.
This means you can make even more money. So a real world example here is using a protocol like Compound Finance. You're rewarded with COMP governance tokens when you provide liquidity through their platform. So like other governance tokens, COMP also allows users who hold that token to vote on changes within the ecosystem, and you can still sell those tokens for cash. So this can be additional income from providing liquidity. Now that you know what yield farming is, let's talk top strategies. The most often used strategy for yield farming involves using an Automated Market Maker or an AMM. With an AMM you're required to invest in a trading pair. This is the swap that I mentioned earlier, like Ethereum and Chainlink, or whichever two cryptocurrencies that you hold that you could help facilitate those transactions. Most commonly, this is a stable coin though, like USDT or Dai, paired with a slightly more volatile asset like Ethereum. By doing so, you're providing liquidity to the AMM. You're doing that so users who would like to trade either one of those two assets are able to do so at a fairly stable price.
The reward you get is again a cut of the trading fees in proportion to how much liquidity you're providing. The most popular places to do this are Uniswap, PancakeSwap, SushiSwap, and 1inch. In the near future, we'll have even more options once the Cardano ecosystem has their Dexes up and running. Now a side note here is there are AMMs which allow you to deposit just one kind of crypto asset instead of the pair. However, those are more rare, but this does put you at less risk of impermanent loss. More on that in a couple of minutes. Now, some high risk tolerance investors take this several steps further to earn even more money.
What they do is they lend and borrow from different dApps to receive the highest amount in rewards possible. This is not something that I recommend. So basically, people will both lock up their tokens and borrow out tokens at the same time to increase exposure and then use those tokens that they're borrowing to provide liquidity elsewhere. It's like leverage liquidity and of course, it can get extremely risky, extremely fast. Again, not recommended. If you're new to this, stick to basic liquidity providing.
Of course, not financial advice. The way I like to think of providing liquidity is how I like to think of staking. If you plan on holding a project long term, then this will just earn you extra income provided that you do your research first. So now let's talk about how much you can earn providing liquidity. And luckily there are tools that can help you calculate the returns before you ever even start. Here we can see that on Uniswap, if you provided $1,000 in an Ethereum-USDT pool, you can get a 56% return given current rates. Now this is quite high returns, and of course, that is subject to volatility and other risks that we'll discuss in a second. A common strategy for success when providing liquidity is only joining pools with a lot of trading volume. So, popular coins. And this is because you need trades to happen within a pool for you to actually make money. So if you're providing liquidity for two rare coins, you're not going to make a whole lot of money. And now that we know what liquidity providing is and some strategies to make money, we need to talk risks.
Do not skip this section. The first risk is a Rug Pull. When you're buying new crypto tokens for a project that hasn't launched officially, you run the risk that that team will take that money and run without ever completing the project. And this also applies to DeFi projects where a new liquidity pool might promise you returns in the 1000 or even million percent range. But then it gets shut down, before you see any returns on your investment.
– Please shut down the system. And the scammers, of course, run away with deposited funds. Now this can absolutely be avoided by just sticking with popular apps and doing your research beforehand. And then you have the risk of providing liquidity for a crypto with bad market mechanics. And this actually happened to Mark Cuban just a couple months ago. He was providing liquidity for a crypto project that included a crypto called Titan and Iron.
Iron was an algorithmic stablecoin tied in price to the other crypto within the pool Titan. And then there was some selling pressure on Titan, and this actually caused both the cryptos to spiral down to nearly zero almost instantly. And everyone basically lost all their money, including Mark Cuban. And this happened because the stablecoin was simply poorly designed. Pretty crazy. But again, a situation like this is totally avoidable. This swap was advertising 2 to 4 million percent annual returns. So greediness gets you in trouble, even if you're a billionaire. Now, the last risk to consider is Impermanent Loss. This occurs when you've deposited two assets into a double sided liquidity pool where it's required that you deposit the same amount of two different tokens. Now it's necessary to do this in most cases, because many exchanges need you to have a a proportional amount of both tokens. for users to borrow against the pair. Now, what happens is as the price of your two cryptos change, the proportion of each coin you hold changes automatically in the liquidity pool, and this happens in order to keep that ratio at 50-50 for each crypto.
Now, this can be an issue if one of the tokens that you deposit skyrockets in price because your position of the skyrocketing coin, will begin to sell off to keep that proportion at 50-50. And here's where the problem comes in. If a crypto in your pair, let's say doubles in prize, you would have actually made more money by just holding that coin instead of using it to provide liquidity. Impermanent loss is kind of like opportunity cost of providing liquidity.
Opportunity cost that you may miss out on monster gains, but this only happens if one coin takes off and the other doesn't, again because of that proportion balance. Now, I don't want to worry you too much because there are methods to limit this issue, and it's much less an issue now than a couple of years ago. On Uniswap, for example, you can choose the trading range, and if prices go beyond that range, so if that crypto doubles, the pair will stop rebalancing, meaning you won't lose all of that upside. So in summary, providing liquidity can be a great way to earn a bit more money on the crypto that you plan to hold long term. This is generally a stable way to earn more money so long as you aren't holding super high risk projects and you're not letting greed get the best of you, which I know is sometimes hard to do. So if you feel a little bit lost in the world of crypto after watching this, and would like a more hands on approach, you may want to consider joining my Patreon, which is linked in the description below.
In there you'll find additional private content, live coaching, and a private community to bounce ideas and ask even more questions. I think you'd really like it. So I'd like to thank you so much for watching and I hope you have a profitable day..