Yield Farming vs Liquidity Mining: What Is Better?
Yield farming and liquidity mining are two terms which are often disorienting for beginning DeFi investors. Some people in the blockchain ecosystem confuse yield farming with liquidity mining, thinking that these two terms refer to the same thing.
However, this is far from the truth: yield farming and liquidity mining are two different concepts, and they both have their unique advantages and disadvantages. But what are yield farming and liquidity mining exactly, and which of these two methods of gaining blockchain-based passive income will be better for you?
What Is Liquidity Mining?
Liquidity mining means adding tokens to liquidity pools of DEXs (decentralized exchanges) such as Uniswap, Sushiswap or PancakeSwaps. By providing liquidity to the market you allow the decentralized exchange to function, and in return you are rewarded with cryptocurrency.
But first things first: what exactly are “liquidity pools”?
When you use a centralized exchange like Binance or Coinbase, the liquidity is provided by the company which owns the exchange. Since decentralized exchanges don’t have their own reserves, liquidity is provided by the users who lock their own funds in liquidity pools.
Simply put, liquidity pools are what allows you to buy and sell crypto on DEXs.
Adding liquidity to decentralized exchanges is called “liquidity mining” because it can bring you profit just like mining cryptocurrencies such as Bitcoin or Ethereum. Both liquidity mining and mining crypto are excellent ways of generating blockchain-based passive income. However, from a practical standpoint liquidity mining and crypto mining are very different.
Crypto mining requires you to buy very expensive hardware which consumes massive quantities of electric energy. Liquidity mining is nothing like it – all you have to do to start profiting from it is to lock some cryptocurrency in a liquidity pool.
Low starting requirements are by far the biggest advantage of liquidity mining. Anyone can add liquidity to a pool, even people with no technical knowledge and not much crypto experience. No huge initial investment is needed either – even a small amount of tokens locked in a liquidity pool can start making you profit.
To sum up: liquidity mining means locking your tokens in liquidity pools on decentralized exchanges like Uniswap or PancakeSwap, and being rewarded for that with new tokens. As DEXs became massively popular, DeFi developers noticed that there’s a way to maximize liquidity mining gains even further – and that’s how yield farming was created.
What Is Yield Farming?
Yield farming can be considered a more complex and more profitable version of liquidity mining. Liquidity mining is a simple process: you add tokens to a liquidity pool and start receiving rewards. With yield farming, you utilize a multi-step strategy which involves various yield generating activities designed to maximally increase your profit.
Here’s an example of a simple 3-step yield farming strategy:
- Take out a loan in stablecoins using your crypto as a collateral
- Become a Liquidity Provider on a DEX by adding stablecoins to a liquidity pool
- Stake your rewards to earn additional yield on return
As you can see, yield farming also utilizes liquidity mining, but it only uses it as a single step in a complex, multi-step yield generating strategy. So while yield farming is based on liquidity mining, it’s incorrect to claim that the two concepts mean the same: yield farming is a more complex and more profitable approach to liquidity mining.
The first DeFi project which introduced the concept of yield farming was Compound (COMP). The users of Compound were able to lend their tokens to others in order to receive yield.
The projects which took yield farming to the mainstream was Yearn.Finance (YFI). Yearn.Finance revolutionized the DeFi ecosystem by automating the process of liquidity mining. YFI works by looking for protocols with the highest APR (Annual Percentage Rate), and automatically putting your funds where they will generate the highest yield for you.
When profitability changes, yield farming protocols like Yearn.Finance move your assets to another protocol to assure optimal rate of profit at all times. It’s not only more profitable, but also much easier on the user’s part: you don’t have to keep track of the APRs of different DeFi protocols and liquidity pools, as the automated algorithm operated by a smart contract does everything for you.
Yield Farming or Liquidity Mining: Which Should You Choose?
As you know by now, yield farming and liquidity mining are not mutually exclusive. In fact, most yield farming strategies heavily utilize liquidity mining as one of the most important steps of the yield generating process.
Of course, at first sight it would seem that complex yield farming protocols are better in all cases, since they include more profit-generating steps and are specifically designed to maximize your gains. However, that is not always true.
The massive success of the original yield farming protocols has caused numerous copycats to arise. Currently, there are hundreds of different yield farming DeFi platforms on the market. Each of these protocols promises you the highest possible Annual Percentage Yield. So what’s the catch?
In theory, everything looks good. You send your tokens to a yield farming protocol, and wait for the complex yield generating strategy to make money for you.
At first sight, everything seems great and you keep gaining a lot of new tokens. The problem is that the tokens you get are usually not quality cryptocurrencies. The tokens of projects which are inflationary, don’t have any utility, or have an extremely large total supply are not really very valuable, and when you decide to cash out, you find out that you actually earned very little, and you have wasted your time accumulating useless tokens.
In other words, in the long-term sometimes simple liquidity mining in a quality liquidity pool on a respectable exchange can be more profitable than using advanced yield farming protocols promising you an incredible APY. Both liquidity mining and yield farming can be profitable – and the best way to make sure that you will make profit is to thoroughly research the platform you plan to use before making an investment.