Blockchain technology growth has an undeniable effect on the evolution of crypto-mining. The first algorithm used in cryptocurrencies was Proof-of-Work (PoW) that requires computing power to secure the network and reach consensus. It was replaced by Proof-of-Stake (PoS) and its modifications: DPoS, APoS, and others. They required large amounts of tokens to run the node but delegated staking allowed receiving rewards even with minor investments. But with the development of the DeFi ecosystem, mining reached a new level: the profitability rose dramatically without a need for large investments. Last week we already looked at different ways of passively increasing cryptocurrency positions. In today’s article, we will look into how DeFi-staking differs from PoS and similar consensus algorithms while describing the pros and cons of each approach.
The DeFi market offers financial services that operate autonomously on the blockchain and act as an alternative to modern banks. Such systems do not need staff: neither supervisors nor employees. Hence, the costs are also reduced. This allows DeFi to provide more accessible financial services than traditional banks can.
All the blockchain transactions are controlled by smart contracts, which act as platforms’ guarantors by blocking tokens. This ensures the safety of the token holders. However, a smart contract must be 100% secure: if the code is hacked, the attackers can end up with a considerable sum of money. This is the critical risk of this type of mining. But let’s first consider the major types of DeFi-mining and then go through their pros and cons.
This type of DeFi-mining is probably the most popular one. It is also called liquidity mining. The essence is that holders lend ETH to certain projects and are rewarded at a fixed or floating rate. In other words, the miners form a liquidity pool. In the traditional financial sector, this role is played by major players: investment funds, banks, venture capitalists, and large private investors. This is most often inaccessible for small investors, but Yield Farming changes everything and makes the market open to a wide range of users.
As a rule, the rate depends on the number of funds blocked on a smart contract: the bigger the sum, the lower the interest rate is. And holders can use platform tokens obtained from liquidity mining to reinvest them in liquidity pools and so on.
On blockchain platforms such as Compound or MakerDAO, users can receive and issue flash loans secured by Ethereum (ETH). Compound users can earn COMP tokens not only for deposits but also for taking out loans.
The main drawback is commissions: the Ethereum platform can not always cope with the load, which has increased due to the DeFi boom. This led to the fact that the transaction fees have reached an unprecedented size: at the Ethereum network’s peak, commissions reached $14.
Suppose you have $1000 in ETH, and you want to lock them in the Uniswap liquidity pool at 20% per annum. At the time of writing, the average Ethereum network commission is $2.3, so you will pay $4.6 to deposit and withdraw the tokens. End of the day, you will spend $6.9 for three transactions, which is 0.69%. With a 20% interest rate, the yield will be about 0.05% per day. It will take at least two weeks to reach the break-even point. But you must also consider that the commissions may increase, negatively affecting interest rate, which will throw you back even further. The lower the invested amount, the further the break-even point is.
In the case of PoS, users pay a small commission, which usually does not exceed a few cents. PoS scripts use high-performance blockchain protocols such as Cardano (ADA), TRON (TRX), Tezos (XTZ), Cosmos (ATOM), and others. On the other hand, with the release of the Eth 2.0 mainnet, the cost of transactions will drop significantly, while the speed will notably increase. However, the updated Ethereum 2.0 network will not be released until 2021.
Compared with Yield Farming, the yield from staking is significantly lower, and the entry threshold is quite high. The yield from PoS rarely exceeds 10% per annum. In addition, you need to configure and run your own validator node. Of course, many blockchain-platforms allow you to delegate your tokens to validators, but those in turn, charge an average fee of 5% to 10% of the income.
In addition, liquidity mining interest is distributed more often. PoS-based cryptocurrencies reward you with tokens for a certain number of cycles, which may take from several days to a month. This depends on the particular blockchain. Liquidity pools calculate interest on a daily basis, and holders can use it to reinvest and thus receive higher income due to compound interest. However, with small investments, the high commissions of the Ethereum network practically negates this advantage.
Yield Farming is more profitable, but do not forget about the risks: liquidity mining, unlike PoS staking, does not guarantee profitability. As with Yield Farming, classic staking offers a typical floating rate. But holders do not bear additional risks other than a fall in the exchange rate of a particular cryptocurrency and the probability of hacking the blockchain’s source code.
Shortcomings with PoS and liquidity mining, in relation to the impact on the rate received, are similar: as the number of blocked tokens grows, so do the risks of rate collapse due to the holders’ desire to realize the profits. If right now, investors start to withdraw ETH in bulk from DeFi protocols and sell them on the exchange, the coin’s exchange rate can easily fall by 50 percent or even more. The same applies to PoS cryptocurrencies. However, liquidity miners do not need to fix profits in ETH tokens: they can only sell extracted platform tokens to make a profit. All of the above mainly depends on large investors: if they start withdrawing funds, smaller investors are likely to follow.
We can definitely say that the high profitability of Yield Farming caused a real stir on the crypto market. But liquidity mining involves additional risks, except for a possible rate collapse. There were cases when violations of the protocols led to serious negative consequences. A vivid example is the Sushiswap (SUSHI) and Maker (MKR) situation. The latter has lost 99% of liquidity after a large influx of DAI users, and the stablecoin’s dramatic 10% increase. The protocol simply failed to ensure the token’s peg to USD.
High commissions in the ETH network make liquidity mining almost unprofitable for smaller players. For long-term investments, yield farming is more attractive in terms of ROI. But you need to be prepared for the fact that APR will decrease as the liquidity pool grows: the bigger it is, the smaller your share will be.
Disclaimer: The contents of this article are not intended to be financial advice and should not be treated as such. 3commas and its authors do not take any responsibility for your profits or losses after you read this article. The article has been presented to provide readers with general information. There is only personal experience described herein. The user must do their own independent research to make informed decisions regarding their crypto investments.