Liquidity Pool vs. Staking: Which Is Better?
In this article, we explain the differences between liquidity mining and staking in DeFi and blockchain investing.
Published May 31, 2022.
What Is a Liquidity Pool?
A liquidity pool is an algorithmically defined storage of assets that facilitates the exchange of tokens on DEXs without a central entity. Cryptocurrencies in liquidity pools are locked in smart contracts and released when users trade using the exchange.
Users of decentralized exchange do not trade directly with each other. They trade with liquidity pools by adding one token and taking out an amount of another token. When there is a discrepancy in the price, arbitragers quickly spot the opportunity and buy tokens from other DEXs or centralized exchanges for resale. Even though this happens often, the token price in the pool may be different from the price on a centralized exchange. Hence, DeFi researchers often talk about impermanent loss. The pool may rebalance and bring the price back to an equivalent amount on other exchanges.
Most of the funds in liquidity pools are provided by liquidity providers who profit from tokens issued as rewards from the fees paid to the DEX by traders. Liquidity mining or yield farming is the supply of assets to pools to earn mining rewards.
What Is Staking?
Staking allows holders of DeFi tokens to earn passive income by leaving them with validators on the platform in exchange for the rewards distributed on the network for transaction validation. We can call staking the time deposit of DeFi because it often attracts an APR or APY, which is paid for by leaving the funds for a fixed period. While the funds are locked, the staker can earn and claim the rewards whenever they wish. These rewards are usually accessible from the user wallets and can be compounded by staking, an option that pops up whenever the user tries to claim tokens.
Validators on proof-of-stake networks use the funds staked to validate transactions and ensure the security and integrity of their respective blockchains. BSC, Polkadot, and Cosmos are examples of networks that pay users for staking their tokens.
Which Is Better?
One major difference between staking and yield farming is that the latter pays higher rewards of up to thousands of percentages in APY. During the Olympus DAO era, some protocols paid as high as a trillion percent in APY. Such numbers are unsustainable, and the respective projects have since crashed significantly.
Most projects try to pay as much as possible to liquidity providers on DEXs to build their community. Those who profit most from liquidity mining are the ones who joined on time. Others who came in the end may experience some risks if the platform suddenly stops gaining momentum. It is also advisable to store rewards in stablecoins to minimize losses.
While yield farming is great and can be highly profitable, staking has more upsides, especially if the token staked is one of the blue-chip crypto assets like Ethereum or Polkadot. The APY for these tokens is low, and you must meet the minimum staking requirements, which is a bit of a barrier to entry.