For someone new to crypto, mining, stacking, yield farming, and liquidity mining may all seem very similar, but they're actually very different concepts and follow entirely different algorithms.
1️⃣ Crypto Mining
Cryptocurrencies are typically decentralized, meaning there is no central authority running the show. For the system to work, it depends on a decentralized network to validate transactions through what is called a consensus mechanism. In the most basic sense, by mining, you are using the processing power of computers to solve cryptographic equations and record that data to a blockchain. Miners verify the hashes of unconfirmed blocks and receive a reward for every hash that is verified. That process is based on what is called a proof-of-work consensus algorithm. The process is computationally intensive because it requires significant amounts of processing power to form a consensus.
For Bitcoin, which is a relatively simple blockchain with functionalities around storing and transferring value, proof-of-work is a feasible solution. However, for other blockchains with more complex functionalities and applications running on top of it, proof-of-work is inefficient and can cause bottlenecks when activity increases. As a result transaction times can be longer and fees can be higher. A good example of this would be Etherium on top of which much of the Defi applications are built on.
Staking looks to increase the efficiency and speed of validation in the network through a consensus mechanism called proof-of-stake. It serves a similar function to mining, in that it’s the process by which a network participant gets selected to add the latest batch of transactions to the blockchain and earn some crypto in exchange. However, the basic concept behind it is reducing the amount of computational power needed to validate each transaction by making users put their tokens on the line (aka. staking them) to act as a guarantee of the legitimacy of any new transaction they add to the blockchain.
The network chooses validators based on:
(1) the size of their stake
(2) the length of time they’ve held it
By many in crypto, staking is seen as a way to put your cryptos to work. By putting your tokens on the line, you receive a reward which is often measured APY. However, staking often requires a lockup or “vesting” period, where your crypto can’t be transferred for a certain period of time.
Becoming a full validator may require a 60k+ investment, continuous computing power with no downtime, and advanced technical knowledge. Because of that, many participants simply contribute to a staking pool. By doing so, the individual can earn rewards without having to operate their own validator hardware and shares the block rewards.
In the most basic term,
3️⃣ Liquidity Mining
In the most basic sense, liquidity mining involves earning rewards [governance tokens (GOV)] by providing liquidity to the system.
Liquidity providers (LPs)
4️⃣ Yield Farming
Both yield farming and liquidity mining aim to maximize returns on governance tokens. While liquidity mining works on the Proof-of-Work or PoW algorithm, yield farming operates using various DeFi applications like liquidity mining, fund leveraging, etc.
💡 Key Terms to remember
- Consensus Mechanism
- Proof of Work
- Proof of Stake
- Staking Pool
- Liquidity providers (LPs)
- Governance Tokens