Investing strategies on DeFi protocols
The following are some of the most popular and well-used types of decentralized financial tools:
Decentralized exchanges (DEXs) offer an efficient way to trade crypto without an intermediary and without giving up custody of your funds. Popular DEXs like Uniswap, Balancer and Curve are known as automated market makers (AMMs) because they use liquidity pools to manage trades.
Think of a liquidity pool as a market between two or more tokens. When someone deposits tokens to the pool, they make themselves eligible to earn trading fees proportional to their share in the pool. Each time someone else buys from the market, the exchange price is determined by a smart contract that looks at the ratio of tokens in the pool, and trading fees are subsequently split amongst liquidity providers.
Lending & Borrowing
Protocols such as Compound Finance offer one of the most common services offered by the financial industry: lending and borrowing of funds. If you’re paying off student loans, banks usually charge a very high interest rate. In DeFi, banks are replaced by liquidity pools where anyone can deposit tokens and borrowers can take from and pay back at an algorithmically determined interest rate. The best part is that your money compounds in real time – every 15 seconds.
Instead of a fund manager, you can choose a tokenized asset management strategy to earn passive income on your crypto portfolio. An example of this is the DeFi Pulse Index, which tracks the top market movers.
Smart contracts are the building blocks of DeFi. While exchange hacks are unlikely, sometimes there are vulnerabilities in the code or a protocol simply runs out of liquidity. To mitigate these risks, DeFi insurance like Nexus Mutual can help protect your tokens and transactions.
Stablecoins are cryptocurrencies whose value is “pegged” to other stable assets like the US dollar. Stablecoins are widely used in DeFi for trading, lending and borrowing. They’re considered one of the building blocks of the DeFi ecosystem, ensuring stability for transactions.
As DeFi has paved the way for decentralized trading and finance tools, creators and developers are now working together to build even more tools for the community. Gitcoin, for instance, is a platform where decentralized projects are funded, and educational resources are used to build open-source projects. Another example is Radicle – a decentralized network for code collaboration, aiming to develop open-source infrastructure that is secure, sovereign, and exclusively built on open protocols.
How Does DeFi Passive Income Work
One of the most popular applications of blockchain technology has become decentralized finance. For those who are ready to dip their toes into the world of cryptocurrencies but aren’t quite ready to make a big investment – especially in the current market – earning passive income with DeFi can be a good compromise.
There are many ways of getting started, from staking digital assets to becoming a liquidity provider or going for yield farming, to name just a few. Do these terms sound like Latin to you? Fear not.
We’re about to explore all ways to generate passive income with DeFi, one by one.
Method 1 : Deposit Crypto For An APY
One of the most straightforward ways to generate passive income with DeFi is to get an interest in return for depositing your tokens into an account. It might sound familiar to you as it’s similar to having a fiat savings account and earning an interest. However, these days interest rates are quite low, if not negative. With DeFi, the opportunity for returns can be significantly higher compared to a high street bank.
Many DeFi platforms call this process “staking” and interest earned can be in the form of the same type of tokens staked or any other token supported by the blockchain. When you stake your crypto assets, you become a transaction validator, or node, for the network. This is very important to the network’s functionality and security, which is why stakers receive financial incentives to keep doing it.
So how can you get started? The first thing you’ll need to do is to purchase cryptocurrency through a broker or a crypto exchange like Binance or Coinbase. Once you have it on a wallet, you’ll be able to deposit your coins onto a protocol or platform that will pay you an annual percentage yield (APY) for it. Coinbase, for example, offers up to 5% APY while the APY on other platforms like Aqru can go as high as 12% or more.
There are many coins and tokens that you can use for staking, but keep in mind that the majority of DeFi platforms operate on the Ethereum blockchain, meaning that Bitcoin (BTC) isn’t typically accepted. Earning a passive income with this DeFi method is most suitable for the so-called “crypto hodler”, that is the investor who’s looking to park their tokens in return for the payment of regular interest.
There are a range of platforms to choose from, each supporting different coins, staking periods and – more importantly – interest rates.
Method 2: DeFi Lending
Lending is another recognized way to earn passive income with DeFi and there is a wide variety of platforms dedicated to this type of crypto lending protocols.
Similarly to staking, which we just explained, you can earn passive income from DeFi lending by depositing your tokens into an account for some period of time. As you might already have guessed, when you lend crypto to a platform, you’re letting it lease it out to other crypto borrowers. In return, you get an interest. Normally, smart contracts will distribute accrued interest in proportion to the amount of assets you’ve locked in.
Another advantage of DeFi lending comes from the fact that since the entire lending and borrowing process goes through smart contracts, the risk that a borrower will default is virtually zero. As such, your assets should always be safe. Most DeFi lending platforms will also let you withdraw your crypto at any time, without exit fees.
Method 3: Yield Farming
Yield is yet another way of supercharging your cryptocurrency while having it parked in exchange for interest or other types of rewards.
Simply put, users of a DeFi platform can place their funds in a liquidity pool. Once these tokens are locked through a smart contract in a decentralized application (Dapp), users are awarded a fee or interest for allowing their assets to be used across the platform or borrowing and selling.
Sounds familiar? Sure. It’s very much like depositing money in a bank account and letting it use it for loans and other operations, for which you receive a fixed proportion of the interest gained. In the same way, yield farms help ensure high liquidity across the DeFi ecosystem.
People who lend tokens to DeFi platforms are often called “yield farmers” and they commonly switch between liquidity pools as a strategy to maximize their returns.
As with any form of investment, it’s important that you conduct proper due diligence on the platform you’re planning to use as not only crypto coins have seen extreme volatility but unscrupulous developers are known to lead scams whereby they suddenly exit projects and run away with investor’s money (”rug pull’).
Method 4: Become A Liquidity Provider
Becoming a Liquidity Provider (LP) is yet another way to earn passive income with your crypto tokens.
However, unlike staking or yield farming, where your cryptocurrency is being used to confirm transactions or fund crypto loans, liquidity providers have a different role – they are used to ensure that token swaps take place more efficiently and rapidly on a decentralized exchange (DEX)
Liquidity providers are also referred to as trade facilitators and they are compensated via transaction fees for the trades they facilitate. Worry not, you don’t have to take an active part in any of these processes.
A decentralized exchange like PancakeSwap, Uniswap and Yearn Finance, use automated market maker (AMM) algorithms to fill orders and process trading services automatically.
As with other ways of earning passive income mentioned before, this too carries a degree of risk, particularly in the current bear market. But you can not only do your research before committing your funds but opt to contribute to assets held in highly-liquid pools with safer crypto assets.
Method 5: Liquidity Mining
Last on our list of the top ways of earning passive income with decentralized finance there’s liquidity mining. Again, here crypto holders lend their assets to decentralized exchanges and get rewarded in return. However, the difference is that liquidity miners tend to be rewarded in the native token of the blockchain they’re using and they also have a chance to earn governance tokens, maximizing the types of involvement they can have with a particular project. Like any liquidity pool, providers are rewarded based on the amount of the liquidity pool they provided for.