One of the great things about decentralized finance (DeFi) is the opportunities it provides for generating passive income. Essentially, this technology is used to bypass the traditional banking system. A new system has been created for payments, loans etc.
Gone are the days of being excluded based on your employment history or credit score. There is no longer a bureaucratic procedure with tons of paperwork. There is just completely transparent and permissionless software to interact with.
Not to mention, the financial opportunity is fantastic. Whether that be lending out your crypto for a nice return or being rewarded just for securing the network. In this article, we will be focusing on the ways in which you can earn a passive income with DeFi. So without further ado, let’s jump right in.
In this guide:
Staking
Staking is a process where users lock up tokens in exchange for rewards. With cryptocurrency, this is usually done to secure the network. Once staked, validators verify transactions and are provided compensation in return.
Luckily not everyone has to verify. Average Joe’s like you and me can delegate tokens to validators in exchange for a cut of the profit. The rewards are usually determined by the lockup period and the rates set by that blockchain. In the case of Ethereum staking is upwards of 5%.
Become a liquidity provider
Thanks to the continued development of the DeFi ecosystem users can now provide liquidity to a platform and earn rewards. But why are liquidity providers necessary? Essentially, decentralized exchanges like Uniswap have automated market maker protocols. There is no order book.
Instead, there are liquidity providers who pool up cryptocurrencies. At this stage, their funds get locked and they receive liquidity provider (LP) tokens. Once pooled a smart contract distributes a percentage of the trading fees to the user as rewards. In order to unlock their funds and the rewards they have to redeem their LP tokens.
Lending and borrowing
One of the most popular ways of earning interest on your crypto is through lending. In a nutshell, lending requires you to lock up your funds in a smart contract. Borrowers then access this capital through loans while paying interest. The smart contract then automatically distributes this interest to lenders based on the value of the loan.
On the flip side, you could use your cryptocurrency as collateral to take out a loan. For example, you could lend fiat money against crypto collateral and pay interest. As long as the lending rate is higher than the interest rate you have to pay on your loan you will be in profit.
Risks involved
Although DeFi presents many opportunities there are certainly many risks involved. Firstly, if you take out a loan there is always a risk of being liquidated. Ultimately, if you fail to pay the interest a smart contract will seize your collateral.
The second risk relates to impermanent loss. Essentially, impermanent loss happens when the price of a token rises or falls after you have deposited it to a liquidity pool. The greater the price change the greater the impermanent loss. This occurs as liquidity providers are only entitled to a share of the pool. If the total pool decreases so will your share.
The third risk is nothing new, hacks. If you interact with a fake website or shady smart contracts your wallet may get compromised. Research is key. Find reputable projects and don’t fall for the common scams. The best way to protect yourself from hacks is using a hardware wallet. The one that I recommend is the Ledger Nano X.
Final Thoughts
As you can see, DeFi has opened up so many prospects for accessing financial services in a totally open and permissionless manner. This presents several ways to earn passive income. From lending to staking, I am certain there is an option for you.
But you have to be careful. Don’t take on excessive risk unless you understand it. The place is rife with scams and you need to be knowledgable to navigate it, but if you do there is serious money to be made.
Want to earn passive income on your NFTs? check out my previous article How to Earn Passive Income From NFTs.
