How to Earn Passive Income with DeFi
While Satoshi Nakamoto’s Bitcoin creation was to bring an alternative to fiat currency, DeFi is looking to take it one step further.
After the evolution of centralized finance in the crypto space, DeFi is looking to battle global finance and the long-established financial sector head-on.
As the name suggests, DeFi looks to bring a truly decentralized, community-driven financial services platform.
DeFi is designed to be both “Permissionless” and “Trustless” in a decentralized world akin to that of Bitcoin.
This is in contrast to the world of CeFi, where there are governance and control over the financial platforms.
As the market leaders look to innovate and deliver an alternative to the existing banking model, there are a number of ways in which crypto holders are able to generate income.
When considering the lack of KYC and AML requirements, due to the decentralized nature of DeFi, DeFi is not only targeting the banked but also the non-banked that is estimated to sit at around 1.7bn.
As is the case with more traditional financial products, investors have the option to generate active or passive income.
Active income would include the trading of assets available across DEX platforms, these being decentralized exchanges. Similar to trading cryptos and other asset classes, this is a hands-on practice and even more so in the volatile crypto world.
Passive income is just the opposite, where investors and crypto holders may earn income from cryptos held but are not being actively traded.
While DeFi is in its very early days, there are a number of ways in which investors can earn passive income. The entire reason for the existence of such platforms and products is to deliver liquidity to the DeFi space through incentivization.
Income-generating DeFi products currently include:
- Yield farming
- Liquidity mining
- Decentralized Exchanges (“DEX”)
Unlike the CeFi space, there is also a low barrier to entry, supporting innovation that will be key in delivering an alternative financial services platform.
So, for those holding stablecoins looking to generate a steady income stream, the DeFi world offers just that.
Taking a closer look at the passive income products on offer:
Yield farming is the generation of yield from crypto assets.
The product is comparable to bank deposits, fixed-term deposits, and even government bonds.
Investors deposit fiat money into financial institutions via bank deposits and fixed deposits, which gives the institution liquidity. Investing in government bonds gives governments liquidity. The liquidity is then used to generate growth by the institution or government.
Not only can the community generate income from crypto assets already held. Yield farmers can also borrow crypto and generate income. This is profitable when interest rate differentials are aligned in favor of the borrower.
Yield farmers can farm yield from DeFi money markets, liquidity pools, and incentives.
As an example, a yield farmer places 10,000 USDT into a DeFi protocol, delivering liquidity to the platform. The protocol gives the yield farmer a reward for depositing the USDT.
The yield farmer then takes the rewarded USDT or other tokens that may be given and deposit it into a DeFi liquidity pool accepting USDT or the token received. The yield farmer then receives a yield kicker from the incentives.
While at present there is an element of active management of assets, the DeFi space is evolving. Currently, yield farmers are manually in search of the best yields on offer. There are new protocols on offer, however, that can do the work for you. These are known as Robo-Advisors or Robot yield toppers.
Smart contract systems use “Oracles” in order to automatically transfer Robo-managed tokens to protocols offering the highest yields for a fee.
“Oracles” are services that provide “off-chain” data to smart contracts. “Off-chain” data is typically market prices of assets and world events, such as sports scores, weather, etc.
The types of returns that a yield farmer can earn are as follows:
- Capital growth: Assets, fees, and rewards may be in stablecoins or non-stablecoins. Capital growth during a staking period is a passive income source. There is a risk, however, of “Impermanent Loss”.
“Impermanent Loss” is an opportunity cost incurred between supplying liquidity to an AMM pool vs simply holding the tokens in a wallet. The loss happens when asset prices diverge from original levels when tokens were first deposited.
Additional income streams include:
- Token rewards
- Transaction fees
The 2nd step that yield farmers take in yield farming is liquidity mining.
From a protocol perspective, a token issuer or DEX rewards liquidity miners for providing liquidity to a specific token.
Here token holders deposit collateral into a liquidity pool offered by an automated market maker, (“AMM”).
Once you have identified a mining pool that accepts your idle tokens, simply stake your token in exchange for incentives. Incentives are normally tokens that holders can later exchange on a DEX.
It’s worth noting that liquidity pools tend to offer better yields than money markets. There is a greater risk, however, which justifies the greater reward.
Automated Market Makers
Automated market makers, more commonly known as AMMs, offer the liquidity pools to enhance farming yields.
In essence, the community trades with smart contracts and not with other community members.
AMMs are smart contracts that create liquidity pools, typically traded by an algo or “Robots” rather than order books.
From a DeFi perspective, AMMs are pivotal in its evolution. The liquidity is a must for the DeFi space to continue to evolve and deliver new protocols and products to the community.
As is the case with any investment, yield farming is not risk-free.
Such risks stem from:
- Smart Contracts: Developers can’t change smart contracts once the rules are baked into the protocol. This makes bugs permanent and could result in the material loss of assets.
- Exchange Rates: Asset price volatility is unavoidable. As previously mentioned, “Impermanent Loss” is one risk related to exchange rates.
- Price Oracles: Price-feed providers rely upon the quality of the data. That leaves “Price Oracles” exposed to price tampering. In an automated world, there are no audits to verify the accuracy of the data.
- Hacks: Thieves and hackers target AMMs, particularly in the early days.
For the crypto market evolution, the most enticing element of DeFi must the offering of financial services without KYC and AML requirements. The DeFi community can enjoy full anonymity, while also enjoying the products on offer than range from trading to taking out loans…
Passive income is a key element, as the DeFi world innovates to even greater automation.
Investing does not come without its own risks, however. In the Trustless and Permissionless world of DeFi, there is no governance to identify the good from the bad.
As we saw in the boom days of crypto, however, this will eventually stabilize. Until then, investors need to tread cautiously when investing in the DeFi space.
- Try to avoid investing in unaudited protocols unless you are fully aware of the risks and can stomach the loss.
- Don’t invest money that you cannot afford to lose. There are Ponzi schemes abound.
- Do some research and identify protocols that are likely to exist for the longer term. The longer the vesting periods and incentives for communities to remain in place for the long haul the better.