Let’s face it – investing in cryptocurrencies isn’t easy, because it’s not always easy to understand. Fortunately, there is a way to help you invest in the crypto markets without the hassles of trading in the traditional market space.
Generally, the main ways to generate passive income through decentralized finance (DeFi) is to adopt a buy-and-hold strategy, stake your crypto, yield farm, utilize liquidity pools, or leverage the borrowing and lending of your cryptocurrencies.
This guide will explain what decentralized finance (DeFi) is, how it works, how you can earn passive income, and how to invest in DeFi assets through crypto lending platforms.
Decentralized Finance Basics
Before we begin, we’ll explain what Decentralized Finance is and the common terminology used when speaking about DeFi.
What Is DeFi?
DeFi — or decentralized finance — is a broad term used to describe financial services built on public blockchains like Ethereum. Unlike traditional financial services, which rely on centralized intermediaries, DeFi applications are built on decentralized protocols that connect suppliers and users.
In the modern financial system, many companies act as middlemen provide to most financial services – holding money in bank accounts, issuing loans, trading stocks and bonds, etc. They hold people’s money and personal data on centralized servers and charge fees to access it.
DeFi, or Decentralised Finance, is a movement that aims to bring the benefits of decentralization to traditional financial services. DeFi is the next chapter in blockchain technology’s evolution to become a powerful force for social good. Anyone can participate in DeFi, and anyone can build on top of it. The protocols are open to all, and the community is transparent.
DeFi allows people to bypass these middlemen altogether by using smart contracts on blockchains like Ethereum.
What are Smart Contracts?
A smart contract is a self-automated computer program that performs precisely as it is set up to do. Once its conditions are met, it automatically executes the terms of an agreement between two parties without any third-party interference or downtime.
Smart contracts make agreements transparent and enforceable without relying on a middleman to execute them. They help reduce costs and counterparty risk by automating payments, removing intermediaries from transactions, or enforcing clauses that would otherwise be unenforceable or difficult to verify.
DeFi aims to be an open financial system that is censorship-resistant and non-discriminatory. In other words, no single entity should be able to dictate rules on how the network operates. Instead, DeFi should be controlled by cryptography and game theory. DeFi allows anyone to interact with any digital asset without permission and trust in any single party.
Why is it called “DeFi”?
The name “DeFi” is short for “decentralized finance.” This term first appeared in late 2018 when a new wave of protocols began to flourish on the Ethereum blockchain.
Before then, various projects experimented with different forms of decentralized finance, including P2P lending platforms like ETHLend and dY/dX (now known as dHEDGE) and sports betting applications like Augur.
Examples of DeFi Projects
One notable example of a DeFi application is MakerDAO, which allows users to deposit ETH as collateral to generate a stable coin called DAI. Users can also borrow against their collateral using the same protocol.
To date, MakerDAO’s DAI remains the most widely-used stable coin on Ethereum, despite recent challenges caused by volatility in the price of ETH. Other examples include Aave and Compound.
How to Generate Passive Income Through Staking
The massive growth of cryptocurrencies has created a new class of investors looking for ways to generate a passive income. With interest rates at such lows and the price of Bitcoin reaching all-time highs, more traders are turning to crypto staking to earn some extra money.
What Is Crypto Staking?
Staking cryptocurrency is validating crypto transactions and maintaining the security of a blockchain network through the generation of new tokens. Cryptocurrencies that use the Proof of Stake (PoS) consensus mechanisms allow users to stake their coins and generate additional income, similar to receiving interest on deposits in a savings account.
People who stake their PoS-based coins essentially provide security and trustless services in exchange for rewards. The more cryptocurrency they stake, the higher their chances are of receiving rewards and generating passive income from staking.
How Does Staking Work?
To participate in staking, users must hold the required amount of coins in their wallets for a predetermined period. Once that period ends, they can receive newly minted coins as rewards for helping secure the network.
Due to the high cost of hardware needed for mining, staking has become an attractive alternative for people looking for ways to earn passive income from crypto without investing large amounts of money.
Unlike mining, staking is not an energy-intensive process, so it can be done with a simple computer or laptop. However, staking does require you to lock up your tokens for a specific period, which might be too inconvenient or risky for some investors.
The amount of income you can earn from crypto staking will depend on several factors, but in general, the more coins you stake, the more money you will earn. This is true for both Proof of Stake (PoS) and Delegated Proof of Stake (DPoS) protocols.
In PoS systems, all people who stake their coins have an equal chance to be selected to validate blocks and receive block rewards. In DPoS systems, however, people who stake coins usually must vote for delegates responsible for validating blocks and earning block rewards. Anyone who votes for a delegate who gets selected can share their profits by receiving payouts.
How to Earn More From Staking
Users who stake more coins get more rewards (e.g., ETH) and influence the network than users who hold fewer coins. Staking can also be used to support masternode networks.
Masternodes are computers that support specialized functions and processes such as instant transactions, privacy features, and governance functions for specific cryptocurrencies. The best example for this type of staking is DASH, where you need 1,000 DASH as collateral to create a masternode and earn rewards from it.
Some of the popular cryptocurrencies that allow staking include:
- Cosmos (ATOM)
- Tezos (XTZ)
- VeChain (VET)
- Algorand (ALGO)
- Lisk (LSK)
How to Generate Passive Income Through Borrowing and Lending
Crypto borrowing and lending allows you to generate a passive income from your crypto assets. Generating this income works by lending your existing cryptocurrencies to other people who want to buy them but don’t have the cash readily available.
You can earn interest on the loaned amount while still maintaining ownership of the cryptocurrency by lending out your coins. This interest can range anywhere from 5% to 40% depending on the asset and market conditions.
This is different from a traditional bank savings account. You do not forfeit ownership or control of your original capital for the duration of the loan period, which in some cases can be as short as a few hours.
After the borrower returns your original funds plus interest, you will still have your original capital and have generated income from it.
You’re not loaning specific coins to one person when you lend your crypto. Instead, the lending platform pools your collateral with others to make up a larger pool of collateral that it uses to facilitate loans. This protects you if some borrowers default on their loans — the collateral will cover it.
The borrowing and lending of Crypto space are fast becoming an exciting and viable option for crypto enthusiasts to generate passive income. There are currently two big players in this space: Goldfinch and Atlendis.
How to Generate Passive Income Through Liquidity Pools
Liquidity pools are at the heart of Decentralized Finance; liquidity pools are pools of assets that people can stake to generate rewards over time. What are these rewards? The short answer is ‘free money — so long as you understand that your money will be locked up for a while and there’s always some risk involved.
Liquidity pools can be used as a passive income tool because they allow you to earn a percentage of fees collected on the platform you’re using. Anyone with a small amount of cryptocurrency can start earning passive income right away.
Depending on how much crypto you have, there’s no need to wait until you’ve saved up enough cash to purchase stocks or real estate.
Many liquidity pools are also non-custodial, which means that the owner has control over their funds.
How to Earn More by Leveraging Liquidity Pools
You don’t need to provide your personal information or get approved for an account. This gives liquidity pool investors more freedom and flexibility than other types of investors have.
Your income will depend on how much you deposit in the liquidity pool, the size of the pool, and how often trades occur. The more capital you have invested, the larger your share of the fees will be.
The process for generating passive income through liquidity pools is simple:
Provide a portion of your cryptocurrency holdings to the pool by depositing them into the relevant wallet address. You’ll receive tokens representing those funds, and those tokens can be sold or traded as you wish.
When another trader wants to make an exchange, they submit an order, and their money goes into the pool while they receive their chosen cryptocurrency from somewhere else. When they submit their order, they pay a fee shared among all users who have contributed funds to the pool.
Some liquidity providers use crypto-to-crypto exchanges like Uniswap, 1inch, and Balancer. But traders who want to maximize their rewards can use a different kind of exchange (a decentralized finance platform) to participate in liquidity pools.
How Do DeFi Liquidity Pools Work?
On DeFi platforms like AAVE, Curve Finance, and Kyber Network, liquidity pools operate using automated market makers (AMMs). These AMMs allow traders to borrow or lend assets without counterparties. They function as decentralized exchanges that continuously generate pricing data based on supply and demand.
When you provide liquidity to a DeFi exchange, you become a liquidity provider (LP). Each LP receives an LP token representing their share of the total value locked in the pool. This token is effectively a loaned asset that can be staked on other DeFi platforms to earn additional rewards.
How to Generate Passive Income Through Yield Farming
Yield farming is a new passive income strategy that’s generating a lot of interest in the cryptocurrency world. It revolves around staking your crypto assets in exchange for a reward: typically, interest payments on the funds you’ve staked.
For some people, yield farming has become a way to earn steady, regular income from their crypto holdings without spending any additional money. For others, it’s an opportunity to accumulate new cryptocurrencies without paying for them upfront.
Yield farming involves holding cryptocurrencies and other digital assets that offer generous rewards for long periods. However, it’s worth noting that this method can be risky since it relies on unstable cryptocurrency prices.
How Yield Farming Works
Many cryptocurrencies and blockchain projects offer substantial returns to users who hold onto their coins or tokens for long periods. The rewards come in the form of more coins or tokens and can be claimed after a specific holding period.
For example, if you purchase a cryptocurrency that offers an annual return of 10 percent, you will receive additional coins after one year at no extra cost. Moreover, the value of your initial investment will grow by 10 percent within 12 months.
But, if the initial coin’s price increases by 10 percent during the same period, your total return can increase above 20 percent. The concept is similar to compound interest, whereby you earn interest on interest earned from your initial investment over time.
Yield farming does not require you to make additional deposits once you’ve bought a coin or token. There are two main reasons why this would be an attractive proposition:
- The tokens can be worth more than the rewards earned. This means that you are effectively getting paid for providing liquidity since the asset’s value has increased relative to the currency you used to purchase it.
- The token could be used as collateral for borrowing in other projects. This is similar to how we can use fiat currency as collateral for a loan. Having access to larger sums of capital allows us to increase our exposure, resulting in more income.
Of course, there are risks involved, but yield farming could be the passive investment opportunity you’ve been looking for if you’re willing to do your research and use the right tools.
Know The Risks Of DeFi
It’s no mystery that investors are looking for new ways to generate passive income, and DeFi is one of the most well-known ways to do so. But there are still several risks associated with DeFi projects, making them risky for an average investor.
You are responsible for your own money on the blockchain. You do not have any recourse if you lose your money to a smart contract bug or exploit, get hacked by a phishing attack, or make a mistake sending to the wrong address.
The most significant risk of any DeFi protocol is the risk that comes with “smart contracts” — computer programs that execute the terms of an agreement automatically without requiring human intervention.
The smart contract code is public and immutable, meaning anyone can look at its source code and be sure that it will consistently execute as expected. This transparency also means it’s easy for anyone to see whether a contract is poorly coded or audited, exposing users to smart contract exploits.
Another risk that comes with using DeFi is counterparty risk. When you deposit funds into a DeFi protocol, you lose control over your assets and your ability to move them freely.
This means you are dependent on the code of the protocol to function correctly and safely store your funds until you want to withdraw them. Another risk comes from holding other cryptocurrencies.
If the price crashes and you hold leveraged positions, you could owe more money than you have in your account.
Some risks can be mitigated but not eliminated. Interest rates may fall in the future. If this happens, you could earn less than expected in interest income. But you may be able to help mitigate this by using a portfolio strategy that fetches interest across multiple protocols.
You might also lose interest income if you withdraw funds before they mature. You can mitigate this by withdrawing after your loans have matured rather than just before.
Since their inception, the number of financing alternatives to generating passive income from DeFI have grown immensely. Today there are dozens of options for generating income with Decentralized Finance! Staking your coins, borrowing and lending, or yield farming are all helpful ways for you to begin generating passive income through decentralized finance.
Additionally, check out these other high paying side-hustles that may also help you begin setting up passive income streams for the future. If you’re in the UK, we’ve got you covered here as well. As you climb your financial mountain, remember to find ways to buy back your time and spend money in ways that make you happy.
As you do so, you won’t just find yourself at the top of your financial mountain, but you’ll find that you’ve chased down the impossible dream of a truly abundant and happy life.
Climb on, FinBase.
**Note:** The author of this article has no affiliation with any of these projects, companies, organizations, and individuals mentioned above, nor is there any compensation for mentioning them here.