4 Ways DeFi Can Generate Passive Income There are several straightforward approaches for maximizing the potential of decentralized finance and open-banking tools.
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One of the beautiful things about decentralized finance (DeFi) is the opportunities it provides for earning a passive income and even managing payroll. Whether you choose to connect to DeFi apps, or dapps, via decentralized Web3.0 gateways or simply through regular web interfaces, many individuals and enterprises are now seeing the benefits of accessing alternative financial products and services.
Because of the decentralized nature of DeFi, participants can choose to interface with them through a variety of means, and the DeFi ecosystem is a large one growing new components every day. Power users such as businesses are now leveraging smart-contract functionalities to automate the terms of their interactions and investments, with DeFi smart-contract tools helping them get the most out of insurance pooling and escrow, for example. Early DeFi use cases also saw synthetics enjoy popularity via decentralized synthetics hubs like Shadows Network.
But perhaps the most interesting aspect for regular DeFi participants is how to effortlessly make a profit simply by leveraging existing crypto capital. By staking the assets you own into DeFi protocols, you can earn profit commonly referred to in the space as "yield," allowing you to grow your crypto stack without risking it through trading or other economic activities. While there are still risks to factor in when interacting with DeFi protocols, on the whole, it's a fairly safe means of generating profit.
Through yield farming, staking and lending, you can earn a residual income that will accrue steadily. All it takes is a little initial capital and a lot of patience. You won't get rich overnight, but in time, your capital will grow. Moreover, with a guaranteed income, you won't sweat the market dips that are part and parcel of crypto; even when prices are dropping, you'll keep on earning.
In this guide, we'll consider four of the most popular means of generating a passive income in DeFi and examine practical examples of how this works. This article assumes you have a basic knowledge of interacting with crypto networks, and are familiar with using an Ethereum-based web wallet such as MetaMask. It's also helpful if you possess some knowledge of popular decentralized exchanges (DEXs) like Uniswap.
Method 1: Staking
Staking is the process by which you lock (or "stake") tokens into a smart contract and earn more of the same token in return. The token in question is usually the native asset of the blockchain, such as ETH in the case of Ethereum.
Why would anyone give you free tokens simply for locking up your existing tokens? Well, there's the rationale behind token incentives besides rewarding network users. Blockchains that are secured by Proof-of-Stake rely on users locking their assets into special smart contracts. These are controlled by network validators, who are tasked with upholding the blockchain's consensus rules and ensuring that no one has tried to cheat the system. Validators who act dishonestly can be penalized by losing part of their stake.
Because cheating makes no sense from an economic perspective, stakers are incentivized to lock up their assets for an extended period of time and earn rewards for contributing to the network's security and decentralization. With Ethereum, users who lock their ETH into the Ethereum 2.0 smart contract will earn additional ETH for playing their part in enforcing its consensus rules. Because this process is automated, it doesn't require manual oversight. After depositing funds into the smart contract, you can leave the Proof-of-Stake mechanism to take care of the rest, while periodically claiming your rewards.
In the case of Ethereum 2.0, you are required to stake your funds for an extended period, so this approach is suited to users who have a low-time preference. Although the minimum requirement to stake in Ethereum 2.0 is set at 32 ETH, some platforms use a pooling mechanism that allows you to deposit a lesser amount.
Method #2: Become a liquidity provider
Decentralized exchanges such as Uniswap and SushiSwap support swaps between token pairs, like ETH and USDT. This liquidity comes from pooled tokens belonging to liquidity providers (LPs), i.e. ordinary defi users who place their tokens into the smart-contract controlling the pool in question. In doing so, you will earn a 0.3% fee from all swaps, proportionally to your pool share, on Uniswap's DEX. The more trades that are conducted via that pool, the more you'll earn.
LPing doesn't always guarantee profit. When the price of one of the pooled tokens fluctuates significantly, you can actually lose money through a process known as impermanent loss (IL). There are ways to mitigate this, though, by choosing highly liquid pools that contain less volatile assets, such as WBTC/ETH.
To maximize your profits, you can analyze data from LP aggregators that pull real-time data and help you project potential returns from various pools.
Method #3: Yield farming
When you LP in a DEX like Uniswap, you will receive tokens denoting your pool share. These tokens can then be locked into yield farms, which are essentially DeFi protocols that reward you with more of the same token or with a different token. This means that while your pooled assets are earning a share of all fees in Uniswap, your LP tokens can also be earned.
It's important when yield farming to conduct due diligence on the platform in question, to ensure that it is scrupulous and that its developers have no intention of "rug pulling" by stealing LP tokens and using them to withdraw liquidity from DEX pools. Select established platforms that have a positive reputation and whose smart contracts have been externally audited.
Method #4: Lending
Lending platforms pay users an APY for locking their assets into a smart contract. These tokens are then utilized by borrowers, who pay interest, a portion of which is returned to the lender. Compound Finance, for example, currently offers an APY of 8.19% for lending DAI. Because the entire lending and borrowing process is governed by smart contracts, there is no risk of the borrower failing to repay their debt. Thus, you should always be able to withdraw your staked assets at any time.