As the cryptocurrency space continues to grow, decentralized finance (DeFi) has emerged as a revolutionary force in finance. It promises to provide access to traditional financial services, decentralized and borderless, redefining how we interact with money. One of the most enticing parts of DeFi is the chance it gives one to generate passive income without actively managing their investments.
How can one use DeFi to generate passive income?
DeFi brings together a broad range of financial services, which include lending, borrowing, trading, and yield farming. The only difference with traditional finance (TradFi) is that they are conducted on decentralized blockchain networks. DeFi stands by a major concept of eliminating intermediaries like banks and financial institutions. As such, it reduces costs, increases accessibility, and enables inclusion on a global scale.
DeFi relies on smart contracts, self-executing blockchain codes, to allow transactions and automate financial processes.
Another significant factor is that DeFi means the community controls user financial interactions. Decentralization means that there is no central authority that oversees what other people are doing with their money.
Like cryptocurrencies, DeFi is being built to take power away from central authorities and put it back into the hands of the people. By using decentralized protocols, users can do things like borrow and lend money without having to go through a bank.
Earning Passive Income with DeFi
Growing use cases around decentralized finance have opened up new avenues for earning passive income for DeFi investors.
Let’s check out the various options available for DeFi-based passive income.
1. DeFi Yield Farming
Yield farming mainly involves providing liquidity to DeFi platforms, often on decentralized exchanges (DEXs), in exchange for rewards. These rewards can be in the form of governance tokens, trading fees, or other incentives.
As an investment strategy, yield farming requires investors to stake or delegate crypto assets in a smart contract-based liquidity pool. The pool then reuses the invested cryptocurrencies to provide liquidity in DeFi protocols and distributes some of the procured fees to the user as rewards.
Yield farming is programmed to earn the highest yield or return possible of all the strategies. However, it tends to be one of the riskier investments in DeFi-based passive income.
Liquidity pools are utilized as a means to facilitate crypto trading on DEXs. It then provides payment or yield for doing tasks like confirming transactions.
2. DeFi Staking
Staking typically involves locking up your tokens for a specific period, which can vary from network to network. It is yet another way to earn passive income in the DeFi space. By staking your tokens, you contribute to the network’s security and earn staking rewards in return.
Staking in DeFi has some similar specs with yield farming and, therefore, incentivizes users to hold their crypto for a longer period. The estimated earning potential through DeFi staking will be determined by two factors — the network’s rewards plan and the duration of the staking.
It is crucial to understand each project’s staking requirements and rewards structure before participating. Some platforms offer flexible staking options, allowing you to unstake your tokens anytime.
3. DeFi Lending and Borrowing
DeFi lending platforms offer an excellent opportunity to earn interest on your cryptocurrencies. To get started, you can deposit your assets into lending protocols, and borrowers pay interest on these assets. The interest you earn is typically proportional to the amount you have lent.
Within DeFi lending systems, investors can engage directly with borrowers using pre-established smart contracts. As such, DeFi lending platforms allow investors to offer their crypto tokens, which can then be borrowed by borrowers and returned with interest within a specified timeframe.
Smart contracts help eliminate the risks associated with lending in traditional finance and remove any collateral requirements.
Suppose you are a Bitcoin holder. You then exchange $1,000 worth of BTC for wBTC and place it within a DeFi protocol, where you can earn an annual percentage yield (APY) of 0.5%. While this APY might seem modest, depositing your BTC into the protocol allows you to secure a collateralized loan, potentially as high as 75% of your BTC’s value, which amounts to $750. This loan can then be utilized to acquire an alternative coin or token with a more lucrative return on investment.
You can then take that loan and deposit (or lend) it. By doing so, you have unlocked a further 75% of the value of your BTC to earn more passive income.
Risks of DeFi-Based Passive Incomes
In crypto, any investment is accompanied by varying risks, which also come with an equally lucrative opportunity for profits. In DeFi-based spaces, prominent risks include scams, hacking attacks, and flawed or over-promised smart contracts.
Additionally, as DeFi-based earnings coincide with the amount of tokens earned, the price volatility of cryptocurrencies may result in a loss in terms of profit during a bear market. In such a case, you may hold the tokens to a time when the market prices go up and provide unrealized gains.
Besides, there may be a risk in the DeFi investment strategy based on the intent of the pool owners. Therefore, it is important to check the credibility of the service providers based on historical payouts.
As the DeFi space continues to grow, we are witnessing the emergence of new opportunities and innovations. Whether you prefer liquidity provision on decentralized exchanges, lending and borrowing, yield farming, or staking, various DeFi strategies can help you put your assets to work and earn a consistent income.
However, it is important to remember that DeFi investments come with risks. Due diligence, diversification, and staying informed about the latest developments are crucial to navigating the DeFi landscape successfully.