Decentralized finance: A beginner's guide to earning passive income with DeFi

Decentralized finance (DeFi) is a successful implementation of blockchain technology that serves as a promising alternative to traditional finance. As the name suggests, DeFi is a blanket term used for a variety of financial products and services that run on decentralized blockchains.

DeFi applications (DApps) are built to eliminate the middleman in financial transactions, historically championed by the traditional financial institutions such as banks. The technology does this by implementing a blockchain-based trust mechanism that allows secure peer-to-peer (P2P) transactions without paying a commission to the bank.

Growing use cases around decentralized finance have opened up new avenues for earning passive income for DeFi investors. To generate passive income, investors need to commit their DeFi assets as resources to confirm transactions and execute processes over the proof-of-stake (PoS) consensus mechanism. 

Let's check out the various options available for DeFi-based passive income.

DeFi yield farming (liquidity mining)

Yield farming or liquidity mining in DeFi relates to the process of earning more cryptocurrencies using existing crypto assets. As an investment strategy, yield farming requires investors to stake or delegate crypto assets in a smart contract-based liquidity pool. The pool reuses the invested cryptocurrencies to provide liquidity in DeFi protocols and distributes a part of the procured fees to the user as rewards.

DeFi yield farms support the use of ERC-20 tokens such as Ether (ETH) for investments and rewards. Yield farming is programmed to earn the highest yield or return possible and tends to be one of the riskier investments in the world of DeFi-based passive income.

Liquidity pools are used to facilitate crypto trading on decentralized exchanges (DEXs), which, in return, provides a “yield” or payment for completing tasks like confirming transactions. The yield success of each pool will be dependent on the strategies implemented on the smart contracts. In addition, the payout will also be determined by the monetary value of tokens invested by the user in the liquidity pool.

When a user deposits or lends cryptocurrency to a liquidity pool, the operator or the farmer aims to redistribute the assets with the end goal for the highest annual percentage yield (APY). The APY is a unit representation to measure the yearly returns earned on investments, including the compounding interest. Typically, traditional banks offer an average savings rate of 0.06% APY, which in the case of DeFi has a much higher potential.

DeFi staking

Staking in DeFi shares a lot of similarities with yield farming and therefore works as an incentive for users to hold their crypto for a longer period. Just like yield farming, users need to deputize or lock up their crypto holdings to become validators on the blockchain.

In staking, users can earn rewards by locking up their tokens for a fixed amount of time, depending on the plans offered by the operator. Every blockchain will require a minimum amount of tokens before it can add a user as a validator, which in the case of the Ethereum blockchain is 32 ETH. 

Moreover, the estimated earning potential through DeFi staking will be determined by two factors — the network's rewards plan and the duration of the staking. In addition to monetary benefits, staking directly contributes to further securing blockchain projects while improving performance. 

DeFi lending

Lending is a blanket term used for a variety of investment strategies involving passive incomes via cryptocurrencies. In decentralized or DeFi lending, investors can interact directly with the borrowers through pre-programmed smart contracts. In other words, DeFi lending platforms allow investors to enlist their crypto tokens, which can be loaned by borrowers and repaid within a set duration with interest. 

Smart contracts not only help in eliminating the risks associated with lending in traditional finance but also eradicate the collateral requirements. However, most lending applications do not require background checks that are essential to mitigate credit and fraud risks.

DeFi lending serves as a peer-to-peer (P2P) service that allows borrowers to loan crypto directly from other investors in exchange for timely interest payments. Unlike traditional lending, smart contracts allow users across the globe to pool and distribute crypto assets without the need for an intermediary.

In addition, the underlying blockchain technology ensures transparent and immutable transactions for all parties involved. 

Differences between DeFi alternatives for passive income

Risks of DeFi-based passive incomes

Every form of investment is accompanied by varying degrees of risks, usually coupled with an equally lucrative opportunity for profits. In DeFi-based earning avenues, the biggest risks include scams, hacking attacks and flawed or over-promised smart contracts. 

As DeFi-based earnings relate to the number of tokens earned, the price volatility of cryptocurrencies might result in a loss in terms of profit during a bear market. In such cases, investors tend to hold the tokens until the market price surges and provides unrealized gains.

In addition, the risk in DeFi investment strategy can also depend on the intent of the pool owners. Hence, it is important to check the credibility of the service providers based on historical payouts.

Tracking your portfolios

With so many different ways to earn passive income in DeFi, keeping track of all of your multiple wallets across various platforms can be a bit of a hassle.

As a result, many DeFi traders now employ portfolio trackers or aggregators, which connect to a variety of protocols and wallets and allow you to evaluate and manage your whole portfolio from a single dashboard. Yield aggregator maximizes efficiency by optimizing the methods for obtaining profit. It might consist of hundreds of farms and vaults that profit from a variety of decentralized services with various business models.

Other aggregators even provide cross-chain integrations and multiple wallet connections, allowing you to access chart views that analyze multiple aggregators' data in real-time. Cross-chain is a technology that allows information and value to be exchanged between blockchain networks, enhancing their interconnectedness. As a result, the walled character of blockchains is broken, resulting in a dispersed ecosystem that is linked.

Additionally, cross-chain integrations assist you in identifying potential APY returns across pools and tracking portfolios across wallets. Moreover, any user can leverage their digital assets to produce passive income using any of these strategies. They provide a critical service to the crypto markets by supplying much-needed capital and liquidity in exchange for rewards — all without the need of middlemen.

However, be aware of scammers and "rug pullers" or projects that merely wish to steal your locked tokens and redeem them at liquidity pools, draining your funds. Make sure the farms and platforms you utilize have a good reputation and have published externally audited smart contracts.

Hence, investors are advised to do extensive research on the parties involved before committing to liquidity pools, staking or lending. For starters, check out Cointelegraph's guide on the basics of DeFi to gain a better understanding of the budding ecosystem.