With banks doing all the work for us, we never really bothered looking deeper into our finances and how everything works. Decentralized Finance (DeFi), the financial system that’s powered by blockchain technologies, isn’t that different from banking. While both DeFi and Traditional Finance (TradFi) offer passive income opportunities, DeFi yield rates can offer far greater returns than are available using TradFi rates, plus more transparency on how your assets perform with information readily available on-chain. In DeFi, smart contracts, or immutable codes stored on the blockchain, automatically execute transactions when predetermined conditions are met, eliminating the need for financial intermediaries. Additionally, the composable money lego nature of DeFi allows users to stack different financial strategies and protocols, making it possible to compound yields in innovative ways.
In this article, we’ll dive into the different ways one can earn passive income in DeFi, which refers to additional returns on cryptocurrency holdings, on top of any capital gains or losses, denominated in the cryptocurrency itself rather than dollar values. For example, earning a 20% annual yield on 1 ETH results in a total holding of 1.2 ETH after one year, regardless of the market dollar value of ETH.
Understanding DeFi primitives can be easier when we draw analogies to traditional finance (TradFi):
* Liquidity Provision (LP): Like an ultra-high-yield savings account, but without FDIC insurance.
* Lending/Borrowing: Comparable to investing in credit assets.
* Staking: Similar to a commodity-linked bond.
* Yield Farming (Active): Mirrors asset management.
* Yield Farming (Passive): Resembles automated index investing.
These concepts might seem unfamiliar, but we’ll break them down in simple terms.
Liquidity Provision – DeFi’s equivalent of Savings and Money Market Accounts
In traditional finance, savings accounts and money market accounts are where individuals deposit their funds to earn interest, while banks use these deposits to lend out to others. In decentralized finance (DeFi), a similar concept exists through liquidity provision, where individuals can earn returns by providing liquidity to decentralized exchanges (DEXs) and lending protocols.
Providing liquidity to Decentralized Exchanges
A decentralized exchange (DEX) is a platform that allows people to trade cryptocurrencies directly with each other without needing a middleman, unlike traditional stock exchanges which require brokers. It’s similar to a peer-to-peer marketplace like eBay, where buyers and sellers interact directly. In a DEX, smart contracts automatically handle trades, similar to how a vending machine dispenses snacks without human intervention.
To facilitate trades, DEXs need a supply of different tokens, which come from what we call “liquidity pools”. Before DeFi, providing liquidity required significant capital and expertise, limiting it to centralized exchanges and professional market makers. Market makers are middlemen in the financial world who are always ready to buy or sell assets like stocks or bonds, making their profit by selling assets for a bit more than they buy them for. This makes it easier for everyone else to trade because there’s always someone available to do business. Today, DeFi democratizes this process, allowing retail traders to provide liquidity passively and earn yields. Instead of traditional market makers, a smart contract called automated market makers (AMMs) set prices and facilitate trading by locking tokens to fulfill buy and sell orders.
Liquidity providers (LPs) contribute the capital needed for token pairs on DEXs, facilitating trading. When traders swap tokens, they pay trading fees, which the LPs earn as profit. LPs may also make money from the difference between buying and selling prices, called “spread”, similar to how traditional market makers make profits. However, LPs face the risk of ‘impermanent loss,’ where the value of their provided liquidity can decrease if the exchange rate of the token pair changes significantly and doesn’t revert. This loss occurs because the pool’s prices, set by the AMM smart contract, don’t adjust as fast as the market’s. If an LP’s share of the pool, or their ‘position,’ shifts due to one token’s price changing, they may end up with less money in dollar values when they withdraw compared to if they had just held onto their tokens. In other words, ‘impermanent loss’ is the risk of your asset pair converts away from the initial 50:50 ratio due to their fluctuating price ratio relative to each other. This loss is called ‘impermanent’ because it’s only realized if the LP takes their assets out of the pool and the exchange rate between the token pair doesn’t revert.
Popular DEXs that operate with liquidity pools include Curve, Uniswap, and Sushiswap. These platforms act as decentralized liquidity hubs, enabling trades between various asset pairs. Beyond trading fees, LPs can earn governance tokens or newly minted tokens, similar to stock in a company, which can appreciate in value over time. For example, Curve issues the CRV token, which gives holders voting rights and potential long-term gains.
Providing liquidity to Lending Protocols
DeFi lending protocols also need liquidity provision. These protocols eliminate the need for expensive legal contracts by using automated smart contracts. Users deposit tokens into funding pools, from which borrowers can automatically borrow using suitable collateral. This process mirrors how banks lend out money from savings accounts.
Protocols like Aave, Compound, and Anchor have allowed individual traders to participate in lending activities since 2020. Deposits are tracked with protocol-issued tokens (e.g., “aUST” for Anchor), which can be redeemed later for the original position plus accrued interest. Yields come from borrowers who pay continuous interest, with protocols taking a cut. While some protocols offer fixed interest rates temporarily, most use floating rates that adjust based on supply and demand.
In DeFi, loans are typically overcollateralized to mitigate risk. This is akin to taking a loan with your house as collateral, allowing you to continue using your house while accessing capital for other expenses. Similarly, borrowers can keep their token holdings, expecting their value to appreciate while using borrowed funds for expenses or other investments. Contrast this with the alternative scenario where one needs to sell their investment to cover expenses, and you can see why DeFi loans are attractive.
However, the risk of liquidation exists if the value of the collateral falls too quickly. Liquidation occurs when the value of the collateral pledged by a borrower drops below a certain threshold set by the lending protocol. In such cases, the lending platform may automatically sell off a portion of the collateral to cover the outstanding loan balance and protect the lender from potential losses. This can happen during times of extreme market volatility or when the collateral asset experiences a significant decrease in value. Liquidation serves as a mechanism to maintain the stability and solvency of the lending platform, but it can result in losses for the borrower if their collateral is sold at a lower price than its initial value. Therefore, borrowers should closely monitor the value of their collateral and ensure that it remains above the liquidation threshold to avoid the risk of losing their assets.
Currently, most DeFi lending focuses on over-collateralized loans. However, platforms like TrueFi and Goldfinch are exploring uncollateralized lending by vetting borrowers using off-chain, real-world information, expanding the possibilities within DeFi.
The various types of “Staking” – DeFi’s equivalent of commodity bonds
Staking: Earn rewards by locking up assets for protocol security
“Staking” is a key concept in DeFi, primarily associated with “Proof of Stake” (PoS) blockchain networks like Ethereum and Solana. Unlike Proof of Work (PoW) networks like Bitcoin, where miners solve complex puzzles to validate transactions, PoS networks select validators based on the amount of cryptocurrency they hold and are willing to “stake” or lock up as collateral.
In layman’s terms, staking your cryptocurrency means joining a team to protect the network. The more people who stake, the stronger the team becomes. If someone attempts to compromise the network, they face the challenge of overcoming the entire team and risk losing their own stake, providing a strong incentive to play fair. Your staked assets help maintain the blockchain’s public ledger, earning you rewards in the form of transaction fees paid by network users. If a network participant behaves dishonestly, they risk “slashing,” or losing some of their stake. This mechanism encourages validators to act honestly, ensuring the network remains secure and transactions are validated properly. In essence, the cost of attacking a PoS network is roughly equivalent to the total value of cryptocurrency staked, making it an economically secure system.
Some networks require a minimum amount of cryptocurrency to participate in native staking, which involves setting up a node (a computer or device that stores a copy of the blockchain) and acting as a network validator. This is an advanced setup that we won’t cover. On the other hand, pooled staking protocols allows users to stake any amount through centralized exchanges like Coinbase or Staking-as-a-Service (SaaS) platforms like Lido, RocketPool, or Ankr. In this setup, pool operators manage the validator infrastructure, earning rewards through block validation and consensus maintenance. These rewards are then distributed to users based on their percentage ownership in the pool.
In short, by staking, you contribute to network security while earning passive income from your staked assets.
Liquid staking: Unlocking liquidity from staked assets for extra earning
Liquid staking takes pooled staking a step further by issuing a receipt token, known as a liquid staking token, in exchange for your staked assets. For example, when you stake ETH with Lido (a liquid staking protocol), you receive stETH, which allows you to earn additional yields in DeFi activities while still contributing to block validation. While your staked ETH remains locked just like regular staking, the receipt tokens are accessible and can be transferred to other wallets. They can also be used as collateral in various DeFi protocols to generate additional rewards on top of staking rewards. If you chooses to participate in other DeFi pools to earn extra yields, the liquid staking token represents your stake in the pool, serves as proof of ownership, and grants withdrawal rights.
Since liquid staking involves interacting with smart contracts, there is a chance of exploitation if a flaw or bug exists in the code. Choosing reputable and audited liquid staking platforms to mitigate this risk is crucial. Liquid staking also introduces extra counterparty risk compared to pooled or native staking, as a result of interacting with a third-party service to receive liquid staking tokens in return.
Restaking: Re-purpose staked and liquid staked assets for even more earning from other networks
Restaking involves staking your cryptocurrency again, allowing you to use your staked assets in different programs or platforms to earn additional rewards, making the same capital more efficient. Restaking applies the same economic game of staking to leverage the substantial staking amount on established protocols to help secure emerging blockchains and apps. With restaking, new protocols no longer need to prop up their own proof-of-stake security systems, which requires substantial capital and an active community. On the other hand, validators and stakers earn extra rewards on top of the reward from the Ethereum network.
Restaking introduces additional slash conditions in exchange for heightened rewards. Depending on the protocol’s terms, slashing poses the risk of significant asset loss for validators who may breach the rules. Stakers opting in are bound by the contract rules and face slash penalties for malicious behavior.
Liquid restaking: even MORE rewards with liquidity from restaked assets
Liquid restaking offers even greater rewards for your staked assets, akin to liquid staking’s innovation, but on restaked tokens. Just as liquid staked tokens (LSTs) make staked tokens transferable, liquid restaking allows you to exchange your staked tokens for Liquid Restaking tokens (LRTs), which can then be utilized for liquidity on various DeFi protocols.
While liquid restaking offers compelling benefits, it’s essential to acknowledge potential risks. These include counterparty risks, similar to liquid staking. Additionally, there’s a slashing risk akin to traditional restaking. To minimize this, Liquid restaking protocols strategically handpick Active Validated Services (AVSes), which are clients of restaking who want to borrow network security from an established network. By selectively choosing AVSes, these protocols mitigate the risk of widespread slashing events across non-blue chip AVSes, thus avoiding a potential spiral of slashing.
From a macro perspective, liquid restaking also serves to lower the likelihood of a liquidation cascade and positions withdrawals from Ethereum as a backup defense procedure. Users can freely exchange their LRTs, such as converting eETH back to ETH, without needing to withdraw from the Ethereum chain, thereby ensuring the network’s security.
Yield Farming: combing various earning strategies to maximize returns
Yield farming involves navigating different protocols and strategies to capitalize on the highest yields available. It’s akin to active asset management, where investors dynamically allocate their funds across native protocol staking, stablecoins, application tokens, trading and lending positions (represented as tokens), NFTs, and various other digital assets on blockchain networks.
Unlike the default action of holding assets in your wallet (DeFi), or holding cash in a standard bank account (TradFi), yield farming involves actively managing a strategy to maximize returns. For instance, an example of yield farming in TradFi would be constantly opening new high-yield savings accounts to earn bonuses and promotional rates. If TradFi were anything like DeFi, investors could continually and instantaneously reallocate their funds across various high-yield savings accounts, investment products, and financial instruments to compound their earnings. Engaging in arbitrage opportunities, seeking out promotional rates, and strategically timing investments to capture market inefficiencies are all tactics that align with the principles of yield farming.
The interoperability of DeFi applications creates a wide range of opportunities for yield farmers. In contrast to traditional savings accounts, the composable “money lego” nature of DeFi allows users to reinvest their earned yield into other liquidity pools, creating a cycle of passive income. This process enables users to continuously earn additional returns while maintaining exposure to their existing positions.
As you can see, yield farming involves active management of one’s portfolio, but investors can outsource this for a fee, which brings us to the emergence of automated yield optimization platforms like Yearn Finance. Yield farming projects enable users to lock their cryptocurrency tokens for a set period into their smart contracts, which then automatically allocate these funds across various DeFi protocols and strategies to maximize yield. Smart contracts are also used distribute interest, with rates ranging from a few percentage points to triple-digits. In many cases, the locked tokens are lent out to other users, who pay interest on their crypto loans. Some of these interest proceeds are then distributed to liquidity providers.
Yield farming payouts can fluctuate significantly from day to day, posing challenges for users. Strategies such as those employed by Yearn Finance involve assessing APRs across various yield farming platforms and depositing tokens in pools with the highest APR. Additionally, liquidity providers may earn tokens from transaction fees, with pools experiencing higher trading volumes typically offering higher returns.
Yield farming carries risks such as potential hacks, rug pulls, or other catastrophic failures. To mitigate these risks, it’s crucial to look for a proven track record of the team, code delivery, and actual usage numbers as indicators of trustworthiness. It’s also advisable to spread investments across several well-regarded protocols and assets that have been thoroughly researched and understood.
Conclusion
DeFi represents a significant departure from traditional finance, offering unique opportunities for investors to earn passive income. While both DeFi and TradFi provide avenues for passive income generation, DeFi’s offers greater potential returns and flexibility. Through automated smart contracts, investors can easily participate in activities such as liquidity provision, lending, staking, and yield farming, all of which contribute to the growth of the DeFi ecosystem. By understanding and leveraging these DeFi primitives, investors can maximize their earnings and participate in the future of finance. However, it’s essential to acknowledge the risks associated with DeFi, such as smart contract vulnerabilities and market volatility, and to approach investment decisions with caution and diligence.
As DeFi continues to evolve, it promises to revolutionize the way we interact with financial services and unlock new possibilities for wealth creation. At 10102, we strive to help guide individuals through the new generation of financial primitives, similar to what NerdWallet did with credit cards. Check out our educational content, tools, and insights to navigate the complexities of the decentralized financial landscape and the future of wealth creation.