Whenever you talk about DeFi, you end up projecting a fabulous future world in which decentralized finance protocols will have rendered banks and traditional financial institutions obsolete. It is nothing less than an emancipatory revolution in which the user has all the power and responsibility over their money, dispensing with the old intermediaries used to subtract greater profits.
At first glance it may seem like a distant world, even unreal. But the fact is that it is already happening and it is not from now. Since 2019, when the decentralized lending platforms that were responsible for the initial wave of growth in the DeFi sector emerged, new ways to generate income from digital assets have been developed.
By depositing their crypto assets in smart contracts tied to a decentralized protocol, some investors have been earning annual percentage returns (APYs) that leave traditional financial sector interest rates eating dust.
However, this is not easy money, since interacting with DeFi protocols requires patience, care and a basic knowledge to connect a digital wallet of Web 3.0, such as MetaMask, to a DEX (decentralized exchange), like Uniswap.
Below are the four main ways to generate passive income using decentralized finance protocols.
The first experiments in DeFi were done in this modality, since the pioneering platforms of decentralized finance were the loan protocols, such as MakerDAO. The concept is simple and straightforward: investors lock their assets in a smart contract of a certain protocol creating a liquidity pool. Borrowers can access these funds by paying interest to the protocol, and the smart contract distributes the interest earned to the lenders in the same proportion as the assets they blocked.
It is an interesting option, especially for those who have little or no experience, since it has a simple mechanics. The tokens are deposited and blocked instantaneously, as instantaneous is also the reverse operation.
The Annual Percentage Yield (APY) is usually more advantageous than the interest offered by the banking system. For example, the AAVE protocol, based on the Ethereum network, offers an APY of 4.05% for USDC deposits.
Another advantage is the low risk of default, since borrowers have to offer assets as collateral that are added to the smart contract, which guarantees the payment of the interest owed.
In the cryptocurrency universe, this term derives from the consensus mechanism known as “Proof-of-stake” (PoS), or proof of stake. The validators that guarantee the security of the network have more power the more tokens they have.
However, since most of the current DeFi protocols are based on the Ethereum network or the Binance Smart Chain, whose consensus models are different, staking only means blocking assets for a longer term in exchange for sharing the income obtained in network.
It could be said that staking is like opening a “savings account” linked to a specific blockchain, in which the investor’s funds are locked in a smart contract.
Most decentralized exchanges offer the option of staking your native token. For example, UNI, in the case of Uniswap, currently the top DEX in the market by trade volume. These tokens typically get a portion of the income generated from the use of the products and services offered by the exchange, which is then, in part, distributed to investors upon unlocking the funds.
Notably, Ethereum is moving from the Proof-of-Work consensus model to the Proof-of-Stake. When this happens, those who are willing to block 32 ETH for each node they wish to run will be able to become validators of the network. To go live, the network will need a staking of at least 524,288 ETH distributed among at least 16,384 validators. Once this condition is reached, validators will begin to receive rewards for their contribution to the operation and security of the network.
DEXs are characterized by working without an order book, unlike centralized exchanges. They work through a system called Automated Market Maker (AMM), in which the order book is replaced by liquidity pools. These funds are made up of pairs of tokens of equivalent value.
The liquidity pools are public. Any investor can become a liquidity provider by locking a pair of tokens in a smart contract. For example, if 1 ETH is trading at 3,000 USDT, the investor will have to make available the tokens of both pairs in equivalent proportions. That is, 2 ETH, 6,000 USDT, and so on.
By committing a pair of assets in a liquidity pool, the investor receives specific tokens linked to the transaction. By redeeming these tokens, the amount invested will be returned, plus the income generated by operations within the pool.
Liquidity providers receive a transaction fee or commission proportional to the amount allocated in the pool. The APY is variable, but it is usually higher than that of the previous modalities because it contains an additional risk known as “impermanent loss”.
In the event of extreme volatility of one of the tokens in the pair, rebalancing the pool price can cause the investor to lose money compared to what would have happened if they had not joined the pool. To minimize this risk, it is advisable to choose highly liquid pools and avoid pairs that contain currencies prone to large price variations.
This modality allows investors to obtain additional income from the provision of liquidity. Liquidity providers receive a specific token that represents their participation in a certain pool. Many DeFi platforms offer “farms” where the investor can allocate these tokens, earning income from them. It is the same principle as betting, but accessible only to liquidity providers.
With so many investment modalities and protocols, tracking the performance of a DeFi wallet is a challenge in itself. Aggregators such as 1inch provide integrations between different blockchains and connections to multiple digital wallets, facilitating access to various data in real time, and even helping to identify the best returns offered in the market.
These are the most popular methods of generating passive income through the decentralized finance ecosystem. Allocating digital assets in exchange for income is a key practice for increasing liquidity and working capital in the cryptocurrency market. However, you have to be careful and watch out for scams and shady protocols. The dangers and the rewards are in equal proportion.