A decentralized financial system (DeFi) is one highly successful application of blockchain technology which acts as a promising alternative for traditional financial. The name itself suggests that DeFi is a general term that refers to a range of financial services and products which are run using blockchains that are decentralized.
Applications called DeFi (DApps) are created to cut out the middleman in financial transactions. They were previously promoted by traditional financial institutions, such as banks. The technology accomplishes this by implementing a trust-based blockchain mechanism that permits secure peer-to-peer (P2P) transactions, without having to pay an interest to banks.
The increasing use cases for decentralized finance have provided new opportunities to earn passive income for investors who invest in DeFi. To earn passive income, investors have to pledge their DeFi assets to be used as resources to verify transactions and implement processes using that Proof-of-Stake (PoS) agreement mechanism.
Let’s look at the different options for passive DeFi income.
Yield farming in DeFi (liquidity mining)
Yield farming, also known as liquid mining within DeFi is the method of generating more cryptocurrency by through existing cryptocurrency assets. As a strategy for investing it involves investors staking or transfer crypto assets to the form of a smart contract-based liquid pool. The pool repurposes the cryptocurrency to supply liquidity for DeFi protocols. It also distributes a part of the fee to the user in reward.
DeFi yield farms permit an ERC-20-based token, such as Ether ( ETH) to invest and earn rewards. Yield farming is designed to generate the highest yield or returns that are possible. It is also known to be among the more risky investments in the world of passive DeFi income.
Liquidity pools facilitate trading in crypto on the decentralized exchanges (DEXs) which provide an “yield” or payment for the completion of tasks, such as verifying transactions. The success of the yields in each pool will depend on the strategies that are implemented in these smart contracts. Additionally, the payout is also determined by the value of the tokens that are invested by the user into the pool of liquidity.
If a person puts money into or lends funds to a liquidity fund, the operator or farmer is looking to redistribute the asset with the aim of achieving the most lucrative annual percent return (APY). This APY is a representation of a unit of the annual investment returns which includes the compounding interest. The majority of banks offer the average rate of savings of 0.06 percent, which is the case with DeFi, which is much more lucrative.
Staking on DeFi has many similarities with yield farming and works as a motivation for customers to keep their cryptocurrency for a longer time. Similar to yield farming, DeFi users have to lock or delegate their crypto accounts to be validated for the Blockchain.
When staking, users gain rewards by locking their coins for a specific duration, which is based on the options provided by the company. Each blockchain requires an amount of tokens in order to be able to add the user as a validator that for the case of the Ethereum blockchain is 32 ETH.
Furthermore, the expected earning potential of DeFi stakes is determined by two elements — the rewards policy and the length of the stake. Apart from the financial advantages, staking is directly linked to secure blockchain-related projects and improves efficiency.
The term “lending” is used to describe a variety of investment strategies that generate the passive generation of income through cryptocurrencies. In decentralized lending, also known as DeFi loans, the investors have the ability to connect directly with the borrower via pre-programmed smart contracts. Also, DeFi lending platforms permit investors to register their crypto tokens. These can be borrowed by customers and repaid over an agreed-upon timeframe with interest.
Smart contracts don’t just assist in removing the risk associated with traditional lending however they also remove collateral requirements. However, many loan applications don’t require background checks which are necessary to minimize risk to fraud and credit.
DeFi lending functions as the peer-to peer (P2P) system that permits the borrowers to lend crypto directly to investors, in exchange for prompt interest payments. In contrast to traditional loans smart contracts enable users around the world to pool and share crypto assets without the need of an intermediary.
Additionally, the blockchain technology guarantees transparency and unalterable transactions for everyone that are involved.
The differences between DeFi options for passive income
The risks of passive income based on DeFi
Each investment type is associated with different levels of risk, typically combined with a lucrative opportunity to make profit. For DeFi-based earning opportunities most of the risks are fraud, hacking attacks, and untrue or over-promised smart contract.
As the DeFi-based income is correlated with the amount of tokens that are that are earned, the volatility of cryptocurrency could result in losses in profits in the bear market. In these instances investors will tend to keep the coins until the market price rises, which can lead to an unrealized gain.
Additionally the risk associated with the DeFi’s investment strategy could depend on the intentions of the pool’s owners. Therefore, it is crucial to assess the credibility of service suppliers on the basis of the payout history.
Tracking your portfolios
There are a myriad of methods to make passive earnings on DeFi and other platforms, keeping track of all your accounts across different platforms can be an issue.
This is why a lot of DeFi traders are now using portfolio trackers, also known as aggregators, that are connected to a variety of wallets and protocols. They let you evaluate and manage your entire portfolio on one dashboard. Yield aggregator maximizes the efficiency of your investment by optimizing the ways of making money. It could be comprised of hundreds of vaults and farms which profit from a range of decentralized services and business strategies.
Some aggregators also offer cross-chain integrations as well as multiple wallet connections, which allows users to view charts which analyze the data of multiple aggregators in real-time. Cross-chain technology allows data and value to be transferred between blockchain networks, increasing their interconnectivity. In the end, the barrier of blockchains is broken, leading to an ecosystem of dispersed networks that is interconnected.
Furthermore, cross-chain integrations aid you in identifying possible yields on APY across pools and keeping track of accounts across multiple wallets. Additionally, anyone can use the digital currency they own to generate passive income through one strategy. They are a crucial service to the crypto market by providing the much-needed capital as well as liquidity in exchange for rewardsand all without the necessity of intermediaries.
Be aware of fraudsters or “rug pullers” or projects that simply want to steal your tokens and then redeem them in liquidity pools, thereby draining your cash. Check that the platforms and farms you choose to use are reputable and have released an audited and externally verified smart contracts.
So investors should investigate thoroughly the parties involved prior to signing up to liquidity pools such as staking or lending. To begin, take a look at Cointelegraph’s article on the fundamentals on DeFi to get more knowledge of the new ecosystem.