How to Earn Passive Income Through DeFi

Decentralized finance (DeFi) has opened up a whole new world for users who, in traditional finance, have been starved of returns for decades. The potential to earn passive income from DeFi is vast, and opportunities abound in this exciting space of ever-evolving platforms, protocols and exchanges. However, this new testing ground is not without its pitfalls and requires a steady hand to navigate. To help you find your way, we have broken the process down to its core elements.

Deposit crypto in DeFi for an APY

The simplest way to earn a passive income through DeFi is to deposit your cryptocurrency onto a platform or protocol that will pay you an APY (annual percentage yield) for it. This is almost identical to how you might deposit cash into a savings account at a traditional bank, although in much of the developed world interest rates are now a thing of the past thanks to prolific money printing by central banks over the past decade.

Depositing on a DeFi platform can be done with a large variety of coins and tokens, but not fiat (traditional currency). And so, your first step will be to buy some cryptocurrency using a fiat on-ramp (i.e. buying crypto with cash). Before you buy your crypto, though, bear in mind that because the vast majority of DeFi operates on the Ethereum blockchain, Bitcoin (BTC) is typically not accepted. 

Choose your token and protocol

Most DeFi protocols will require you to deposit an Ethereum (ERC-20) token to earn an APY. This could be Ethereum’s native currency, Ether (ETH), or – more commonly – a stablecoin like DAI or USDT since you don’t need to worry about market volatility. There is also an Ethereum version of Bitcoin, wBTC, whose price is pegged to the biggest cryptocurrency. To find out which coin or token you want to deposit, you might first take a look at the different returns being offered for different assets.

The growth of DeFi over the past year has led to a proliferation of protocols, and it can be difficult to know which to choose. DeFi Pulse’s ‘Earn Income’ tool allows users to search platforms by asset, so that would be a good place to start. Once you’ve decided which token you want to deposit, you can buy and trade on a centralized or decentralized exchange. There are now a number of aggregators that can help you find the best swap rate for your cryptocurrency, such as 1inch.

Liquidity mining 101 

While earning interest on your assets is pretty great, that is by no means all you can do in DeFi. The next step in the passive income journey is to get involved in liquidity mining, aka yield farming. There are a number of avenues to begin with. The first might be to stake or trade any rewards that you get for depositing your crypto: typically the native token of whatever protocol or platform you have deposited with. 

These governance tokens often give holders the right to vote on changes to that protocol, a facet that has made many of them valuable on the secondary market. You usually have two options: stake these tokens with the issuing protocol for further rewards, or trade them on an exchange (DEXs like Uniswap will have all of them listed, while some centralized exchanges support the most popular ones). You might choose to trade a token because you can swap it for a stablecoin that you can earn more interest on, for example.

Boost with borrowing and lending 

Another route to passive DeFi income involves borrowing a token or coin from a platform that you can then put back into either the same or another platform for rewards. If you are a Bitcoin holder, for example, you might first swap $1,000 of BTC for wBTC and then deposit that into a DeFi protocol for an APY of 0.5%. This is a small return, but by virtue of depositing that BTC, you are able to take out a collateralized loan, perhaps up to 75% of the value of your BTC ($750), for another coin or token that is offering a high return. 

You can then take that loan and deposit (or lend) it. By doing so, you have essentially unlocked a further 75% of the value of your BTC to earn more passive income. Meanwhile, you continue to benefit from the capital growth of the original asset (which in BTC’s case, has been pretty strong of late) as well as interest and native/governance tokens that you can then stake with the platform or trade on a DEX to take part in more liquidity mining.

Passive income pitfalls 

The above process can technically be carried on ad infinitum, resulting in the notoriously complex DeFi ecosystem. In fact, what we have outlined above barely scratches the surface of what experienced users are able to do in DeFi, where leverage and derivatives can be used to pump returns by up to 15 times. As you might expect, however, all of this comes with risk, and for those participating in multi-layered liquidity mining, this risk can be very high.

Multiple threats face users holding assets with numerous platforms, not least the potential losses from smart contract exploits (also known as flash loan hacks), as well as high transaction fees (aka ‘gas’) when the Ethereum network is congested. These fees can eat into huge portions of your returns. Impermanent loss, where the price of your assets moves against you while deposited with a protocol can also be a big issue. Moreover, with interest moving on a daily basis, often decreasing as more users pile in, there is potential opportunity cost from having your crypto locked in an under-paying protocol.

DeFi doesn’t have to be difficult

In short, in order to fully participate in earning a passive income through DeFi, a user needs to be highly experienced and often capital rich to take advantage of high volume opportunities and be resilient to losses. And, importantly, this is a far cry from the founding ethos of DeFi, which was envisioned as a space that anyone could take part in depositing, borrowing and lending for wealth creation that for so long has been the preserve of wealthy elites in traditional finance. 

We at YIELD App don’t think it should be this way, which is why we have founded our platform: a place where users can participate in DeFi from depositing traditional currencies to off-ramping profits without the need to enter into a complex and risky web of exchanging and trading. Through our innovative investment funds that pool assets to achieve the highest returns at any one time, our users will be able to take advantage of the best of DeFi at accessible levels. We believe this is the next stage of DeFi’s evolution and we invite you to come along with us.