Passive income with the use of decentralized finance

Most people who have invested in cryptocurrencies in the past or in the last year do not know what to do with them or where they could store them safely. There is a range of options here to keep your funds safe and get passive rewards at the same time. Among all the different ways to generate passive income with your crypto assets, staking and yield farming are in the spotlight. Which earning strategy is better depends on the individual and their requirements.

Passive income using DeFi

Decentralized finance has caused a real revolution in the crypto world and opened the door to many innovations that will allow independent cooperation on the decentralized network in the future. The whole purpose of the DeFi system is to remove the control that banks and other institutions currently have over money, financial products and financial services around the world.

Decentralized finance cuts out middlemen by enabling people, merchants and businesses to conduct financial transactions through a brand new technology. The technology is based on a financial peer-to-peer network that uses security protocols, connectivity and advanced software and hardware.

Decentralized finance aims to eliminate centralized financial models and enable people to trade, lend and borrow funds, regardless of where you are, who you are and why you need these funds. It also gives people greater control over their money through the use of personal wallets and services ment for individuals.

For easier understanding, consider how you get a loan in centralized financing. First of all, you need to go to your bank or to any other lender and apply for a loan. If the loan is approved, you will pay interest and service charges.

In the case of using a decentralized finance system, you would use your decentralized finance application (dApp) to input your loan needs, then an algorithm would connect you with users who lend cryptocurrency that match your needs and requirements. To approve the loan, you should agree to the lender’s terms and conditions and thus receive the loan. The transaction is thus recorded in the blockchain; you receive the loan as soon as it is approved by the mechanism. After the loan is executed, the lender can start collecting payments from you, at pre-agreed intervals.

In addition to lending, the world of decentralized finance offers us other alternatives for using our cryptocurrencies: staking, yield farming and liquidity mining.

Staking

If you’re a long-term cryptocurrency investor, you’ve probably heard of the concept of “staking” or pledging cryptocurrencies. The staking method has been implemented by many cryptocurrencies for the purpose of validating transactions in their system. Anyone who is ready to pledge their currencies for a certain period of time in the future is thus rewarded with interest that is paid regularly and thus brings passive income to your investment. The method is especially suitable for investors who do not intend to sell their investment quickly and thus can protect themselves against the annual price volatility in the crypto market. Of course, the platform needs to be liquid enough to withstand larger outflows during times of falling cryptocurrency prices.

Cryptocurrency staking is a process that involves locking, or pledging, your crypto assets, which are used to support the blockchain network and validate transactions. The staking method can only be used in projects that operate on the “proof-of- stake” principle of confirming transactions. This method is a more energy-efficient alternative to the original “proof-of-work” model, where the maintenance of the network requires mining devices that use computing power to solve mathematical problems.

Staking is a great way to use your cryptocurrencies to earn passive income, especially with some projects that offer high annual returns.

How cryptocurrency staking works?

The original purpose of staking or pledging funds is to use these funds to drive the entire blockchain network of a particular project. When talking about the use of the “proof-of-stake” model, it is important to mention that it is a method of confirming transactions in the network. “Proof-of-stake” model is used by many projects because it is very environmentally friendly compared to the “proof-of-work” model, which requires a lot of computing power and a graphics card, where a lot of energy is consumed to confirm transactions by solving the computer generated mathematical problems. This is precisely why the Proof of Stake model is much more useful as it can handle a larger number of transactions.

Therefore, everyone present in the network can pledge their cryptocurrencies, into a specific protocol or into a smart contract on the blockchain. From among these participants, the protocol selects “validators” to validate blocks of transactions. The more coins you stake, the more likely you are to be selected as a validator. Every time a new block is added to the blockchain, new cryptocoins are minted and distributed as a reward to all validators of the block. In the vast majority of networks, rewards are paid out in cryptocurrency on which the network is built. For staking on the Ethereum network, you will be rewarded with Ethereum coins. In some networks, rewards can also be paid out with another cryptocurrency.

So, if you want to start staking cryptocurrencies, you first need to find a coin that uses a PoS or “proof-of-stake” system. The most well-known are Ethereum, Cardano, Solana and Polkadot. The next step is to choose the amount you want to pledge. Many popular exchanges enable the staking function right on their platform, where the annual return is lower than on other platforms, since you are responsible for your funds yourself.Here is an example of a staking option on the Binance exchange:

For comparison, we can look at how you would go about staking the HEX coin by interacting directly with the protocol and not through an intermediary such as Binance.

First, we need to create a Metamask wallet, which we install in the Google Chrome browser. We transfer the amount of HEX coins that we intend to pledge to our wallet and then connect to the website go.HEX.com with the wallet.

Here it will be necessary to give the website access to our wallet for interaction, with the HEX protocol.

Once your MetaMask wallet is connected, the page will automatically update (as shown below). Then click on the “Stake” tab.

Here you will be able to create your position and choose the length of time and amount of HEX coins you intend to stake. It is also possible to create several different positions, i.e. for different lengths of time.

Once you have selected the desired amount and length of time, the Metamask wallet will again ask you for permission to continue. Once the transaction is confirmed, you will notice that your newly created stake is displayed under the “Active stakes” column and will be on the waiting list until the day turns ends at 00:00:00 UTC (when all stakes are updated).

In principle, the process is the same for all projects that offer the possibility of staking, so the steps will be quite similar regardless of which cryptocurrency you want to stake.

In case you would like more stable investments and a relatively stable annual return, most platforms offer to pledge your stable coins, where the annual return is around 10%.

When you pledge your funds, it is important to know that these coins are still yours, but in most cases they are “locked” for a certain period of time. The length of the minimum period or how long your funds will be locked depends entirely on the offer on the platform where you are staking. Among the most popular platforms that offer the service are Coinbase, Binance, BlockFi, Gemini, Kraken and Nexo. Here, the rate of annual return is slightly lower, since you do not take full responsibility for your funds, but the exchange where you provide the service. Which platform you choose depends on your requirements and other factors that affect your investment. The offer on the platforms varies depending on the annual rate of return, the minimum required investment, the range of cryptocurrencies offered, the value of costs and other factors. Of course, it is also possible to stake cryptocurrencies on other platforms, where the annual returns are higher and the offer of currencies is much larger, but it is necessary to be aware that the risk is also greater.

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Yield farming

Yield farming is a very popular way to increase your crypto assets with the help of loans. An interesting analogy comes from agriculture, showing an innovative way to “grow your own cryptocurrency”. The method involves lending crypto assets in exchange for interest on DeFi (decentralized finance) platforms. So, you lock your crypto coins into a liquidity pool or fund where these funds provide liquidity to the protocol and are used to carry out trading, lending or borrowing. By providing liquidity, the platform earns commissions that are paid to investors based on their share of the liquidity pool. This is why yield farming is also known as liquidity mining.

How does Yield farming work?

The concept of liquidity pools can be compared to a decentralized bank, where we can accumulate our funds by lending, borrowing and acting as an exchange of two currencies.

Liquidity funds, or rather liquidity pools, are essential for AMMs (Automated Market Makers), of which the Uniswap application is one of the most famous ones.

AMM (Automated Market Makers) offers independent and automated trading using liquidity pools that act as a replacement for the traditional system of sellers and buyers as we are used to on centralized financial exchanges such as Binance, Kraken, Kucoin and others. Since they do not need a counterparty for trading (the buyer does not need a seller), the constant liquidity of each currency pair is maintained.

LP (liquidity pool) tokens are issued to all providersof liquidity and represent their share in the liquidity fund.

For example, if a trader wants to exchange Ethereum (ETH) for Dai (DAI), they will have to pay a commission. This fee is paid to Liquidity Providers (LPs) in proportion to the amount of liquidity they add to the fund. The more capital an individual contributes to the liquidity fund, the higher his rewards. For example, if you contributed $10,000 to a liquidity fund that contained $100,000, you would receive a token for 10% of that fund. This token can be redeemed for a portion of trading fees.

So when we talk about the Yield farming strategy, we have 3 options for earning:

  • Liquidity Provider: Users deposit two different coins on a DEX (decentralized exchange) to provide trading liquidity. Exchanges charge a small fee for each exchange of two tokens, which is paid to liquidity providers.
  • Lender: Coin holders can lend cryptocurrency to borrowers through a smart contract and earn commissions on the interest paid on the loan.
  • Borrower: An investor can pledge one token as collateral and receive a loan of another. In this way, you can earn a return with borrowed coins. By using this strategy, a “yield farmer” retains an initial position that can grow over time, while earning a regular return on his borrowed coins.

Popular AMM platforms:

Uniswap is a decentralized crypto exchange and protocol that was developed in 2018 and runs on the Ethereum blockchain. It still remains one of the most popular decentralized exchanges with the most liquidity. All liquidity pairs on Uniswap are built from two tokens. An additional advantage of the protocol is that it allows users to list tokens on the exchange for free, while traditional centralized exchanges charge very high sums for this service.

It is an open-source system, which means that others can easily copy it and create their own platform, as Sushiswap did.

Sushiswap is one of the more popular copies of Uniswap and belongs to the DeFi protocols. Although they both work almost exactly the same, the critical difference between the two comes down to Tokenomics, i.e. different strategies for issuing new coins.

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Sushiswap offers additional rewards for offering liquidity as well as lending. On the other hand, Uniswap has much more locked-in liquidity and a higher market turnover, which demonstrates the users’ confidence in the platform.

Another version, which is also a copy of the Uniswap protocol, performs its operations using the Binance Smart Chain (BSC) network, and not Ethereum. Although there are far fewer cryptocurrencies built on the BSC network, the transaction costs here are much lower, as well as significantly faster transactions.

Pancakeswap offers many other options for extra income, such as staking individual coins.

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Balancer is a smaller DeFi protocol that is currently ranked ninth in size in terms of the amount of funds locked into liquidity pools. Although it is a smaller protocol, Balancer’s AMM system offers many more features. For example, Balancer supports up to eight different coins in one liquidity pool. This makes prices much more stable compared to liquidity funds based on only two cryptocurrencies.

 

With other DeFi protocols, trading fees are determined by the platform itself. Balancer allows creators of liquidity funds to set their own fees. This encourages more competition between funds, as users will constantly search for the fund with the highest return. Users can even create private liquidity pools where only certain participants can join.

An example of adding liquidity

First of all, it is important to know that you can add any token, that is built on the Ethereum network and isadded in combination with the same value in Ethereum token, to liquidity pools. So you need:

  • A Metamask wallet
  • Any ERC-20 coin + ETH tokens
  • Uniswap

In this example, we will use the Uniswap platform and add DAI cryptocurrency to the liquidity pair. The process is the same for all ERC-20 tokens.

To get started, you will need ETH and your target ERC20 token (DAI) in the same wallet.

Once you have your tokens, click on the “Pool” tab and make sure the “Add liquidity” option is selected at the top of the page. You will see ETH automatically selected in the top box and select your token in the bottom box. You may need to click “import” next to the token and approve the contract interaction notification in your Metamask wallet.

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Select the amount of tokens you want to add and the corresponding amount of ETH will be automatically filled in the box above. At the bottom you can see the current exchange rate and pool size. Click “Add liquidity” and approve the transaction notification through the wallet.

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Once the transaction is confirmed on the blockchain, you will see the amount of ETH and DAI liquidity provided and your share of the pool in percentage. This liquidity is used when users trade ETH/DAI on Uniswap, meaning that the ratio between your ETH and DAI may change over time. You may have more ETH or DAI depending on how people trade, but the dollar value will remain the same.

To remove liquidity and receive your rewards, make sure you are back on the “Pool” tab and select “Remove liquidity” from the dropdown menu. Select the ERC-20 token you have secured liquidity for and the balance shown above will equal your number of LP tokens. Click this number to fill the field with the total pool share.

Once the transaction is confirmed on the blockchain, you will receive ETH and DAI to your wallet, the LP tokens will disappear and your pool share will return to 0.

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Risks of yield farming

In yield farming, we have to pay attention to many risks that every investor should understand well. Fraud, hacking and volatility losses are nothing new in the world of DeFi. The first step for anyone who wants to use DeFi is to research the most trusted and proven platforms.

As the first risk, we can mention the so-called “rug pull”, which is a form of exit scam, in which a developer or cryptocurrency creator collects money for a project and then abandons it without returning the funds to investors. In 2020, about 99% of all fraud was in the form of a rug pull or some other exit scam that yield farmers are particularly sensitive to.

The next risk is a little more difficult to understand, but it is also very important in case of high volatility in the market. This is about the concept of “impermanent loss”. This loss usually occurs when the ratio of tokens in the liquidity pool becomes uneven.

Impermanent loss affects liquidity pools that should have the same token ratio, i.e. 50/50. In a DAI/ETH liquidity pool, liquidity providers must provide equal parts of DAI and ETH to the pool. So when traders on a decentralized exchange trade the liquidity pool, the ratio will change based on how many tokens are in each pool, affecting the price of those tokens.

In the case that Ethereum coin reaches 10 times the stablecoin’s DAI (which means 1000%) in a very short period of time, our stock of Ethereum coins in the liquidity pool will also drop very quickly, as we have pledged our ETH coins for use as liquidity and due to the large demand traded in exchange for DAI coins, where the value remained stable. Thus, by offering liquidity, we would miss out on the great growth of Ethereum.

Impermanent loss can be roughly calculated by comparing your token values in the liquidity pool to the value if you were to simply hold those tokens. As stablecoins mostly have stable prices, liquidity funds using stablecoins (nor. USDT/DAI) may be less exposed to non-permanent loss.

DeFi Yield farming has long been one of the most exciting sectors of decentralized finance and the crypto market. In a very short time, it quickly gained popularity and proved that due to the large sums of money and utility, it urgently needs help from the regulators.

Although the current level of risk is still quite high, the rewards it offers can be very attractive.

However, for those who are willing to accept these risks, DeFi offers extremely innovative ways of “farming”.

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