In the era of passive income generation, DeFi is king. Using DeFi and its applications, people from across the globe are generating amazing returns over and above their main income source. In the crypto space, people HODL money to generate returns, and it has become the most common strategy for passive income.
However, the buck doesn’t stop here with DeFi-based passive income generation. DeFi has presented individuals with a wide range of earning potential powered by lending protocols, DEX, and liquidity pools. Let’s find out the ways and means in which DeFi helps people earn passive income.
What is DeFi? A Brief Introduction.
Decentralized Finance, or DeFi, comprises products and services that run on a decentralized network of computers. Decentralized means no central authority or body takes care of the processes and systems within.
As the central authority is removed, the network of computers work together to execute all the transactions. This DeFi system is an alternative to the existing traditional financial system, which is run by governments and corporations.
Passive Income Generation with DeFi
Passive income has become a buzzword in the community today. While some people are taking towards the gig economy to earn passive income, others are investing in crypto to earn rewards. These rewards come from different methods, which we will discuss below.
1. Lending Protocols
Lending protocols allow users to lend crypto money or assets to other people and users to gain interest payments. There are many platforms available in the crypto space that allow people to lend money. However, the interest rates offered by these platforms differ.
Given the high-interest rates, individuals can earn a higher income than the traditional lending system. Lending also works by lending money to a platform in return for interest payments.
These lending protocols are governed by smart contracts. Hence the interest is forwarded to the lenders promptly at the right time. The DeFi space works exceptionally well with smart contracts, as these self-executing contracts remove all ambiguity and set things in motion automatically. Given that the smart contracts are involved, the borrower won’t default, ensuring zero risk for the lenders.
2. Yield Farming
Generating yield on the existing tokens in the liquidity pool of a crypto platform is another way of earning passive income. The users are required to put funds in the liquidity pool and lock them through a smart contract. Usually, these platforms are decentralized applications or Dapp.
The users submitting their funds within the liquidity pools get interest based on the amount and time period for which they lock the funds. Higher amounts locked for a longer time period get a higher yield as compared to lower amounts.
Individuals submitting their funds in the liquidity pools can also take them out and deposit in other platforms, which generate higher passive income. However, it is essential to conduct research about the platforms and liquidity pool performance before depositing funds.
Some scams have been running in the crypto space where users are asked to deposit funds. At some point, the platform is suddenly closed, and the owners run away with the funds, which is called a rug pull scam.
A similar method to yield farming is staking. In staking, the individuals deposit money in a platform under the rules of a smart contract. They lock the tokens to earn income on the deposited amount of tokens. A higher staking amount generates higher income and vice versa.
Mostly, staking is done with the native token of the platform on which the individual chooses to stake. Staking is similar to depositing money in a bank account and gaining interest. However, the difference here is that your money is not governed by a single entity.
In staking, the individuals earn money, according to the APY. Depending on the APY, the earning potential is decided; hence, APY becomes a key factor in choosing a platform for staking. Out of all the passive income generation options, staking is the easiest one, to begin with.
These three are the major passive income generation techniques in DeFi. However, for a beginner to choose between one of these is not an easy task. Let’s compare them to gain better clarity.
Difference Between Yield Farming, Staking, and Lending
The first parameter you must look for is the consensus mechanism. Out of the different consensus mechanisms available, all three run on proof-of-stake. Proof of stake or PoS means when the blockchain works via selected validators who gain a share based on their holdings. Often cryptocurrency platforms have a limit to select blockchain validators.
Profit Margins: Among the three options, yield farming or liquidity mining has the highest profit margins. The other two mechanisms have the same level of margins, but it is lower than yield farming.
Time Required: One of the key contentions users have with yield farming is a long time required to stake the assets. Naturally, among the three, yield farming requires the highest timeline so that a user can keep earning passive income. In the other two options, staking and lending, the users can choose their timeline. For instance, they can choose the timeline for staking their assets or lending them to another user or platform. Evidently, a longer time in both these systems means higher income.
Risk Level: A core principle of the economy is that assets with high returns also have the highest risk. The same applies to the crypto economy as well. Since yield farming or liquidity mining has the right returns, they also have the highest risk. Staking has a low-risk level as the money is deposited for a long time and generates true passive income for a longer time. Lending has a moderate risk, as the borrowers can default, but the lenders are protected by the platform through which they are lending.
To Sum it Up
With multiple avenues available to the users for earning money, crypto investors and enthusiasts can handpick from the best method they are comfortable with. However, the key is to choose the platform with due diligence and extensive research about its past performances.