Decentralized finance (DeFi) is proving itself as a competitive alternative to traditional finance, which is a successful implementation of blockchain technology. Several financial products and services that can be operated on decentralized blockchains all fall under decentralized finances.
The requirement of any mediator in carrying out financial transactions can be eliminated using decentralized applications. These mediators are usually banks that have mastered their services in the past.
Without paying any commission to the bank, the decentralized technology implements a mechanism that is based on the blockchain that permits the users to carry out peer-to-peer (P2P) transactions.
The investors working on decentralized finance systems have found new opportunities to earn passive income through DeFi as the applications of the concept are becoming mainstream. Investors must commit their funds and assets to generate passive income through decentralized finances.
This is a mandatory process for a transaction to get confirmed and for the execution of all mechanisms through the Proof of Stake protocol.
Here is a detailed guide article that will help the readers to understand the concept of decentralized finances and how they can find different opportunities to earn passive income through decentralized finance systems.
What is Decentralized Finance (DeFi)?
Decentralized finance is a new concept in the banking and financial sector that utilizes blockchain technology and allows users to make peer-to-peer transactions. By adapting to decentralized finance protocol, the investors can handle their funds and assets on their own and more money than the services offered by traditional financial systems.
Moreover, the users do not need to pay any charges or fees to access their financial wallets.
How Does Decentralized Finance (DeFi) System Work?
The DeFi system aims to provide services and benefits such as loans, payments, and interests on depositing funds, etc., to its customers provided by the traditional financial system by remaining integrated into decentralized technology. Therefore, it is creating new opportunities for the provision of the same services and products to its customers.
To achieve its goals, the decentralized finance system uses blockchain technology and smart contracts. The use of blockchain technology will help in keeping track of all the transactions that will be held over the network. On the other hand, the main building blocks of the decentralized finance system are known as smart contracts.
The transactions are automatically executed by smart contracts to enable DeFi. The set of instructions is achieved when the instructions required by smart contracts are fulfilled.
How to Generate Passive Income Through DeFi?
Several methods can be used by investors to earn income passively using the decentralized financial system at the time of a bear market or to overcome any potential loss in crypto trading. Some of these methods are mentioned below.
- DeFi Yield Farming/ Liquidity Mining
The process of earning more crypto assets using the crypto assets that are already present with the user is known as liquidity mining or yield farming in a decentralized financial system. The investors are required to delegate or stake their crypto assets in the liquidity pools based on smart contracts as an investment strategy in yield farming.
In order to provide liquidity to the decentralized financial protocol, the invested crypto assets as used by the pool again, and a part of the procedure fees is given as a reward to the users. For making investments and paying rewards, the use of ERC-20 tokens is usually supported by the yield farms operating on decentralized finances.
In a world based on passive income through DeFi, yield farming is considered one of the riskiest investments as it is programmed to return the yield while earning the highest income possible.
To carry out crypto trading conveniently on decentralized exchanges, usually, liquidity pools are used. These pools then provide the users with a payment or yield after completing tasks such as confirmation of a transaction.
The strategies that are implemented over the smart contracts will decide the yield success of each liquidity pool. Moreover, the monetary value of the tokens invested in the liquidity pool by the user also determines the payout value.
The assets are redistributed by the farmer or the operator with the aim that he can produce the highest possible annual percentage yield (APY). This procedure is repeated whenever a crypto asset is deposited or lent to the liquidity pool by any user.
In order to measure the returns earned on investments annually, including the compound interests, APY is used as the unit representation. The decentralized financial systems have a comparatively higher potential of earning APY than the traditional banks, which usually offer an APY of 0.06% approximately.
- DeFi Staking
There are a lot of similarities between staking and yield farming in the decentralized financial protocol. Staking functions as an incentive for the users so that they can keep their crypto holdings with them for a relatively long time. The users have to lock their assets or substitute them in order to become validators on the blockchain network, similar to yield farming.
The users can get the opportunity to earn rewards if they lock up their assets for a fixed amount of time using the staking process.
All this depends on the operator and the kind of offers he gives. Before the addition of any user as a validator, a minimum amount of tokens will be required by every blockchain. For example, 32 ETH is the token if staking is done on the Ethereum blockchain network.
In addition to that, there are two factors that will decide the earning potential of staking through the decentralized financial protocol. These two factors are the duration of the staking process and reward plans offered by the network.
Moreover, while providing monetary advantages, the blockchain network is further secured in addition to improvement in the performance of the projects.
- DeFi Lending
The various strategies that involve the concept of earning income passively using crypto assets are all summed up under the term lending. Using the smart contracts programmed beforehand, the lenders can interact with the borrowers directly in the lending process operating on a decentralized financial protocol.
Moreover, the crypto tokens of the investors can be listed using the lending platforms of a decentralized financial system. These tokens can then be borrowed as loans by users, and then they can pay them later with interest within the time fixed by the investor.
Not only are the risks integrated with lending in traditional financial systems eliminated while using smart contracts, but they also discourage the collateral requirements. But it should be kept in mind that background checks for preventing credit and risks of scams are not carried out by every lending application.
The borrowers are allowed to take crypto loans from the investors directly and then pay them back in a fixed amount of time with interest using the decentralized financial lending that serves as a peer-to-peer service for them.
Without any involvement of an intermediate body, users worldwide can distribute their assets and pool them using DeFi lending, unlike traditional financial systems. Moreover, it ensures transparency and rigid transactions for all parties using blockchain technology.
What are the Differences Between All Three DeFi Alternatives Used for Passive Income?
Some critical differences between yield farming, staking, and lending are mentioned below.
- Consensus Mechanism
All three methods yield farming, staking, and lending use the Proof of Stake protocol while operating on a decentralized financial system.
- Profit Margin
The profit that can be gained while earning passive income through a decentralized financial system is highest if one uses the yield farming method. On the other hand, DeFi staking and lending offer average profit margins to the users.
- Time Required
In order to carry out yield farming using the decentralized financial system, a more extended period of time is required to earn an appropriate passive income that is usually not fixed. However, in DeFi staking and lending, the time period is decided by the operator and is generally set.
- Risk Involved
If the customer opts for using yield farming operating on a decentralized financial system to earn passive income, he should keep in mind that it involves a higher risk factor. However, making passive income through DeFi lending involves a moderate risk factor, and the risk of any scam or fraud is relatively lower if one chooses for DeFi staking to earn income passively.
How to Initiate Earning Through DeFi?
As DeFi is built on smart contracts that operate on the Ethereum blockchain. The simplest method to begin is to invest in the native coin of Ethereum, which is Ether.
This investment may provide exposure to multiple projects in the crypto space and also help in upgrading the trade portfolio of the users. The experts believe that the simplest way to begin with DeFi is to adapt different methods present for earning passive income.
Risks Involved with Passive Income Based on Decentralized Finance
Although there are maximum chances of profit integrated with every type of investment, however at the same time, there are equal chances of risks involved when it comes to trading.
The most significant risk that comes with any trade is the risk of cybercrimes and scams. In addition, problematic and flawed smart contracts and the complexity of the trade process are also some of them.
Moreover, the reliability of the service provider is also an essential factor to be looked upon as the potential of risk also depends on the pool owner and his intention. Here are some critical risks that may create problems for traders thinking about earning passive income through DeFi.
There comes an integrated gas fee whenever one deals with smart contracts. The gas fee is similar to a token required to run a machine. As one proceeds in the trading process, earning passive income through the decentralized financial protocol might increase the cost ultimately.
Traders that have low budgets or beginners might find it costly. Some traders have claimed that it may cost about 200 dollars in gas fees for s single round trip.
Dealing with decentralized financial systems is not as easy as visiting traditional banks. Due to the numerous applications and investment opportunities available, a decentralized financial system may become difficult for beginners to figure out the better ones.
In addition, transferring funds could also prove overwhelming for some to initiate trading in the DeFi space. They have to move funds from any exchange to their wallet that is not under the custody of any regulatory authority.
- Scams and Fraud
As the profit potential in earning passive income through the decentralized financial systems is much higher than the traditional ones, cybercriminals and scammers have found their way out by seeking benefits by luring new customers with high offers and emptying their wallets within no time. Therefore, it is essential t check the credibility before falling for an extraordinarily high yield offer.
As some of the decentralized applications are vulnerable to coding, therefore, it is possible that some of the coins may also get stolen from the wallet. Moreover, there may be a chance that the user might lose access to his wallet and lose all his holdings.
As the number of tokens earned is considered during DeFi earnings, it is a possibility that one may lose in terms of profit due to the volatile nature of the crypto market during a bear market. The investors are advised to keep their tokens and wait for the market to rise again to earn maximum profits.
Although the downsides of market volatility can be compensated through earning income using yield farming, the investors still might face inevitable fluctuations that may lead to significant losses. It is possible that, in some cases, the investor may lose all his funds earned in a year in a single day.
- Fluctuation in Yields
As crypto assets are full of fluctuations, and one cannot predict anything about them beforehand; therefore, the yield earned through crypto trade cannot be predicted too. It is possible that as the supply supports a particular application, the yields for others might start falling.
- Dying Projects
Another risk involved with crypto income is that as a project’s core team pursues another better one, the present decentralized application may decline. The application will function the same way; however, there would be no better opportunities created for the users using it.
How to Keep Track of Trading Portfolios?
It might become difficult for investors to keep track of their wallets as several options are available for traders to earn income passively using the decentralized financial system. Therefore, certain aggregators or portfolio trackers are employed by some traders using a decentralized financial system.
These trackers help traders in the management and evaluation of their entire portfolio using a single dashboard. This is done by connecting the wallets to several different protocols.
By optimizing the methods used for obtaining profit, these yield aggregators maximize efficiency. There are multiple farms and vaults that might provide profit to the traders by integrating decentralized services into the business models.
In addition, integration between chains and connection between different wallets is also provided by some of the aggregators. These tools help analyze various aggregators by giving access to several chart views.
It is known as cross-chain technology when information and data are allowed to be exchanged between different multiple blockchains to increase the interconnections among them. This results in dispersion within the ecosystem linked with one another as it breaks the walled character of the blockchain network.
Moreover, potential returns in APY among all pools can be identified, and portfolios across all wallets can be tracked using cross-chain integrations. Using any of these strategies, users can earn passive income by leveraging their digital assets.
However, by supplying the required liquidity and capital to the crypto market in return for rewards, a critical service is provided to crypto markets without any involvement of intermediate bodies.
Traders need to beware of rug pullers and scammers or choose any project that may aim at asking for credentials again and again to steal their funds and assets. Therefore, before finalizing any platform or farm, one should look out for its credibility and reputation and make sure that the smart contracts offered by them are audited and published externally.
Therefore, it is always advised to traders to carry out thorough research before making any decision in the crypto space and gain a better understanding of the budding ecosystem before committing to any method of stacking, lending, or liquidity mining.
This convergence of decentralized financial systems and digital applications in the crypto space may provide many promising opportunities for investment for the traders as the potential gain earned through a decentralized system is much more than the traditional centralized financial systems.
However, traders are advised to make decisions carefully while dealing with DeFi systems and not fall for scams and frauds, as there is a possibility that one wrong move may result in the loss of all the crypto holdings earned through DeFi yield farming, staking, or lending.