A beginners guide on how to Generate Passive Income via the DeFi route.

The world of Decentralized Finance has plenty in store for beginners to participate in the growing DeFi world. Users can use their crypto assets to generate passive income. They can commit their tokens to help secure the blockchain protocols in return for earnings on their deposited assets. So you get dual advantage of HODLing your favorite token as well as generating some returns on it. In the past few years, there has been a plethora of DeFi products that have entered the market, but before investing it is important to have a fair idea about different products as DeFi is not a get rich quick scheme. You may fall in a trap. By gaining knowledge about four of the most important methods, you can easily make some passive money with DeFi-

Lending

The most basic method even in traditional finance, if you have spare money you lend it out to a bank or an institution, you get an interest on this. In the same way, the DeFi world also leveraged this and primary protocols were based on lending. MakerDAO is one of the examples of an early DeFi project which had its focus on lending. Its amazing to note that the concept of DeFi loans is very simple and not at all complex as it sounds.

How do you start ?

You have to simply lend out your crypto to a platform. The platform will make use of smart contracts to lock the assets. The borrowers can access the funds from the platform as loans by keeping their other assets as collateral. With time the borrower has to pay back the loan amount along with interest. the interest is then distributed amongst the lenders in proportion of the assets they have locked. The smart contracts basically act as middleman or intermediaries to facilitate loans to borrowers and enforce interest repayments.
This is also one of the most trusted methods of DeFi since the process is quite straightforward and easy to understand. You have to simply lock your tokens to generate interest, you can also unlock them whenever you want. And yes, you get higher interest rates as compared to traditional lending!
You can try out Compound, which is a leading DeFi protocol. It offers upto 8.1% on various assets.

Staking

It is another common method for DeFi passive income generation. It is a form of consensus mechanism i.e Proof of Stake. Here the user locks in their token in a smart contract and in turn earns more of the same token. The token generally is the native token of the blockchain. For example ADA, the native token of Cardano. It simply implies that the user is placing their assets as stakes on the platform and in return the network incentivizes the users with the tokens of the network. You can think of it as opening a savings account on blockchain.


Apart from this, the contribution of the tokens in staking also determines the governance rights. The users with higher stake have the advantage of validating transactions of the network. Staking plays a crucial role in encouraging users to hold and stake their tokens for a longer period of time to earn rewards from the net revenue.
Interestingly in most of the Decentralized Exchanges which use AMM (Automated Market Maker) systems, allow the users to stake the native tokens. This kind of facility is also known as Savings Option. Using this option, a user can earn a share of revenue generated by all operations on the platform.
Example- The investor can earn from swaps on the liquidity pool. The rewards can be earned as additional tokens when the funds are withdrawn from the Savings Option.

Liquidity Providers

A promising DeFi method is providing liquidity. Decentralized Exchanges like Uniswap have become popular and successful with the adoption of AMM protocol. A DEX does not have an order book like a Centralized Exchange. A DEX generates a liquidity pool which comprise of various token pairs that have equally distributed values. The rise in equal value tokens pairs has helped establish the foundation for trading markets on a DEX.


You can easily access Liquidity pools on a DeFI platform and anyone can provide liquidity. A simple example would be that you can contribute $1000 by providing $500 in ADA and $500 in USDT. When you deposit or lock your tokens, you receive LP (Liquidity Provider) tokens which represent your total share in the liquidity pool. You can anytime redeem the LP tokens for unlocking your assets along with the income accumulated from exchanges in the trading pair.
The amount of assets in the liquidity pool determine how much of the share of swap fees you get.
The Annual Percentage Yield is higher as compared to other methods but it is also associated with a risk i.e. of Impermanent Loss. IL is caused due to high fluctuations in the price of pooled tokens.
There are some precautions which you can take to mitigate the risk-
1) Select Pools with high liquidity.
2) Select pools with stablecoins or less volatile assets.

Yield Farming

We learnt that you can provide liquidity to a DeFI protocol by locking your assets and in turn you get LP tokens. You hold your LP tokens and later exchange them to recover your original assets along with the rewards. But wait! You could do more. You can instead lock your LP tokens in Yield Farms, another form of a DeFi protocol and earn rewards.


You might be puzzled that its similar to staking and providing liquidity. So the major difference is that to become a yield farmer, you have to become a liquidity provider first.
But also be warned that you need to have due diligence while opting for yield farming. There maybe rug pulls where the developers can just compromise LP tokens for withdrawing liquidity from the exchange. Always stick to reputed platforms and don’t fall for greed with newer platforms that offer higher returns. You can even check the external audits of the smart contracts of the protocol to stay safe.

Conclusion

There are a lot of potential options to earn passive income with DeFi. The cryptoverse has completely revolutionized after DeFi has set in. The functionality and value of crypto has changed. It has opened up opportunities for accessing financial services in the Decentralized world.


Sign up on CoinDCX now, the leading Indian Crypto Exchange.

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