A successful application of blockchain technology, decentralized finance (DeFi), offers a possible substitute for conventional finance. DeFi, as its name suggests, is an umbrella word for various financial services and solutions that utilize decentralized blockchains.

The goal of DeFi apps (DApps), historically supported by traditional financial institutions like banks, is to do away with the middleman in financial transactions. This is achieved by the technology’s use of a blockchain-based trust mechanism, which permits safe peer-to-peer (P2P) transactions without the need to pay a fee to the bank.

Decentralized finance’s expanding use cases have created new opportunities for passive income for DeFi investors. Investors must commit their DeFi assets as resources to approve transactions and carry out procedures over the proof-of-stake (PoS) consensus mechanism to generate passive income.

Let’s examine the numerous DeFi-based passive income alternatives that are available.

DeFi yield agriculture (liquidity mining)

Yield farming, also known as liquidity mining in DeFi, generates more cryptocurrency income from already-existing crypto assets. To use yield farming as an investing strategy, investors must stake or assign cryptocurrency to a liquidity pool powered by smart contracts. The pool gives the user a portion of the obtained fees as rewards and repurposes the invested cryptocurrency to offer liquidity for DeFi protocols.

Ether (ETH) and other ERC-20 tokens are accepted for investments and rewards on DeFi yield farms. In DeFi-based passive income, yield farming is one of the riskier investments since it is set to generate the best yield or return possible.

On decentralized exchanges (DEXs), liquidity pools are used to enable cryptocurrency trading. These liquidity pools offer a “yield” or money for completing duties like confirming transactions. The smart contracts’ tactics will determine each pool’s yield success. The reward will also depend on how much the user puts in tokens in the liquidity pool, measured in money.

The operator or the farmer seeks to redistribute the assets with the end goal of the maximum annual percentage yield when a user deposits or lends cryptocurrencies to a liquidity pool (APY). The annual percentage yield (APY) is a metric that expresses the annual investment returns, including compound interest. Traditional banks typically provide savings rates of 0.06 percent annual percentage yield (APY), while DeFi has a far higher potential.

Staking DeFi

Staking in DeFi is similar to yield farming, encouraging users to keep their cryptocurrency for extended periods. Users must deputize or lock up their crypto holdings to become blockchain validators, just like yield farming.

Users can earn incentives by staking their tokens for a predetermined period depending on the operator’s plans. Before a user may be added as a validator, every blockchain will require a minimum number of tokens, which in the case of the Ethereum blockchain is 32 ETH.

The network’s rewards plan and the staking length will also affect the predicted earning potential through DeFi staking. Staking directly contributes to further securing blockchain projects while enhancing performance, in addition to providing financial rewards.

DeFi financing

Lending is a catch-all word for various investing methods, including cryptocurrency-based passive income. Through pre-programmed smart contracts, investors can communicate with borrowers directly in decentralized or DeFi lending. In other words, DeFi lending systems let investors market their cryptocurrency tokens, which can then be borrowed by borrowers and repaid with interest within a predetermined time frame.

In addition to removing the risks involved with lending in traditional banking, smart contracts also do away with the need for collateral. However, background checks are crucial to reducing the dangers of fraud and bad credit and are not generally required for lending applications.

In exchange for prompt interest payments, DeFi lending acts as a peer-to-peer (P2P) service that enables borrowers to borrow cryptocurrency directly from other investors. Smart contracts, as opposed to conventional loans, enable people worldwide to pool and distribute crypto assets without needing a middleman. Additionally, the blockchain technology that underpins them guarantees transparent and unchangeable transactions for all parties concerned. 

Risks of passive income based on DeFi

Every type of investment has variable levels of risk, usually along with a possibility to profit that is just as rewarding. The biggest threats to DeFi-based earning opportunities include con artists, hackers, and shoddy or too optimistic smart contracts.

DeFi-based rewards are based on the number of tokens gained. Therefore price volatility of cryptocurrencies during a bear market could result in a loss in terms of profit. Investors frequently cling onto tokens in these circumstances until the market price soars and they realize unrealized gains. Additionally, the intention of the pool owners can affect the risk in the DeFi investing strategy. Therefore, it is crucial to investigate the legitimacy of the service providers using past payouts.

Also, read – Importance of Total Value Locked (TVL) In DeFi protocol

Monitoring your investments

Keeping track of your several wallets across various platforms can be a bit of a bother with DeFi’s abundance of passive income opportunities.

Since you can review and manage your whole portfolio from a single screen, many DeFi traders now use portfolio trackers or aggregators, which connect to several protocols and wallets. Yield aggregators optimize the ways of making money to maximize efficiency. It might consist of many farms and vaults that make money from various decentralized services using different business models.

Other aggregators go so far as to offer cross-chain interfaces and numerous wallet connections, giving you access to chart views that instantly evaluate data from several aggregators. Cross-chain is a technology that improves the interconnection of blockchain networks by enabling the interchange of data and value. As a result, blockchains lose their walled nature, creating a linked, scattered environment.

Cross-chain interfaces also help you track portfolios across wallets and find potential APY returns across pools. Additionally, users can use one of these methods to leverage their digital assets and generate passive revenue. By offering much-needed capital and liquidity in exchange for incentives — all without the use of middlemen — they offer a crucial service to the cryptocurrency markets.

However, watch out for “rug pullers” and con artists who only want to take your locked tokens and redeem them at liquidity pools to siphon off your money. Check the reputations of the farms and platforms you plan to use and see if they have any published, externally reviewed smart contracts.

As a result, investors are recommended to conduct in-depth due diligence on all parties before joining liquidity pools, staking, or lending. To start, read Cointelegraph‘s primer on the fundamentals of DeFi to learn more about the nascent ecosystem.