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Decentralized finance, or DeFi, are financial apps that use smart contracts on the blockchain to bypass financial intermediaries. Users can lend, borrow, provide liquidity, trade cryptocurrencies, and earn triple-digit interest rates in this peer-to-peer system.
DeFi is the best way to earn passive income in crypto, with several ways to do it.
DeFi isn’t one app but an entire suite of apps with smart contract capability across many blockchains. Smart contracts are computer code, allowing users to avoid financial intermediaries.
DeFi applications include decentralized exchanges (DEXs), stablecoins, lending apps, “wrapped” tokens, and automated market makers (AMMs).
Decentralized exchanges are peer-to-peer marketplaces where traders make transactions directly with each other, not handing over crypto to a financial middleman. Smart contracts execute this through computer code.
Stablecoins are cryptocurrencies whose price is backed by a real-world asset to stabilize their price. These coins are commonly pegged to the value of 1 US Dollar. Stablecoins are typically controlled by a company or consortium of companies, like Circle with USDC.
Lending apps function like regular lending with users depositing assets to earn interest or borrow assets. Aave, an open-source and non-custodial protocol running on Ethereum, is an example of this.
“Wrapped” tokens
Blockchains do not naturally communicate with each other, which is a headache for users. For example, you cannot send Ethereum-based tokens to a non-Ethereum wallet address, which you may have found out the hard way if you’ve ever deposited Bitcoin to an ETH address or vice versa.
To alleviate this inter-blockchain problem, you can create a “wrapped” version of your Bitcoin for use on Ethereum or any other blockchain. An equivalent amount of bitcoin collateralizes this wrapped bitcoin.
AMMs allow digital assets to be traded in a permissionless environment and automatic way using liquidity pools instead of the traditional buyer and seller format. Liquidity refers to how easily an asset can be converted to another asset, usually fiat cash.
For AMMs, market liquidity is the ability of a coin to be bought or sold without causing a drastic price change. Each AMM has its own mathematical formula to determine the price of assets in the liquidity pool.
(Some of these DeFi tokens are the actual blockchain token, like AVAX and LUNA.)
Staking
There are two kinds of staking in crypto. You can stake coins to secure the blockchain in Proof of Stake blockchains, like Solana, Binance Smart Chain, and soon to be Ethereum. You can earn 5 to 10% interest through this kind of staking.
Some DeFi apps offer a form of staking. The AMM PancakeSwap calls it “Pools,” which you can see below. Stake a coin and earn interest in the native coin of the app. In the case of PancakeSwap, CAKE tokens are made every block. To counteract this inflation, deflationary games like the Lottery are used to burn tokens.
Liquidity Pools/Farming
Yield farming via liquidity pools is the best and most popular way to earn passive income with crypto. AMMs incentivize users to supply liquidity by distributing the trade fee amongst the liquidity providers in proportion to their amount of liquidity provided. This fee is typically .3%, with the AMM sometimes taking 10% of that fee.
Raydium, shown above, is a Solana-based AMM. Supplying RAY and ETH will earn 48% APR paid out in the native token of the AMM, RAY. Yields from supplying liquidity range from 10 to 100% or more for pools with less total value locked (TVL).
Buying DeFi tokens
If you don’t want to use DeFi apps, you can always buy their tokens. All centralized crypto exchanges offer a variety of DeFi coins, many with a heavy emphasis on Ethereum alts.
You can easily buy DeFi tokens through a DEX or AMM; you’ll only need the blockchain crypto of that dApp or a popular stablecoin like USDC or BUSD. There are a seemingly infinite number of DeFi tokens and apps to invest in.
Risk
Hacking is widespread in DeFi. DeFi can be hacked by exploiting code, causing your coins to disappear instantly. Many DeFi apps are non-custodial, meaning you retain custody of your coins, so be safe with your private keys.
To minimize this risk from hacking, stick with the most popular apps in terms of trading or liquidity volume. The risk of a large dApp like Uniswap being the victim of an exploit is less compared to a newly created or smaller-volume dApp.
The main risk of supplying liquidity and yield farming results from impermanent loss. Impermanent loss occurs when you provide liquidity to a liquidity pool and the price of your deposited assets changes.
The price of your coins may rise, but the value as a proportion of the liquidity pool may be less than the price of the coins if you had HODLed instead. This risk of impermanent loss can be offset by the double and triple-digit yields earned in these AMMs.
As with all investing, only invest what you can afford to lose.
