What is the DeFi A Beginners Guide to Decentralized Finance to Earn Passive Income?

The simplest way to earn a passive income through DeFi is to deposit your cryptocurrency on a platform or protocol that will pay you an APY (annual percentage yield).

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Decentralized finance (DeFi) is a successful application of blockchain technology that offers a viable alternative to traditional finance. DeFi, as the name implies, is a catch-all term for a wide range of financial products and services that operate on decentralized blockchains.

DeFi applications (DApps) are designed to cut out the middleman in financial transactions, which has traditionally been championed by traditional financial institutions such as banks. This is accomplished through the use of a blockchain-based trust mechanism that enables secure peer-to-peer (P2P) transactions without the need for a bank commission.

Growing use cases for decentralized finance have created new opportunities for DeFi investors to earn passive income. Investors must commit their DeFi assets as resources to confirm transactions and execute processes via the proof-of-stake (PoS) consensus mechanism in order to generate passive income.

Let's take a look at the various options for DeFi-based passive income.

DeFi yield farming (liquidity mining)

Yield farming, also known as liquidity mining in DeFi, is the process of earning more cryptocurrencies by mining existing crypto assets. Yield farming, as an investment strategy, requires investors to stake or delegate crypto assets in a smart contract-based liquidity pool. The pool repurposes the invested cryptocurrencies to provide liquidity in DeFi protocols and distributes a portion of the fees as rewards to the user.

DeFi yield farms accept ERC-20 tokens like Ether (ETH) for investments and rewards. Yield farming is designed to generate the highest possible yield or return and is one of the riskier investments in the world of DeFi-based passive income.

Liquidity pools are used to facilitate crypto trading on decentralized exchanges (DEXs), in exchange for a "yield" or payment for completing tasks such as transaction confirmation. The yield success of each pool will be determined by the smart contract strategies. Furthermore, the payout will be determined by the monetary value of tokens invested in the liquidity pool by the user.

When a user deposits or lends cryptocurrency to a liquidity pool, the operator or farmer intends to redistribute the assets in order to achieve the highest annual percentage yield (APY). The APY is a unit of measurement for yearly returns on investments, including compounding interest. Traditional banks typically offer an average savings rate of 0.06 percent.

DeFi staking

Staking in DeFi is similar to yield farming and thus serves as an incentive for users to keep their crypto for a longer period of time. Users must deputize or lock up their crypto holdings in order to become blockchain validators, similar to yield farming.

Users can earn rewards by staking their tokens for a set period of time, depending on the plans offered by the operator. Every blockchain will require a certain number of tokens before allowing a user to become a validator, which in the case of the Ethereum blockchain is 32 ETH.

Furthermore, the estimated earning potential from DeFi staking will be determined by two factors: the network's reward plan and the length of the staking. Staking directly contributes to further securing blockchain projects while improving performance, in addition to monetary benefits.

DeFi lending

Lending is a catch-all term for a variety of investment strategies involving passive income generated by cryptocurrencies. Investors in decentralized or DeFi lending can interact directly with borrowers via pre-programmed smart contracts. In other words, DeFi lending platforms enable investors to list their crypto tokens, which can then be loaned to borrowers and repaid with interest over a set period of time.

Smart contracts not only help to eliminate the risks associated with lending in traditional finance, but they also eliminate the need for collateral. Most lending applications, however, do not require background checks, which are necessary to mitigate credit and fraud risks.

DeFi lending serves as a peer-to-peer (P2P) service that allows borrowers to loan crypto directly from other investors in exchange for timely interest payments. Unlike traditional lending, smart contracts allow users across the globe to pool and distribute crypto assets without the need for an intermediary.

In addition, the underlying blockchain technology ensures transparent and immutable transactions for all parties involved. 

Differences between DeFi alternatives for passive income

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Risks of DeFi-based passive incomes

Every type of investment carries varying degrees of risk, but it is usually accompanied by an equally lucrative opportunity for profit. Scams, hacking attacks, and flawed or over-promised smart contracts are the most common risks in DeFi-based earning avenues.

Because DeFi-based earnings are proportional to the number of tokens earned, the price volatility of cryptocurrencies may result in a profit loss during a bear market. In such cases, investors typically hold the tokens until the market price rises, providing unrealized gains.

Furthermore, the risk in the DeFi investment strategy can be affected by the pool owners' intent. As a result, it is critical to investigate the credibility of service providers based on past payouts.

Tracking your portfolios

With so many different ways to earn passive income in DeFi, it can be difficult to keep track of all of your multiple wallets across various platforms.

As a result, many DeFi traders now use portfolio trackers or aggregators, which connect to various protocols and wallets and enable you to evaluate and manage your entire portfolio from a single dashboard. Yield aggregators maximize efficiency by optimizing profit-generating methods. It could be made up of hundreds of farms and vaults that profit from a variety of decentralized services with different business models.

Other aggregators even offer cross-chain integrations and multiple wallet connections, allowing you to access real-time chart views that analyze data from multiple aggregators. Cross-chain is a technology that allows for the exchange of information and value between blockchain networks, thereby increasing their interconnectedness. As a result, the walled nature of blockchains is broken, resulting in a dispersed but linked ecosystem.

Cross-chain integrations also help you identify potential APY returns across pools and track portfolios across wallets. Furthermore, any user can use any of these strategies to generate passive income from their digital assets. They play an important role in the crypto markets by supplying much-needed capital and liquidity in exchange for rewards — all without the use of middlemen.

Be wary of scammers and "rug pullers," as well as projects that simply want to steal your locked tokens and redeem them at liquidity pools, draining your funds. Make certain that the farms and platforms you use have a good reputation and that externally audited smart contracts have been published.

As a result, before committing to liquidity pools, staking, or lending, investors should conduct extensive research on the parties involved. To begin, read Cointelegraph's guide on the fundamentals of DeFi to gain a better understanding of the nascent ecosystem.

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