A Beginner’s Guide to Generating Passive Income Using Decentralized Finance (DeFi)
Financial innovation has made decentralized finance (DeFi) a buzzword. DeFi is a general term used to define a variety of financial products and services that run on blockchains, and now encompasses everything from payment and transfer services to lending, borrowing and trading. It is a combination of technologies and business models that tackle existing problems in the financial market.
To understand what decentralized finance is, we must first understand what it is not. Unlike traditional finance which operates between savers and borrowers, DeFi seeks to eliminate third parties from the equation. To do this, the technology applies a blockchain-based trust mechanism, thereby enabling peer-to-peer (P2P) transactions without paying any fees to a third party such as a bank.
Here’s everything you need to know to generate passive income through DeFi.
Staking is the oldest and most basic method of earning cryptocurrency. It is the mechanism by which users can earn rewards by locking their assets. In decentralized finance, staking can be used to earn rewards for loans or for operating a decentralized exchange. For example, you can deposit Ethereum (ETH) and after a few months you will get more ETH rewards for depositing and supporting the DeFi exchange.
But why would you get more tokens? Well, there is a logic behind token staking. “Staking operates on a Proof-of-Stake (PoS) consensus mechanism which ensures that validators or “miners” who are responsible for verifying transactions do not trick the system. If they do, they may be penalized by losing part of their stake,” EasyFi Network, a decentralized finance platform, wrote in a statement to indianexpress.com.
It should be noted that every transaction on the blockchain ecosystem must be verified by “validators”. In exchange for verifying the transaction, they are rewarded with a “block” that awards them tokens, for their contribution to the security and decentralization of the network.
Passive income can be earned in different ways, one of which is by lending and borrowing digital assets on DeFi platforms.
EasyFi Network, for example, provides digital assets for borrowing and lending. But what makes it profitable? The platform notes that if you own Ethereum, you can either lend it to a platform and earn a fixed return, or exchange ETH for wrapped Ethereum (wETH) and use it as part of a DeFi protocol to earn an annual percentage return. (APY) from 0.5 percent to 8 percent. You can also borrow up to 75% of the value of your cryptos in exchange for secured loans. You can, in turn, trade or deposit these assets in a DeFi protocol to generate additional passive income.
Produce your own tokens
Producing your own token is a way to make money in decentralized finance. Creating your own token and allowing people to use it as a way to earn a return on their assets is a great use case for decentralized finance. Some people have created tokens that have their own unique function, such as serving as a vote in an organization. These people can make money by providing liquidity to other tokens. If someone is looking to trade tokens they own but can’t get rid of them easily, they can trade them for your token. If the token is accepted by other decentralized exchanges, those exchanges are likely to pay the token holder a small amount as a percentage of the profit they make.
Currently, investing in DeFi is done through yield farming, a method that works similarly to staking. However, unlike staking, it is based on something called Liquidity Pools (LP).
By locking up your assets, you earn something called LP tokens, which are needed to invest in DeFi products. You have the option to keep the LP tokens or exchange them for other cryptos and earn a cup. The final payout is determined by the monetary value of the tokens invested in the liquidity pool.
Development of smart contracts
Developing smart contracts allows you to create a custom use case for blockchain technology. If you develop a smart contract and deploy it on a decentralized network, you can earn money by charging developers for using your code.
“There are several ways to make money with smart contract development. You can offer your code for free and earn a share of the profits from your code. Or you can charge a one-time fee for a specific instance of code. The Staking is a way to make money with the development of smart contracts. If you develop a smart contract that allows you to earn a share of the profits generated by other decentralized applications, you are staking,” the platform explained in a communicated.
Every form of investment is subject to risk – and because blockchain is a nascent technology, it comes with varying degrees of risk. In DeFi, some of the major risks could come in the form of carpet pulling scams, but again, this could also happen outside of the DeFi space.
It is extremely important to check the reliability of any DeFi platform before investing in it, as you risk losing your profits if the market is bearish. DeFi gains are directly proportional to the number of tokens received, so you could also lose if the market is volatile. There is no room for opportunists in DeFi, as decentralized finance grows, individuals will have a fair chance to participate, resulting in many wealth-building opportunities that were previously reserved to the rich.