Earning Passive Income | Through Staking, Liquidity Pools and Lending
We’re often looking for ways to make our money work harder for us. Earning passive income is one of the drawcards of owning cryptocurrency. Just like earning interest on your traditional finance(TradFi) savings, there are methods outside trading or investing that could increase crypto holdings.
Alternative sources of income can help with periods of loss, and potentially don’t require as much time and effort as other trading activities. However, like any crypto project or investment, earning passive income involves different levels of financial risk.
TLDR — three key ways you can earn passive income:
Staking — Locking funds in a crypto wallet to support security and operations of a Proof of Stake blockchain network.
Providing Liquidity — Providing funds to a liquidity pool on DEXs in order to help facilitate exchanges. You can earn a percentage from every exchange.
Lending — Peer-to-peer lending to other DeFi users to collect interest.
Key Differences Between the Three Methods
Doing more with your crypto can be rewarding, however, it’s important to do your own research, and understand the key differences and risks related to these methods.
Purpose and Availability
Staking has a unique role, as it has a technical role in transaction validation, and helping Proof of Stake blockchains remain secure, efficient and scalable. Instead of requiring expensive mining rigs to validate transactions, tokens are locked to help validate transactions. As Bitcoin and Ethereum 1.0 are built on a Proof of Work consensus mechanism, it did not support staking. The anticipated ETH Merge update from PoW to PoS has allowed users to stake their token and earn additional ETH.
Complexity and effort required
Typically providing liquidity requires more active management to switch between liquidity pools for higher reward, and yield farmers typically implement complex strategies. Providing liquidity can be typically more suited to those who are willing to take the effort to research and actively switch between pools.
Risk-Return
There are risk-return trade-offs for different methods of earning passive income. e.g. Providing Liquidity is typically more profitable, but holds higher risk.
1. Impermanence Loss — Providing liquidity can be profitable but also bears the risk of impermanent loss (in contrast to lending and staking). Impermanent loss occurs when the price of your tokens changes after you deposit them. The greater the change, the greater the potential loss. Providing liquidity typically has higher APY — with some platforms providing up to 75%-200% APY, whereas lending and staking typically pay between 3%-9% APY.
To understand impermanence loss, consider a scenario where you provide 1 ETH and 100 DAI to a liquidity pool where the deposited token pair needs to be of equal value, and you hold 10% of the total pool.
When a price change occurs, the liquidity pool would remove ETH and add DAI to maintain the 50–50 ratio. It can be seen that if you had decided to HODL instead of depositing into the liquidity pool, the value of the 1 ETH and 100 DAI would have been higher than what you were entitled to withdraw from the liquidity pool.
Impermanence loss example — assuming no fees
Liquidity providers are often rewarded with a proportionate amount of trading fees for adding assets to the pool, which can often offset impermanent losses. Uniswap, for example, charges a flat trading fee of 0.3%.
One way to lower impermanent loss is to provide liquidity to pools of tokens of similar volatility. Such as a USDC-USDT liquidity pool, or ETH-BTC liquidity pool.
2. Default risk — Like in TradFi, lending holds the probability of default risk where the borrower is unable to return your loan of principle and interest. DeFi Lenders don’t hold the risk of the counterparty being unable to make repayments, hence, it is important to do your research. You may want to look at platforms with a large user base and an established community. Research the loan repayment track records of any DeFi lender you choose.
3. Smart contract risk — A smart contract typically acts as a digital agreement that is enforced by a specific set of rules on a blockchain. They are typically used to lock funds for yield farming and lending. Smart contracts can reduce the need for intermediaries as it will be self-executed once the contract requirements are fulfilled. However, smart contracts are written by humans in code, and therefore open to vulnerabilities and bugs.
Platforms to Try
For Liquidity Pool
- Uniswap (Ethereum, Polygon, Arbitrum and Optimism)
- PancakeSwap (Binance Chain)
- Raydium (Solana)
For DeFi Lending
Staking
- Lido (Ethereum and Solana)
Finally, when evaluating passive opportunities and which channel to use, there are a few questions that are good to consider. We’ve made a short (and non-exhaustive) checklist.
- What security measures are in place? (E.g Security audits)
- What are the potential risks and rewards?
- Are there any insurance policies?
- Are there any lock-in periods?
- How do fees compare to other platforms?
- How volatile is the token you are investing with?
- Is it a scam/rug pull?
- Are there high gas fees?
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