Passive Income Strategies in DeFi
Now that we’ve covered the building blocks of DeFi and a few models for token valuation — let’s talk passive income strategies and their relative risk/reward profiles.
Lending
The process of locking up funds on P2P and pooled lending platforms for a period of time to earn interest.
- Difficulty: Low — Once you’ve acquired cryptocurrency holdings, you can passively lend and rely on smart contracts liquidation thresholds to preserve your initial loan amount and earn interest
- Profitability: Average (< 10% p.a.) — Interest rates can be fixed or variable based on current market rate and users can shop for the highest interest rates between platforms on Loanlist
- Risk: Average— While most lending products are currently over-collateralized and feature automated liquidations to protect lenders, the possibility of smart contract bugs and price volatility/opportunity cost while assets are locked (illiquid) should be considered carefully
- How to Get Started: Aave
Liquidity Provision
DEXs offer the opportunity for Liquidity Providers to deposit ETH and ERC20 tokens into a liquidity pool in exchange for a proportional amount of its trading fees.
- Difficulty: Low — Simply deposit an equivalent amount of ETH and an ERC20 token into the pool
- Profitability: Variable — Trading fee based rewards vary with exchange volume and total liquidity
- Risk: Average — Similar to lending, the primary risk in liquidity provision is price volatility. Proper hedging strategy can help offset volatility risk at the expense of profitability
- How to Get Started: Uniswap
Staking
The process of storing tokens in a specific wallet and performing various network functions to receive a reward. Staking is an alternative consensus mechanism to mining.
- Difficulty: Average — The degree of active involvement required to earn staking rewards varies by token, but can include functions like weekly minting/burning to maintain a specified collateralization ratio
- Profitability: High (5–60% p.a.) — Staking rewards are attractive but come with their fair share of risk. Current rewards can be sorted and analyzed on StakingRewards.com
- Risk: High— Due to the risk of slashing and the network activity required to remain eligible for staking rewards
- How to Get Started: Synthetix
Zero-Loss Lottery Pools
These pools are essentially savings accounts with weekly interest pooled and awarded to one lucky winner via lottery system.
- Difficulty: Low — Simply purchase digital lottery tickets via platform interfaces to enter for a chance to win
- Profitability: Variable — As with most lottery systems, profitability per ticket adjusted for the probability of actually winning is low
- Risk: Low — Given that the smart contract is bug-free, your capital will be returned in full at the end of the lottery period
- How to Get Started: PoolTogether
Options Trading
Options contracts offer the buyer the opportunity to buy or sell an underlying asset at a later date. In a sideways market, options can be used as an income strategy by selling covered calls.
- Difficulty: High — Due to the precise timing and execution required to trade options at a profit
- Profitability: Variable — Profitability of selling covered calls is dependent on the interest premium and price movement
- Risk: High — Due to the high degree of volatility in crypto markets, even skilled traders often fail to accurately predict price movement. Additionally, as Options aren’t widely available yet, there is platform and liquidity risk to consider when trading
- How to Get Started: Opyn
Node Operation
Running nodes is a technical process similar to running a server requiring the performance of several functions to maintain network uptime and capacity.
- Difficulty: High — Due to its highly technical nature, networks often only designate specific users with a proven track record and sufficient capital for node operation
- Profitability: Variable — Due to the significant upfront investment to become eligible for node operation coupled with network adoption risk, profitability may vary
- Risk: Variable — Risk is based on the competence of the node operator to avoid slashing and incentive structure of the network. Third party node infrastructure providers are also becoming available to mitigate risk and reduce operating overhead/expense
- How to Get Started: Edgeware
Mining
The process of using specialized computing hardware to solve complex cryptographic math problems to secure a blockchain network for a reward.
- Difficulty: High — The mining industry is dominated by corporations with significant resources to research and develop the required hardware
- Profitability: Low — Due to fully-scaled competitors and high-cost overhead
- Risk: High — While lower hash rate Proof of Work (POW) coins can still be profitable to mine for individuals, they are often subject to high price volatility and low liquidity
- How to Get Started: Ethereum (moving to Proof of Stake soon)
As with any investment strategy, it’s imperative to thoroughly understand the associated risks and implement best practices for downside protection. The information above is intended as a high-level overview and starting point to understanding the current risk/reward profiles of each passive income opportunity — as always, be sure to DYOR.
In my next post, I’ll describe how crypto traders are using DeFi primitives like leverage and flash loans to convert low margin arbitrage opportunities into highly profitable low risk trades.
Hope you enjoyed and thanks for reading!
Disclaimer: All of the information (above and linked) is for entertainment purposes only and is not to be taken as investment or financial advice.
