While it may initially seem like a distant or even utopian scenario, the reality is that this shift is already underway, and it is not a recent development. Since 2019, with the emergence of decentralized lending platforms driving the initial growth of the DeFi sector, new opportunities to generate returns in DeFi from digital assets have emerged.
By depositing cryptoassets in smart contracts linked to a decentralized protocol, some investors have experienced annual percentage yields (APY) that far exceed the interest rates offered by the traditional financial sector.
However, it is crucial to understand that this is not a simple path. Participating in DeFi protocols requires patience, caution and a basic understanding of how to connect a Web 3.0 digital wallet, such as MetaMask, to a Decentralized Exchange (DEX) such as Uniswap.
The following are the main ways to generate passive income through decentralized finance protocols.
The first trials in the field of Decentralized Finance (DeFi) were conducted through lending protocols, notable examples being pioneering platforms such as MakerDAO. The premise is clear and straightforward: investors lock their assets into a protocol-specific smart contract, thus creating a pool of liquidity. Borrowers can access these funds by paying interest to the protocol, and the smart contract distributes the interest earned among lenders in proportion to the assets they locked.
This option is attractive, especially for those with little or no experience, due to its simple mechanics. Depositing and locking tokens are instantaneous processes, as is the reverse operation.
The annual percentage yield (APY) is usually more beneficial than the interest offered by the conventional banking system. An additional advantage is the low risk of default, since borrowers must offer assets as collateral that are incorporated into the smart contract, thus ensuring payment of the interest due.
As an example, the Aave protocol, based on the Ethereum network, presents a competitive APY for different assets, while Compound offers a wide range of options for those looking to diversify their lending portfolio. Find out more about Aave and Compound.
Within the field of cryptocurrencies, the term "staking" comes from the consensus mechanism called "Proof-of-Stake" (PoS), where the validators that ensure the security of the network have more influence according to the number of tokens they hold.
However, since most current DeFi protocols are based on networks such as Ethereum or Binance Smart Chain, with different consensus models, staking simply refers to locking assets for an extended period of time in exchange for participating in the revenue generated by the network.
We could equate staking with opening a kind of "savings account" associated with a specific blockchain, where the investor's funds are locked in a smart contract.
Most decentralized exchanges offer the option of staking their own native token. For example, on Uniswap, the leading DEX in the market in terms of trading volume, staking of the UNI token is possible. These tokens typically earn a portion of the revenue generated from the use of the exchange's products and services, and this revenue is partially distributed to investors when funds are unlocked.
In addition, Ethereum has already migrated from the Proof-of-Work consensus model to Proof-of-Stake. In this new phase, those willing to block 32 ETH for each node they wish to execute will be able to become network validators.
Liquid Staking allows users to stak assets in networks using Proof-of-Stake (PoS) without the need to completely block their funds. Protocols such as Lido allow users to liquid staking Ethereum, meaning they can obtain a token representing their stake, which is exchangeable and usable on other DeFi platforms. Rocket Pool is another prominent protocol, allowing Ethereum users to do staking of amounts less than 32 ETH and receive liquid tokens in return. Find out more about Liquid Staking protocols in our article.
DEXs stand out for operating without an order book, unlike centralized exchanges. They use a system called Automated Market Maker (AMM), in which liquidity pools replace the traditional order book. These pools are composed of pairs of tokens of equivalent value.
Liquidity pools are open to the public, allowing any investor to become a liquidity provider by locking a specific pair of tokens into a smart contract. For example, if 1 ETH is worth 3,000 USDT, in the traditional way of providing liquidity the investor must provide both tokens in equivalent proportions, such as 2 ETH and 6,000 USDT, and so on.
By committing a pair of assets in a liquidity pool, the investor receives specific tokens linked to that transaction. Upon redemption of these tokens, the amount invested is returned along with the income generated by the transactions within the pool, if not previously claimed.
Providing liquidity in DEX such as Uniswap and SushiSwap allows investors to lock a specific pair of tokens into a smart contract, and in return receive a proportion of the commissions generated. This investment method allows for attractive APYs, although there is a risk ofImpermanent Loss. Velodromea DEX based on Optimism, also uses this AMM system to enable the provision of liquidity of token pairs.
Cross-chain or bridging refers to the provision of liquidity for the transfer of assets between different blockchain networks, facilitating interoperability between different chains. Although often used interchangeably, they have a subtle difference: bridging refers specifically to transferring assets or data between two chains via a "bridge," while cross-chain refers to general interoperability between blockchains, encompassing other forms of interaction.
Protocols such as Across y Stargate are examples of platforms that enable the efficient and secure transfer of assets between different networks. Investors providing liquidity to these bridges can generate returns in DeFi in return by facilitating asset mobility in the DeFi ecosystem. Learn more about Cross-Chain related platforms in our article.
It is a more comprehensive strategy than simply providing liquidity, as it involves active participation in various DeFi protocols to maximize returns on digital assets.
This tactic enables investors to generate returns in DeFi by providing liquidity. Liquidity providers receive a specific token that represents their participation in a particular pool. Many DeFi platforms offer "farms" where investors can deposit these tokens, earning returns for their participation. This process resembles the principle of gambling, but is exclusively available to liquidity providers.
Given the diversity of investment modalities and protocols available, tracking the performance of a DeFi wallet can be challenging. Aggregator platforms like Debank make this task easier by offering integrations between various blockchains and connections to multiple digital wallets, simplifying access to real-time data and helping to identify the best performance opportunities in the market.
Providing liquidity is only the first step. Protocols such as Beefy y Gamma allow investors to do yield farming by optimizing their rewards through auto-compounding strategies. This maximizes returns, although it requires more advanced knowledge to manage investment strategies efficiently.
These are the most popular methods of generating passive income through the decentralized finance ecosystem. Allocating digital assets in exchange for income is a key practice to increase liquidity and working capital in the cryptocurrency market. However, one must be careful and watch out for scams and disreputable protocols.
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