Everyone wants to make money on their investments, especially without having to do much. This is why many people like putting their money into things like savings or bonds that have stable and somewhat predictable returns. Passive income being earned through dividends on stocks also attracts a lot of investors for a similar reason.
Outside of traditional finance, passive income is actually quite easy to find through decentralized finance (DeFi) platforms. Things like providing liquidity and farming can give DeFi users returns that are exponentially higher than through traditional means, though not without some risks. In this guide, we’ll outline some of the easiest ways to make money through DeFi.
What is DeFi?
Decentralized Finance, or DeFi, covers a variety of decentralized applications (dApps). This includes financial services such as decentralized cryptocurrency exchanges (DEXs), lending platforms, yield aggregators, and automated market makers (AMMs). All these DeFi platforms provide users with opportunities to use their crypto to generate passive income returns, which attracts many users. You can do this by providing liquidity to a DEX/AMM, providing liquidity to a lending platform, farming, borrowing, and more.
Five Ways to Make Money in DeFi
Below we’ve outlined four of the best ways that you can make money by participating in DeFi. For each method we’ll discuss how it works, some platforms where you can do them, and the blockchain networks where they’re available. All 4 methods are actually somewhat similar, and can often be done in conjunction with one another depending on the platform. Let’s start with providing liquidity.
Providing Liquidity to a DEX/AMM
DEXs and AMMs are ostensibly the same type of platform. They are both user-funded and allow you to swap supported cryptocurrencies. Because the platform’s liquidity is provided by its users, rather than a centralized authority, they’re the ones collecting trading fees and/or commissions. Depending on the DeFi platform and the position of the user, it can be extremely worthwhile.
Providing liquidity means providing either a pair of assets in equivalent dollar amounts to a decentralized exchange (DEX) such as Uniswap, or providing a single asset to a decentralized lending platform such as AAVE (more on this later).
By providing liquidity in a pair to a DEX such as Uniswap, you earn a prorated share of the trading fees earned by the pool which you deposit into. For example, you can provide liquidity to the ETH-WBTC pair on Uniswap, and you’ll then earn both ETH and WBTC in trading fees as trades are made by other users. Of course, the more liquidity you provide, the higher the share of the fees you’ll receive.
Popular DEX/AMMs
Below are some popular DEX/AMMs and the networks they can be found on:
- Uniswap (Ethereum, Arbitrum, Polygon, Optimism, Celo)
- PancakeSwap (Binance Smart Chain (BSC), Aptos, Ethereum)
- SushiSwap (18 networks including Ethereum, Arbitrum, Polygon, BSC, Fantom, Avalanche, and Harmony)
- Balancer (Ethereum, Polygon, Arbitrum)
Farming
Farming is similar to providing liquidity, and in some cases the term is used interchangeably. However, it’s not exactly the same as providing liquidity and not all platforms offer farming. Generally speaking, farming means providing your liquidity to a specific pool only, and in exchange you earn an extra reward in the form of the platform’s token. For example, on PancakeSwap, you earn CAKE (PancakeSwap’s asset) from providing liquidity to specified pools (but not all pools). This means, if you provided Binance Coin (BNB) and USD Tether (USDT) to PancakeSwap, you earn BNB, USDT, and CAKE.
In contrast, Uniswap doesn’t offer farming, so you’d only earn the two assets you provide. The draw for providing liquidity to Uniswap over PancakeSwap is trading volume, which is much higher there, meaning more fees for liquidity providers to collect.
Popular Farming Platforms
- PancakeSwap (BSC, Aptos, Ethereum)
- Minswap (Cardano)
- SushiSwap (18 networks including Ethereum, Arbitrum, Polygon, BSC, Fantom, Avalanche, and Harmony)
- SUN (Tron)
Providing Liquidity to Lending Platforms
Providing liquidity to a lending platform means providing a single asset to a decentralized lending platform such as AAVE or MakerDAO. You then earn a rate of return that is based upon supply and demand for that asset, meaning how many other users are providing it, and how many users are looking to borrow it.
For example, if you’re providing ETH to AAVE, there is already so much supply that the return is barely 2%, but there is more demand than for WBTC, which has a return of 0.02%.
Popular Lending Platforms
- AAVE (Avalanche, Optimism, Ethereum, Polygon, Fantom, Harmony, Arbitrum)
- MakerDAO (Ethereum)
- JustLend (Tron)
- Compound (Ethereum, Polygon, Arbitrum)
Borrowing from Lending Platforms
This is a somewhat more complicated and risky way in which to make money in DeFi. Though you receive an APR from providing liquidity to a lending platform such as AAVE, as seen earlier, the return is often fairly low.
However, because it is a lending platform and you’ve provided collateral, you can also borrow assets. This incurs an APR which you have to pay back, but it means that you can potentially buy an asset using a loan, make money on it, take the profits, and then pay back the loan. This can be quite lucrative depending on how well you play the market, or quite devastating if you do it poorly.
Liquid Staking
Liquid staking is a form of staking that allows you to still trade and move assets that you’are staking. A more typical form of liquid staking is Cardano (ADA) protocol staking, where you can freely trade or sell your staked ADA at any time, and your rewards are prorated based upon your running ADA total during the staking period, which is 5 days.
Liquid staking is available for a variety of digital assets, with platforms such as Lido taking a commission in exchange for providing you with staking infrastructure. For example, when you stake ETH on Lido you receive stETH (Staked Ethereum). This stETH entitles you to the redemption of your ETH rewards and your staked ETH when you want to withdraw them, but is also a tradable token that you can also buy or sell. If you sell or trade all your stETH it means you can’t withdraw any ETH from the pool. Conversely, buying more stETH on the market would entitle you to a greater redemption of ETH.
Popular Liquid Staking Platforms
- Lido (Ethereum, Solana, Moonbeam, Moonriver, Terra Classic)
- Rocket Pool (Ethereum)
Are There Risks to Participating in DeFi?
Yes, there are certainly risks to participating in DeFi. The two biggest risks are impermanent loss and protocol hacks/smart contract bugs.
Protocol Hacks/Smart Contract Bugs
This risk depends on the security of the platform and its smart contracts. There could be weaknesses in the platform’s code that allow hackers to expose vulnerabilities and affect users’ holdings. Newer platforms and bridges tend to be the target for hackers because they frequently miss issues in their code during audits. It’s likely best to stay off newly launched platforms until they’ve been proven safe. A platform like Uniswap is perfectly safe to use as it has been around for years without incident
Impermanent Loss
Impermanent loss means that the amount of tokens you deposited into the pool may not be what you get back. It occurs when you provide liquidity to a liquidity pool and the dollar value of your deposited assets changes compared to when you deposited them. The bigger the change in value, the more you are exposed to impermanent loss.
For example, when you deposit ETH and USDT into a liquidity pool and the value of ETH goes up, the pool automatically adjusts ratios of each asset in the pair as their prices change, resulting in differing amounts when you withdraw. In this scenario, you’d end up with more USDT when you withdraw than you had started with, and less ETH. Whereas, if you’d just held the ETH in your wallet, the value of the ETH would simply be higher and you’d have the same amount. This is what makes it a “loss”.
It’s important to remember that impermanent loss can easily be offset depending on the rate of return the pool is providing. If you lost 10% of your ETH but made a 20% return, you still made 10% overall. Impermanent loss also doesn’t occur until you actually remove the liquidity from the pool either, as pool values could balance out over time even if they’re currently skewed one way or the other. Liquidity pool pairs with fairly stable dollar values will experience far less impermanent loss than ones that are very volatile as well.
Just be sure to be aware of the risks in DeFi before jumping in, or you could be in for a surprise.
