Ways of Generating Income with DeFi
In this blog post, we're going to talk about digital assets. And more precisely, about Defi (decentralized finance). If you're into technology or finance, you've probably heard about DeFi by now. It's been the hottest topic in the crypto space since the 2020 "DeFi summer" (prices rocketed gazillion times). At its peak in December 2021, the total value locked (TVL) in decentralized finance protocols reached over US$250 billion. At that time, it represented 8.2% of Crypto's total market capitalization, which peaked at around US$3 trillion in November 2021. Since the crypto winter began, DeFi has lost about 75% of its total TVL, which currently stands at US$66.6 billion.
The simplest way to earn a passive income through DeFi is to deposit your cryptocurrency onto a platform or protocol that will pay you an APY (annual percentage yield).
In a nutshell, you can buy digital assets (for example, ETH, USDC, USDT etc.) and deposit these assets to DeFi protocols, which enable you to earn yield. This can be not easy at first, but it's worth your time if you want to earn a higher return on your assets than holding money in your bank account.
This article is not a step-by-step guide. There are plenty of guides if you're interested in taking advantage of this opportunity (DYOR, not financial advice). But we'll review the four main ways to earn yield with DeFi protocols.
Lending is probably the easiest way to earn yield. You can deposit your crypto asset into a smart contract. The platform lends this asset out to interested borrowers. Usually, borrowers have to provide collateral in the form of another crypto asset (for example, you don't want to sell your BTC, but you can put it up as collateral you can redeem once you pay back the loan). The interest accrued will be distributed to you by the smart contract. The most known lending protocols include MakerDAO and Compound Finance.
Most DEXs use automated market makers (AMMs), whereby liquidity providers send their tokens into a liquidity pool to achieve this. Akin to traditional lenders and banks, providers offer their liquidity in exchange for interest. DEXs generate revenue by taking fees for every transaction.
Staking is the closest to what you'd call a savings account in traditional finance. You "lock" your tokens into the smart contract and earn a yield on that. In the Proof-Of-Stake algorithms, stakers also secure the network. For example, DEXes (decentralized exchanges and AMMs, for that matter) have their native token, which you can stake on their platform. The incentive here is the (partly) shared revenue of the platform, which the stakes receive as a reward. To learn more, check Uniswap or Sushiswap.
DEXs have liquidity pools, which are made up of token pairs of equal value. For example, take the token pair ETH and UNI. A liquidity pool should have an equal value of both. These liquidity pools are the trading markets and enable the loss of the order book mechanism centralized exchanges use to provide trading pairs.
These liquidity pools are public; you can provide liquidity by locking in token pairs of equal value. If 1 ETH = 1000 USD and 10 UNI = 1000 USD, then to be a liquidity provider, you'd need to lock in 1 ETH and 100 UNI tokens.
As a liquidity provider, you'll earn a fraction of the swap/trading fees that the pool generates. Liquidity providers can experience something that's called impermanent loss. Here's how Binance (the biggest crypto exchange) defines impermanent loss:
Impermanent loss happens when you provide liquidity to a liquidity pool, and the price of your deposited assets changes compared to when you deposited them. The more significant this change is, the more you are exposed to impermanent loss. In this case, the loss means less dollar value at the time of withdrawal than at the time of deposit.
Yield farming is connected to liquidity providing. Because when you provide liquidity, you usually receive LP tokens. These LP tokens represent your proportional shares in the liquidity pools. When you redeem your LP tokens, you will receive your initial contribution and any fees you've earned.
However, these LP tokens can be "farmed". It's the same activity as staking, but only for LP tokens. And many platforms enabling you to provide liquidity now will also allow you to farm your LP tokens. This means you can earn additional income. Sounds weird and even crazy? It is. But it's a way to earn income.
Is Generating Income with DeFi protocols legal in Estonia?
Yes, you can stake company funds and earn extra income via DeFi protocols. It can also be the company's main field of activity.
Do you need a license when investing in DeFi protocols?
No, you don't need a license unless you are using the company's funds. The company might require an investment licensee if you plan to onboard third-party funds. Still, if the funds came from the usual "FFF" (Friends, Family & Fools - people who are either close to you – or believe in your idea so much that they are ready to risk their own money on your dream), you don't need an activity license. Check out our FinTech Launchpad and get in touch to see how we can help and support you with your crypto activities.
Does Comistar Estonia support crypto investment, including DeFi, CeFi, and CryptoCrypto's trading?
Yes, we support crypto activity; we handle accounts for crypto exchanges to regular companies that invest and deal with Crypto. Some of our more prominent clients can be seen on our Cryptocurrency license webpage!
DeFi turns crypto assets into productive assets. Meaning, like rental income, it generates cashflows. Whether the underlying asset is fundamentally a good asset is a debate for another time. But it's good to be aware of the possibilities, as many people earn a lot of money using these new technologies.
As always with Crypto, whatever you decide to do, make sure the project is legit, and you can trust your money.