Introduction
Passive income has become a buzzword amongst influencers and entrepreneurs. Warren Buffet outlines its basic premise in his famed quote: ‘‘If you don’t find a way to make money while you sleep, you will work until you die.’’
It is best understood as a type of income acquired with minimal – or in some cases, no – labor. Broken down to its fundamentals, it is the practice of using existing assets to generate further assets. The nascent and ever-growing world of DeFi has opened up limitless opportunities for investors looking to earn passive income. This article provides general strategies for investors who want to put their DeFi assets to work.
What is DeFi?
Setting the scene. Bitcoin represents the first peer-to-peer electronic payment system that allows the trustless transfer of value between two unknown parties without a centralized intermediary. Ethereum represents the first Turing-complete blockchain; it can understand agreements and implement future agreements. This means Ethereum can use code to perform tasks with the only prerequisites being correct instructions, sufficient processing power, and sufficient time. The implementation of smart contracts, a program that runs on the Ethereum blockchain, has broadened the horizons of the crypto space to an almost unfathomable extent and birthed an entirely new financial system collectively termed “DeFi.”
Decentralized Finance, or DeFi, is the umbrella term for decentralized applications that provide financial services on the blockchain. At its core, DeFi revolves around individuals autonomously using their money without the need for centralized entities to participate in financial services. In short, an alternative financial system that relies on programmable smart contracts instead of traditional intermediaries. Nansen provides a fuller overview here: What is DeFi?
One thing crucial to DeFi’s existence is liquidity. A financial system needs many things, but liquidity is the lifeblood; without liquidity, everything else fails. Centralized financial institutions such as commercial banks make money by loaning money out and collecting interest, this allows people to buy something they cannot afford such as a house, and the borrower pays back the principal plus interest. Banks are distributors of capital, whereas within DeFi individuals take on this role. Individuals provide liquidity to protocols and become the financiers of this burgeoning decentralized landscape.
What are the Best Passive Income Strategies?
No hard and fast rules for the “best” passive income strategies exist, and what works well for one user may far exceed the ideal risk profile of another. If investors understand their financial goals and risk tolerance, selecting the best DeFi passive income strategy becomes far easier.
The following strategies require appropriate crypto assets and a non-custodial wallet, with the most popular being MetaMask which is available as a browser extension and mobile app.
Staking
Staking remains a great way to earn money in DeFi. Networks pay investors for providing security, and the greatest advantage of staking is that it only requires a single asset. Staking is ideal for investors who have conviction in an asset and plan to hold it long-term. Any blockchain that utilizes the Proof of Stake (PoS) consensus mechanism allows for staking. A brief distinction will be drawn here between validators and delegators. Validators run nodes responsible for validating transactions – this requires more capital and technical efficiency – and delegators delegate their stake to a validator node.
The PoS consensus model is the agreed rule for adding blocks to the network. The fundamental process of staking involves locking digital assets, and said assets are used to validate transactions, and each time a new block is added, the network gifts the validator responsible additional tokens.
In return for providing security services stakers receive coins from the network. Nansen provides a broader overview of this DeFi earning strategy: Nansen's Guide to Staking.
Additionally, many platforms offer users a portion of platform fees in exchange for locking up token supply. This mechanic is also referred to as staking, though in this instance the tokens are not used to secure a Proof of Stake system.
Pros
- Simple source of passive income
- Participants contribute to the security of the network
- Straightforward and easy to start
Cons
- Lock up times (Illiquidity)
- Volatility of staked asset
Best Platforms for Staking
Lido.fi
Lido has solved the greatest issue faced inherent to staking: that of illiquidity. The platform supports staking for Ethereum, Solana, Polygon, PolkaDot, and Kusama. Nansen’s dashboard shows that more than 84,000 participants have locked up a total of 4.38 million ETH. Investors can stake their ETH and receive stETH which can be used to engage in layered earnings. Unique to Ethereum staking is that ETH will not be unlocked until ETH 2.0 goes live, which has an estimated time horizon of 6 to 12 months. Lido allows investors to leave their staking position prematurely or hold onto their stETH and receive rewards daily.
Staking ETH is a fantastic passive income opportunity. Investors can generate roughly 5% APR (Annual Percentage Return) on a blue-chip crypto asset.
Pooled Staking Platforms
Investors who want to stake crypto are often best off staking ‘natively’. Interest rates are better, and the process philosophically aligns better with DeFi’s ethos with individuals staking rather than a semi-centralized solution. Cardano, Avalanche, PolkaDot, Cosmos, Algorand, and Elrond are some of the largest PoS cryptocurrencies offering staking opportunities. Investors must find the correct wallet, but the process can be worth it depending on each investor’s goals.
Centralized Exchanges
The leading centralized exchanges tend to offer staking facilities for investors uncomfortable taking ownership of their assets and wanting to earn yield with minimal exertion and oversight. However, these large nodes run counter to decentralization and arguably reduce a network’s security.
Nansen Opportunities
It would be impossible to list all the staking opportunities considering the breadth of DeFi, but Nansen’s DeFi Paradise Multichain comes closest. It displays the top staking contracts ranked by transaction volume. With liquidity begetting liquidity, this dashboard exists as a powerful tool in any investor’s arsenal for finding and executing staking opportunities.
Providing Liquidity
Liquidity mining is a necessary component for the operation of decentralized exchanges and a great way to earn passive income within DeFi. Investors contribute liquidity to liquidity pools on decentralized exchanges facilitating permissionless swaps. In return for providing this liquidity, investors are rewarded a percentage of the trading fees collected by the pool.
To understand liquidity mining, participants must understand how decentralized exchanges work. Centralized exchanges employ an order book model that matches buyers and sellers based on certain criteria. In contrast, decentralized exchanges use the automated market maker (AMM) model which enables automatic and permissionless swaps as traders interact directly with the liquidity pool. The more liquidity in the pool, the less slippage, and the better the trading experience. Therefore, decentralized exchanges incentivize investors to provide liquidity.
Liquidity mining exists on a spectrum from low risk to extreme risk depending on the pair used to create the LP (Liquidity Provider) token. Naturally, an increase in risk aligns with an increase in potential returns. Nansen provides complete guides to liquidity mining and the best decentralized exchanges: Liquidity Mining & Best Decentralized Exchanges.
Pros
- Source of passive income
- High potential returns
- Accessible to all levels of investor
Cons
- Volatility
- Impermanent Loss (the difference in price at deposit vs withdrawal which can outweigh the gains made from trading fees)
- Rug Pulls
Best Platforms for Liquidity Mining
Investors looking for liquidity mining options can search through hundreds of decentralized exchanges and all the pairings offered by these platforms, or they can use Nansen's DeFi Paradise Dashboard. This dashboard compiles the most active liquidity pools from on-chain data and delivers unparalleled market insight.
Nansen allows investors to identify the best liquidity pool based on their own criteria. Pools can be filtered by Net APY (Annual Percentage Yield), showing a liquidity pool’s actual return after the impermanent loss has been calculated. Investors with a high-risk tolerance can jump into these pools, grab the rewards, and then exit, deploying a mercenary strategy. Investors with a low-risk tolerance can find large, highly capitalized, and stable liquidity pools with little risk of impermanent loss. All are provided at a single point of contact. Nansen has also provided multi-chain functionality; investors can see liquidity pools across the entire DeFi ecosystem.
UniSwap
UniSwap pioneered the AMM model, one of the oldest and most established decentralized exchanges. It hosts a majority of the largest liquidity pools in DeFi. Many of these pairings are ETH or WETH (Wrapped ETH) with stablecoins. These pairings are stable with a low risk of impermanent loss. However, UniSwap does also provide more volatile pairings.
PancakeSwap
PancakeSwap launched in 2020 and has since become the most visited decentralized exchange. PancakeSwap is a fantastic option for participants with a higher risk appetite and those who want to avoid Ethereum’s gas fees. PancakeSwap also boosts specific pairings for investors who have time-locked the native token CAKE on the platform. Many investors opt for the CAKE-BNB pairing- currently paying out 22% unboosted and 43% boosted.
TombSwap
Further along the risk horizon is TombSwap. This decentralized exchange houses itself on the Fantom network and is part of the larger TombFinance seigniorage protocol- this is not recommended for new investors. The term ‘degen’ is crypto slang for degenerate, and this type of investor searches for maximum risk and maximum returns. The Fantom ecosystem attracts plenty of these characters and, although fraught with danger, can offer very sizable returns. TombSwap currently features some of the best yield farming returns within DeFi, with nearly 20% APR returns on stable pairs including its new L3USD stablecoin.
Yield Farming
Yield farming is the generic and wide-reaching term for generating yield with crypto assets. Lending, staking, and liquidity mining are all included in its definition, and it builds on the basic premise of interest payments for loaned assets. Except within DeFi the possibilities grow increasingly expansive as the sphere develops. Nansen provides a more in-depth guide on the basics and the best strategies for investors looking to generate returns with stable assets: Best Yield Farming Strategies & Best Stablecoin Yield Farming Strategies.
Pros
- Source of passive income
- High potential returns
- Accessible to all levels of investor
Cons
- Volatility
- Impermanent Loss (the difference in price at deposit vs withdrawal which can outweigh the gains made from trading fees)
- Rug Pulls
Best platforms for Yield Farming
BeefyFinance
BeefyFinance is a yield aggregator that auto compounds yield to maximize returns. BeefyFinance works across multiple chains and takes the yield earnings then reinvests them to maximize returns. This auto compounding protocol represents an incredibly low-touch passive income revenue stream.
Lending
Lending has been at the core of economic activity forever, and DeFi lending operates somewhat similarly to the traditional lending process of banks, except the loans are permission-less. Users deposit funds into smart contracts and are paid interest payments from borrowers who utilize the funds. Lending remains a straightforward passive income strategy involving a single asset that can be withdrawn at will by the depositor. Due to the over-collateralized nature of DeFi lending protocols and the absence of credit, these loans are typically safer than traditional loans with less risk of creditor default.
A key point investors should be aware of is credit utilization rates. The more utilized a pool the more attractive the supply APY. Investors who want to maximize returns should look for opportunities with low total supply and high utilization rates. As with any endeavor, the risk factor increases as the reward increases. For those curious to learn more, Nansen provides a more extensive guide to lending and the opportunities of arbitrage that flash loans made possible: Crypto Lending & Arbitrage on Decentralized Exchanges.
Pros
- Simple and flexible source of passive income
- Drives real-world economic activity
Cons
- Not all digital assets are eligible for lending
- Variable interest rates
Best platforms for Lending
Aave
Aave is the largest DeFi lending protocol and, along with Compound, has popularized non-custodial money markets. Investors can deposit their assets across a plethora of chains and receive a variable interest payment depending on the current utilization of the pool. Aave has recently announced they plan to release a decentralized stablecoin GHO. Investors will be able to mint GHO against their collateralized assets. These assets will continue to generate interest making GHO the first yield-generating stablecoin.
Venus
Venus is a DeFi lending platform based on the Binance Smart Chain. Venus allows investors to earn yield on a broad range of assets, some of which are unavailable on other platforms such as XRP & LTC. At the time of writing, Venus offers 1.91% on the USDC stablecoin.
Conclusion
DeFi has introduced autonomous asset management for individuals globally. By removing the centralized authorities who typically collect fees, DeFi instead lets investors collect these fees. And with so many options available, finding stable and dependable yields has become more complex, which is why investors who want to outperform the market must use blockchain analytics platforms like Nansen. Nansen synthesizes vast quantities of on-chain data enriched with millions of wallets for investors into simplistic visualized dashboards allowing them to spot opportunities others cannot.
DeFi’s need for liquidity constantly grows, and thus new opportunities present themselves. This novel strategy to bootstrap liquidity has led to a synergistic relationship between the services offered and the investors financing them, creating excellent passive income strategies for investors.
