- Quick guide on how to earn passive income in DeFi.
Reddit channel user Primoss /defi shared a Fast guide on how to earn passive income in DeFi, to prevent users from making costly mistakes (gasoline or unwanted risks). If you just want a high Annual Percentage Yield (APY), this may not be for you.
What you need to keep in mind is that Not all passive income is created equal. The cited APYs are useless for comparison purposes in DeFi because they mean different things in different contexts. Let’s take a look at some popular “passive income” strategies and how APYs differ.
Loan APY
What is it? The easiest strategy to understand. You deposit your assets in a protocol, borrowers without permission take that capital in exchange for collateral and interest.
What are the benefits? Interest is paid on the same asset that was borrowed, so it’s great if you want to be exclusively exposed to one asset (eg lend ETH and receive interest on ETH). When markets experience high volatility, bid/loan APYs increase as traders take advantage of arbitrage or other opportunities and borrow more. This allows you to “safely” stand aside while earning interest
What are the risks? The quality of the collateral is the biggest risk. If someone borrows your ETH, but collateralizes it with 3 times the amount in RUGCOIN, the collateral ratio is negligible. RUG could go to $0 in an instant and faster than the protocol can liquidate the position, so the borrower keeps the ETH and you stand to lose it all.
The protocols reduce this risk by allowing token holders to vote on which assets are “safe”, but then we revert to centralized decision making. Sushi Loans allow pairwise lending so you always know what the collateral is backing the borrower; sadly, this model is not that big yet.
Single Cryptocurrency Staking APY
What is it? It is locking your asset to support a protocol/blockchain. Very similar to loans in that you earn a return on the same asset, regardless of its value in USD. You can stake ETH to secure ETH2, stake LUNA to secure the Terra network, stake SUSHI to earn SUSHI, or stake/block CRV to earn Curve fees. In most cases, you get a “receipt token” (eg: stETH, bLUNA, xSUSHI, veCRV) that represents your stake and can be redeemed for your base deposit + earned token at a later date.
What are the benefits? Most staking opportunities allow you to vote or even propose changes through governance mechanisms that will be proportional to your stake (similar to being a shareholder); in addition to obtaining a return.
What are the risks? When you stake your asset, you trust that the protocol will provide you with long-term value. RUG paying 8000% APY stake means nothing if the project doesn’t move forward. You will receive 9 times more RUG which is worth less and less over time.
Annual Interest Rate (APR) of Liquidity Funds (LP)
What is it? It consists of depositing (usually) two tokens that allow other people to exchange them. You are “creating the market” because you provide both tokens and facilitate trades of token A for token B and vice versa.
Traders pay fees (0.01% – 1%) and all fees are shared proportionally between all liquidity providers. Because you are on the supply side of the market (supplying liquidity), you have to be either extremely happy or extremely neutral to hold those two assets (eg ETH + BTC) in any ratio because as the prices of each move asset, the amounts of the assets you provided fluctuate constantly to maintain the value of the pool at 50/50.
The APR quoted is always based on the trading rates for the last 24 hours divided by the total value locked (TVL) in the same period multiplied by 365 days.
What are the benefits? You earn the trading fees. This is why you should look for groups that have high “historical” volume relative to TVL. A pool may have a high APR just because the volume on the last day spiked and induced them to invest. When markets are choppy and trading sideways, LPs are a great strategy because you profit from all the volatility (ie you sell volatility when it rises).
What are the risks? Transient gain/loss. As the amounts of tokens supplied fluctuate with market prices, it is likely that you will withdraw fewer coins from token A than you deposited in the event that token A increases in value against token B.
LP Staking APR
What is it? It consists of depositing your LP tokens with a protocol in exchange for rewards paid in other tokens. This is also called liquidity mining because you are rewarded for providing liquidity – “Proof of Liquidity”. The protocols do this to lock down LP positions and ensure that the protocol’s native token remains easy to trade.
The protocols decide how many of their own tokens they want to spend as liquidity rewards and decide how much over time. The quoted APR is usually calculated by taking the market value of the tokens sent as rewards to LPs, divided by the TVL. This means that if the protocol decides to send 1000 tokens to the ETH-BTC pool per week, the APR will be 1000*token price/ETH-BTC deposits. This is key because the APR is highly dependent on the value of the protocol token, so it can be misleading.
What are the benefits? If you really believe in the protocol, you can deposit your LP and farm your token instead of buying it (and then single stake that token for more rewards). Your LP position will continue to earn commissions, thus doubling your accumulated returns. Rewards APR may mitigate temporary loss.
What are the risks? The protocols play with the math of APRs and typically quote the APR for trading fees along with the APR for rewards. A healthy APR is made up of a higher Business Fee APR than a Rewards APR; otherwise it will not be sustainable in the long run.
In addition to the risks of a pullpull or more complex attacks, your risk is the opportunity cost of being lured into providing liquidity for the ETH-SHIT pair, staking for SHIT rewards, and losing money because the temporary loss will eat up your ETH and the rewards will be worth 0.
We hope this guide was helpful and now… Go trading!
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