– By Francis, Accountant turned Developer looking to shine a light on web3
So, you have some crypto, and someone on YouTube says, “this isn’t financial advice, but you can earn passive income if you do Staking, Farming, or provide Liquidity.” What do you do? Go YOLO on your newly acquired crypto and buy all the Futures you can get, or play it safe and understand what these new “passive income” options are?
The current banking system works becauseit’s centralized, but crypto aims to replicate this through innovative methods. Decentralized Finance or DeFi fits right into that by providing financial tools through smart contracts to its users without the interference of third parties such as brokers, exchanges, and banks.
Smart contracts are programmable agreements that automatically execute, and it governs how two or more parties interact with each other based on programmed conditions.
For any financial transactions to occur on any exchange, there must be Liquidity, and Liquidity in crypto means that participants can convert their coins into cash or crypto at any time without any delay.
Also Read: How to Buy NFTs in Kenya
There are a few DeFi tools that we can probably use to earn income on the side, but they do carry their risk as everything in finance.
Staking goes hand in hand withProof of Stake (PoS); by leveraging the finances of its participants to verify and secure the network, it allows the introduction of new transactions into the blockchain network. Users with the highest stakes are randomly picked to validate a Proof of Stake blockchain transaction.
In exchange for verifying the network by staking funds, participants earn rewards. The rewards are chain-specific; if you stake carrots, you get carrots; if you stake Cardano (ADA), you get back Cardano (ADA).
When staking, coins are generally locked for a specific amount of time, either 30 days or up to a year.
The downside of staking is that the value of the coins staked can go down during this period, and participants aren’t allowed to transfer or sell during that period. Even when it is removed, there is still an unlock period which is the time it takes for the funds to be accessible again.
This creates a reasonably useful source of passive income for participants. Risk and security can depend on how the smart contract was created if standard practices were not followed.
Risks:
- Slashing— cutting funds for verifying bad transactions
- Volatility Risk— prices go up fast and drop even faster
- Loss or Theft of Funds— wallet could be compromised and exposed to malicious actors
- Waiting Periods for Rewards— coins value drop while locked up results in reduced returns
- Liquidity Risk— low market cap of the token could make it difficult to sell or convert token
Yield is generally what someone makes from investing. Yield Farming adds funds to a decentralized liquidity pool to earn returns on your investment. We could do this on platforms like Pancake swap, Uni Swap, and 1Inch.
This creates a convenient way to earn passive income through a liquidity pool of crypto assets.
Through the power of smart contracts, investors can lock their assets in a Liquidity Pool. While it is locked, other users can borrow the assets from that pool, and investors are rewarded with an Annual Percentage Yield (APY). It is the foundation as it facilitates exchange and lending services. It also maintains the Liquidity of the assets on different decentralized exchanges.
Automated market makers control yield farming. This sophisticated smart contract facilitates automated crypto trading by using a liquidity pool, allowing no human error during the processing of the transactions. One major risk occurs in creating the smart contract due to human error or malicious code. Liquidity is maintained in this pool as it does not require there always to be a buyer or seller on the opposite end of the transaction.
Major features of the AMM smart contract are:
Liquidity Provider-the investors that contribute their crypto to the liquidity pool with the desire to earn interest from it.
Liquidity Pools— contain the funds that aids users to buy, sell, borrow, lend, and swap tokens.
Risks:
- Impermanent Loss— crypto is volatile by nature; the value of coins could go down while it is being held, resulting in some loss.
- Contract Risk– contracts could have bugs that result in Loss of funds.
- Rug Pull— developers take investors’ funds and abandon the project.
Inventors who participate in a liquidity pool offer their assets to be used in crypto trading and not lending or borrowing. They contribute Liquidity to the network of cash flow within the network. Otherwise, there might not be enough cash moving through the network at a given time, hindering fast buying and selling.
The investor provides two assets in the form of trading pairs (coins that can be traded for each other), e.g., ETH/UDST or USDT/MATIC, and as a reward, they receive liquidity tokens (LP). They also get rewarded with governance tokens created when a new block is added to the chain. Governance tokens allow holders to vote and make decisions on the smart contract when issues arise and decide on changes when needed.
The rewards rate is based on their share of the total liquidity pool.
Governance tokens can be exchanged for rewards or cryptocurrencies.
Risk:
- Impermanent Loss— crypto is volatile by nature; the value of coins could go down while it is being held, resulting in some loss.
- Contract Risk– contracts could have bugs that result in loss of funds.
- Rug Pull— developers take investors’ funds and abandon the project.
All the options provide ways of creating income for their users. Before anyone rushes in to use these investment tools, they should have at least a baseline understanding of what is happening instead of only looking at how much returns they can get. Knowing it is profitable is one thing, but understanding it risks risk and functionalities is valuable as well.
