Posted 9th August 2023

Passive Income in DeFi: A Beginner’s Guide to Yield Farming & Staking

passive income defi a beginners guide

In recent years, earning a passive income in the Decentralised Finance (DeFi) space has become very popular. DeFi has given people the opportunity to earn higher returns than on savings accounts and other investments.

In this article, we explain the different types of passive income available for crypto investors.

5 ways of earning passive income with DeFi

DeFi provides investors with five ways of making money from crypto. Let’s have a look at how they work.

1. Yield farming

DeFi yield farming allows users to earn a return from lending their crypto assets to other users. Yield farming in DeFi is sometimes called “liquidity mining”.

With this type of trade, everyone wins – yield farmers and borrowers. Yield farming lets lenders earn interest on their loans and borrowers benefit by having access to the funds they need.

AAVE is a great example of how yield farming works in the real world. AAVE is a DeFi platform that allows users to lend and borrow cryptocurrencies. Many consider it the best yield farming DeFi app, although many others are available.

You can access the best DeFi yield farming rates on apps like AAVE.

There have been other exciting, new DeFi yield farming developments that have come to the market.

They include:

  • Compound: This platform rewards token holders with its native COMP currency for lending and borrowing.
  • Uniswap and Balancer: They offer fees to users for adding assets to their liquidity pools.
  • Curve Finance: This automated market maker (AMM) focuses on trading assets with the same value. You get additional rewards for staking your assets on Curve’s liquidity pools.

Synthetix offers its own platform-specific SNX rewards. Ampleforth offers AMPL tokens if you add funds to pools that contain AMPL and WETH (wrapped Ethereum). This helps the pool ensure there are enough funds for others to trade between AMPL and WETH for which you get rewarded. 

Some platforms also offer governance tokens to incentivise yield farmers. Governance tokens give you the right to take part in decision-making on a DeFi platform or blockchain.

The release of bonus tokens by DeFi platforms has helped yield farming become more profitable. Kinesis’ crypto analyst Sean Dickens writes: 

“These tokens were designed to incentivise users to participate in the platforms and offered rewards in these native tokens for doing so. Yield farming allowed users to earn even more rewards by utilising these tokens in other farms – generating even greater rewards for users.”

While you can make good profits, investors should also consider the risk of significant losses due to market volatility. 

2. DeFi mining

DeFi mining is complementary to yield farming and it builds on its foundations. It offers digital asset holders another way to earn more money.

In DeFi mining, users provide liquidity to a particular DeFi protocol. This is often in the form of an asset pair, usually two different cryptocurrencies like Ethereum and a stablecoin such as USDT. This makes it easier for others to trade between the two cryptos in the pool. To encourage users to add liquidty, they earn extra rewards.

In many cases, the rewards are the protocol’s native tokens. However, users can also earn rewards in other tokens as part of promotional events or partnerships.

3. DeFi APY

In both yield farming and mining, an important metric is the APY, short for Annual Percentage Yield. 

APY is the expected rate of return or yield on a cryptocurrency investment over a year. APY figures also take compounding into account.

So, if a DeFi protocol offers an APY of 10%, the initial deposit will increase by 10% over 12 months. However, that’s only if market conditions remain constant over that time and users don’t withdraw their deposited funds.

Platforms like Uniswap encourage users to provide liquidity by putting their assets into a liquidity pool. In return, they reward these users with a cut on the fees generated from trades that occur in the pool. 

Returns vary depending on trading volume and volatility in the pool. To help users estimate actual returns, they can use analytics tools like UniswapROI and DeFiPulse. They analyse historical data and current market conditions to provide earnings insights.

While the APY is an important consideration, users should weigh the potential risk of impermanent loss. This is where the value of assets you provide as liquidity changes which can lead to both profits and losses. 

4. Defi crypto staking and yield staking

Defi staking is when users voluntarily lock up their digital assets within a DeFi protocol.

DeFi staking is similar to yield staking but it’s a bit broader in scope. With yield staking, users take part in Proof-of-Stake (PoS) or Delegated Proof-of-Stake (DPoS) activities. They stake their crypto which the network then uses on essential operations like block validation.

In both DeFi and yield staking, the blockchain networks might require users to subject their staked assets to a “lock-up” period, which means users can’t move or sell their assets for a set period of time.

The lock-up period of time may be non-existent or up to several years. By doing this, they give the network or liquidity pool greater stability and security.

Both DeFi and yield stakers earn rewards in return for their commitment, typically in the form of additional tokens. 

Staking has grown more popular ever since the 2022 changes to the blockchain technology of the Ethereum network. The network moved to a Proof-of-Stake mechanism, which made earning passive income easier and more reliable.

5. Borrowing and Lending dApps

The APYs users enjoy when employing farming, mining and staking DeFi techniques can be very impressive. They’re often better than they’d get from traditional financial services providers.

To make sure the loans users make to DeFi apps and networks are secure, both employ over-collateralisation ratios.

AAVE, covered earlier in this article, does this too. Users can earn interest by depositing cryptocurrencies into AAVE liquidity pool. Borrowers can access these pools to borrow cryptocurrency at favourable rates. 

Borrowers however need to provide collateral that’s greater in value than the amount they want to borrow. That’s how DeFi apps and networks provide a safety net to their lenders.

For those new to DeFi, investing in Ether (ETH) could be a good option as most DeFi projects are on the Ethereum blockchain.

What are the most profitable DeFi strategies?

Staking and liquidity mining can deliver high returns from the growing DeFi crypto market for minimal effort.

Often, the annual percentage yield (APY) can range between a lucrative 10-20%. Compare this to the negligible interest rates available with traditional financial instruments.

While staking and liquidity mining are popular, remember that your income can vary. Your returns will depend on the assets you provide, the value of your holdings and the decentralised exchange you choose.

In recent years, yield farming has become a more attractive way to earn on assets that would otherwise sit dormant in a custodial wallet. However, it is still an extremely dynamic and fast-changing space. Farmers need to be vigilant and spend time identifying the most profitable strategies.

To quote crypto analyst Sean Dickens once more:

“It’s not just about selecting the highest yield-generating platform, but also understanding the protocol’s history, audit reports, reviews and ‘tokenomics’.”

Investors cannot simply look at the APY to guarantee a continuous acquisition of profits. They must be diligent with their strategies in the ever-changing market.

DeFi offers a plethora of opportunities for investors seeking passive income. From staking and liquidity mining to yield farming, the options are as diverse as they are promising.

It is important to note that these strategies remain undoubtedly “high risk, high reward”. You need an element of caution before diving into an abundance of strategies in the DeFi landscape.

For those new to the scene, the knowledge required for yield farming can make it riskier than other staking or passive income options. Only the most advanced users will likely be able to access the highest return rates.

If you’re thinking of making a start in yield farming, it’s key that you perform due diligence first. Always ensure you have a thorough understanding of DeFi systems to ensure your investments will be safe and profitable.

This publication is for informational purposes only and is not intended to be a solicitation, offering or recommendation of any security, commodity, derivative, investment management service or advisory service and is not digital asset or cryptocurrency trading advice. This publication does not intend to provide investment, tax or legal advice on either a general or specific basis.