Decentralized Finance, commonly known as DeFi, refers to blockchain-based products geared at offering automated financial services using smart contracts. With everything from savings to lending, borrowing, margin trading and derivatives, the DeFi ecosystem thrives on the notion of compatibility – or the idea of pairing products together for unique benefits.
Ethereum has largely served as the primary aggregator of DeFi products due to it’s high praise in regards to decentralization and security. Ethereum’s vast network of distributed nodes paired with a significant capital pool offer stronger security foundations than competing smart contracting platforms such as EOS and TRON which do not have the same amount of nodes or capital.
The DeFi ecosystem offers numerous mechanisms to earn passive income using ETH or other Ethereum-based assets. These mechanisms are commonly referred to as different “sectors” and can largely be synthesized as Staking, Lending, Savings and Leveraging. Other DeFi sectors include Assets (Wrapped Bitcoin), Payments (Connext) and DEXs (Uniswap).
Ethereum allows users to earn interest on a handful of cryptocurrencies with minimal risk. While these savings rates do carry with them the risk of platform failure (Ethereum network issues), they are by far the safest returns in the blockchain space.
When it comes to DeFi saving products, stablecoins are generally the best place to look for an annualized return that can be denoted in USD. Seeing as 1 stablecoin *should* always equal 1 dollar, these returns are easier to assess than volatile assets like Ether who’s price may change on any given day.
Dai – the decentralized stablecoin created through the Maker protocol – is commonly referred to as the leading DeFi stablecoin. MakerDAO’s Multi-Collateral Dai launched the start of the Dai Savings Rate – a passive savings system for Dai holder to earn an annualized return by storing their tokens in Vaults.
The Dai Savings Rate (otherwise denoted as the DSR) can be accessed through Oasis Save. When connecting to Oasis through an Ethereum-based wallet like Ledger, Trezor, MetaMask or Coinbase Wallet, users are prompted to unlock their Dai in order for it be stored in a Vault. The DSR at any given time can be seen on the left-hand side of the dashboard under “Balance”
The DSR is dynamic, meaning that MKR token holders can vote to adjust the annual rate at any time. At inception, the DSR was set at 6% APR. Many exchanges have also signalled that they will implement support for Multi-Collateral Dai, meaning that there are likely to be a number of different outlets to tap into the DSR.
- Permissionless – Anyone with Dai can earn interest from the DSR
- Efficient – DSR interest is accrued automatically and can be withdrawn at any time
- Stable – Dai is significantly overcollateralized, indicating that it will maintain it’s peg of $1
- Variable – the DSR is likely to fluctuate
- Locked – Dai that earning interest via the DSR can not be spent or used elsewhere
- Capital Intensive – Users must lock a minimum of 150% collateral to issue new Dai
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To earn passive income, it’s common to post collateral in the form of a stake. Staking can be described as holding funds in escrow in exchange for a future benefit. Many products will require staking to be done in the form of a native ERC token, rather than staking ETH itself. With Proof of Stake, users stake ETH to act as a validator, earning block rewards and transaction fees as rewards.
Synthetix is a synthetic derivatives platform which leverages a native token – SNX – for the ability to create tokenized derivatives (called Synths) through a product called Mintr. Users must stake 750% collateral in order to create new Synths and are rewarded in the form of a pro-rata percentage of the 0.3% trading fees collected by the platform. Rewards are distributed in the form of a native stablecoin, Sythetix Dollars (sUSD) which can be spent on other synthetic assets on the platform.
- Secure – all Synths are secured by a minimum of 750% value in SNX
- Stable – rewards are paid in a stable currency, allowing for more traditional valuation methods
- Permissionless – SNX and sUSD rewards can be claimed at any time following a minimum vesting period
- Obscure – Synth creation requires slightly complex knowledge
- Capital Intensive – 750% collateralization requires significant capital to earn rewards
- Volatile – SNX price may change at any time
Uniswap is a permissionless DEX allowing users to swap between any two Ethereum assets with minimal slippage. Uniswap creates unique asset pools for each trading pair, allowing traders to share in the usage of that pool in the form of a 0.3% transaction fee. To earn a portion of fees, users “Add Liquidity” by supplying 50% ETH and 50% of the asset (SNX, DAI or ETH for example) being pooled. In exchange, users receive “Liquidity Pool Tokens” which represents a pro-rata claim over all fees generated on a given pool. The returns on liquidity provider pools can be viewed here.
- Opportunistic – Users can choose to pool liquidity for specific assets during times of high demand
- Efficient – Adding liquidity generally takes less than a minute and only costs gas fees
- Permissionless – Anyone can add choose to add liquidity at any time
- Volatile – Returns on pools are highest when prices are stable, with returns diminishing as asset prices increase or decrease
- Niche – Uniswap remains an obscure exchange, meaning collected fees are much smaller than that of centralized exchanges like Binance
- Specialized – Pools require an equal split of ETH and the asset being pooled, requiring traders to know how to obtain that asset prior to contributing to its pool
It is possible to earn interest on cryptoassets by loaning them through various protocols on the Ethereum network. These lending protocols work in a decentralized way without a middleman or custodian.
DeFi has enabled the lending of digital assets in a peer-to-peer fashion. Companies such as Compound Finance provide frameworks for this lending in the form of an intuitive dashboard and interest earning smart contracts. Compound leverages cTokens which represent the claim of a specific asset relative to the size of the lending pool at large. To use Compound, users deposit support assets and receive cTokens in return. cTokens earn interest relative to the given Supply APR.
- Easy – Interest can be earned through the deposit of any supported asset
- Secure – Compound is the largest lending provider on the market
- Accessible – Anyone can deposit assets in exchange for cTokens at any time
- Tracking – cToken balances are not 1:1 which can make it difficult to value holdings
- Minimalistic – Lending rates on large assets like ETH tend to be quite small
- Variability – Supply APRs tend to change frequently
Ether can be stored in a Maker Vault to issue Dai – a decentralized stablecoin. When creating new Dai by locking Ether, traders can take their newly acquired stablecoins and purchase additional Ether. This loop effectively leverages an outstanding Ether position by going long on Ether price. If the price of Ether increases, it can be sold at a profit and used to unlock additional Ether from the underlying vault.
To leverage Ether, traders can use Maker’s Oasis Borrow to open a new Vault. From there, users are prompted to create a new Vault by selecting “Ether” as their collateral type, and stating how much collateral they would like to store in the Vault. All Dai requires 150% overcollaterization, and we recommend that all Vaults are backed by a minimum of 175% collateral to avoid a liquidation penalty in the event of a sudden price swing.
Once collateral has been posted and the amount of new Dai to be issue has been set, users can manage their Vault position via the Oasis Borrow dashboard. This is where users can view the Stability Fee, or an annualized rate charged on all collateral being stored in the Vault. Stability fees can be paid in either DAI or MKR and must be paid in full when a Vault is closed. More Dai or Ether can be added or withdrawn from a Vault at any time, so long as the collateralization ratio remains above 150%.
When leveraging ETH, users take on the risk that their Vault may be liquidated, resulting in a 13% liquidation penalty. Similarly, if ETH depreciates in value from the time a leveraged position is created, a Vault becomes more at risk with less Dai value to repay or re collateralize the Vault. The creation of a Vault incurs a larger gas fee than normal transactions, generally ranging from between $0.50 to $1 depending on network congestion
- Efficient – The process of opening a Vault takes less than 5 minutes
- Permissionless – Traders do not need permission to use newly minted Dai to buy ETH
- Risk Management – Leveraging ETH through Vaults is at a far lower margin than secondary exchanges off (commonly 10-100x margin compared to a maximum of `1.67x margin)
- Self-Accountable – Maker does not support margin trading, meaning traders need to monitor their exposure, profits and losses
- Fee-based – All Vaults accrue Stability Fees, meaning active leverages must take an annualized debt into account
- Volatility – If not properly maintained, leveraging ETH through Vaults may incur high penalties if a position is liquidated due to under collateralization or rapid price swings
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Ethereum-based assets which can earn a passive income include:
Ether can be staked via Proof of Stake for block rewards and transaction fees. Similarly, ETH can be lent out via Compound or supplied to a Uniswap pool for liquidity fees.
Synthetix Network Token (SNX)
SNX can be staked via Mintr to create Synths and claim trading fees. Synths require 750% overcollateralization while reward are distributed in Synthetix Dollars (sUSD).
Dai can be leveraged for passive income in multiple forms. Dai locked via Maker Vaults automatically earns the Dai Savings Rate. Dai deposited in Compound earns supply APR in the form of cDAI. Dai can be wrapped via chai.money to become Chai, a tradable version of Dai earning the Dai Savings Rate.
Kyber Network Crystals (KNC)
Kyber Network’s native token, KNC can be staked to earn a percentage of trading fees on the platform with the Katalyst upgrade.
LivePeer Tokens (LPT)
Users can bond tokens to a Livepeer video transcoder to perform work on their behalf, earning newly minted tokens and fees.
As with all forms of passive income, there are inherent risks:
With passive income assets being built on Ethereum, they are largely reliant on the underlying success of that protocol. In the event that Ethereum were to suffer from scalability issues or collapse from any number of unknown reasons, all of these passive income opportunities would cease to exist.
Smart Contract Risk
Many passive income opportunities leverage the use of smart contracts for the autonomous distribution of rewards. As contracts aggregate more capital, they become subject to malicious actors seeking to find vulnerabilities to extract their holdings. Platforms like Nexus Mutual have emerged to insure smart contract risk, with security audits playing a vital role in the usage of prominent DeFi products.
Many passive income assets have historically been known to have volatile prices. When looking to earn a passive return, it’s important to recognize that the USD price of any given DeFi asset can change in a moment’s time. With this in mind, it’s recommended to keep detailed notes on the entry and exit prices of your investments to more easily track profits and losses.
Maker’s Multi-Collateral Dai introduced the Dai Savings Rate – an annualized interest earned when locking Dai via a Maker Vault. Many have come to see Dai as the defacto stablecoin in DeFi, largely based on the amount of products that have included Dai as a payment, rewards and staking mechanism.
With this, the DSR can be considered (with caution at this stage) to be Ethereum’s “Risk-Free Rate“. The DSR is expected to increase as Ethereum becomes more risky and decrease as it becomes less risky.
Seeing as the DSR is baked directly into the Maker protocol, it is likely to be one of the last points of failure for the Ethereum protocol at large. If Dai’s peg were to break, the DSR provides an easy mechanism to tilt the odds in any given direction, incentivizing traders to purchase and lock Dai with an attractive DSR when it falls below a dollar and encouraging holders to sell Dai with a potentially negative DSR when it is priced higher than a dollar.
While the larger risk of Dai will be tested through the introduction of real-world assets such as treasury bonds and real-estate mortgages, the existing DSR serves as a great indicator of Ethereum’s risk-free rate within a protocol-based asset pool.
Passive Income FAQ
How much can I earn?
Returns for the vast majority of financial activity on Ethereum varies between 1% to 6% depending on the platform – although it is possible to find higher returns from time to time.
The exception to this is the Augur prediction market platform, which allows users to earn passive income on the prediction markets they create.
In this instance, the upside is effectively unlimited as it is based on the amount of uptake a market has.
Augur markets that attract a large amount of volume can be extremely lucrative for their creator.
What are some of the ways to earn passive income?
There are several methods for earning passive income on Ethereum. A few are:
With the pace at which Ethereum is developing, it is likely that more opportunities become available in the years ahead.
What are the risks of earning passive income on Ethereum?
Risks vary between protocols. For example, the DAI Savings Rate is a low level protocol that is baked into the DAI token contract.
On the other hand, the Coinbase savings rate (which is paid to holders of the USDC stablecoin) is reliant on the Coinbase platform and carries counter-party risk (the user relies on a custodian).
New platforms also face the risks associated with unproven token models.
Where can I learn more about DeFi?
Sites such as defipulse.com can be used to view DeFi leaderboards, many of which are denominated in terms of Total Value Locked (TVL) – simply indicating the amount of capital (priced in USD) is locked within any given protocol. To understand why USD is being used, it’s important to recognize that different DeFi protocol leverage many different types of cryptocurrencies, each of which have unique prices. By organizing TVL in terms of USD, it becomes easy to standardize the aggregate value one protocol has locked versus another.
Other sources such as DeFi Score were created to add a degree of risk assessment to different DeFi products, ultimately geared at helping non-technical users understands the pros and cons associated with the various services and returns offered by different products.
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