Using your smartphone, you can request a loan from someone you know nothing about –what they look like, where they live. Are you surprised? Of course, I would be as well if I were oblivious to the possibilities available with DeFi.
You pay more attention to the buzz surrounding crypto's large price pumps and the sudden 10x, 100x gains of crypto assets in the CeFi ecosystem because they quickly put you in a position to profit. But even so, these pumps do not occur frequently, and you may not always be active to catch these waves and profit from the significant price surge.
I understand how difficult it is to keep an eye on the crypto chart, closely follow the trends, and remain active with trades. It's a lot to do, especially if you're a beginner who hasn't yet become familiar with the ecosystem.
With decentralized finance (DeFi), you have access to a whole new world of opportunities–to generate passive income–without the need to sell your valuable coins or trade every up, down, or sideways trend.
Initially, DeFi limited the capabilities of crypto investors. As a result, people were limited to trading their assets for instant profit or hodling for long-term gains.
However, decentralized finance has evolved, transforming crypto transactions' functionality and profit possibility. Several financial services can now be accessed through a decentralized framework, paving the way for many to earn passive income without traditional spots or derivates trading.
DeFi keeps expanding daily, allowing investors to invest and earn without going through complicated measures. With decentralized applications (dApps), you can utilize protocols powered by smart contracts that will enable you to earn passive income by staking, yield farming, providing liquidity, lending your digital assets, etc.
Liquidity Provider (LP)
Liquidity refers to the ability to buy and sell an asset without significantly affecting its price. In other words, liquidity is a platform's ability to raise cash when it needs it.
To understand how liquidity works, let's take a look at how centralized exchanges (CEXs) operate; In practice, market makers ensure CEXs have enough liquidity by placing buy and sell orders in the order book of CEXs. The order book contains orders at various price points and sizes equally distributed across the purchase and sell ends; this allows sufficient liquidity to be available to market makers.
However, because of the decentralization in DeFi, there are no market intermediaries. Instead, decentralized exchanges (DEXs) use automated market makers (AMM) to determine asset swap prices. Since, unlike CEXs, DEXs do not rely on the order book to provide liquidity, how do DEXs facilitate trades without causing a huge price impact?
To solve this dilemma of liquidity and price impact, DeFi allows users to provide their assets to protocols while earning percentages in trading fees. Typically, liquidity providers will earn a share of the fees in proportion to the number of assets provided. So, for example, if a liquidity pool has $500,000 and your share is only $50,000, you will receive 10% of the total fee revenue in the pool.
In Sushiswap, transaction fees are 0.3%, 0.25% are shared among liquidity providers, while 0.05% is shared among SUSHI holders, who govern the ecosystem. So, if the trading volume for a day on Sushiswap is $1,000,000, the entire fee collected will be $2,500, and all LPs will earn profits in proportion to their stake, i.e., the person who provides 10% liquidity will make $250. This is a win-win for people who intend to hodl their assets for long; while holding, they can earn passive income by providing liquidity instead of just allowing assets to lie fallow in wallets.
Liquidity pools are open to the public on a DeFi platform and allow anyone to contribute liquidity to the pools. You will be required to supply two different assets that form a pair to the intended pool. For example, you could provide $1000 in liquidity to the BTC/USDT pool pairing by offering $500 in BTC and $500 in USDT. You would receive liquidity provider tokens, known as LP tokens, after locking in assets in a liquidity pool. The LP tokens represent an individual user's share of the total liquidity pool.
Another way you can earn from the DeFi ecosystem is by lending your asset. DeFi reshaped finance by enabling decentralized lending and borrowing, dubbed 'Open Finance,' to provide cryptocurrency holders with lending opportunities for annual returns.
Putting your assets to a DeFi lending protocol is probably the most risk-free method to earn a reasonably consistent income with your DeFi funds. In addition, by supplying your assets, typically in stablecoins, you will begin earning interest from borrowers who use the funds for trading purposes.
Funds security is guaranteed, as the borrower must provide collateral worth more than the intended lending amount, which will be remitted to you if the person defaults on payment. Smart contracts facilitate all these, which act as intermediaries or facilitators of loans to borrowers and enforce interest repayments from collateral deposits. As a result, lending is a low-risk way to profit in bull and bear markets.
Staking is often a collective term for DeFi activities requiring short-term or long-term commitment to crypto assets. As a result, staking is securing tokens in a smart contract while earning more tokens of the same crypto asset.
DeFi staking is the practice of locking your crypto assets inside a DeFi smart contract in exchange for extra tokens. In terms of context, it is similar to having money deposited in a fixed account with your traditional bank, where you earn interest on the money you put in overtime.
Staking aids a network's consensus while rewarding users who participate by depositing their assets for a period. Here, you (the staker) become a validator in the Proof-of-stake (PoS) blockchain network by staking your assets in a DeFi platform. As a validator, you are entitled to staking rewards after blocks are validated; however, you must diligently carry out your staking duties to the PoS network to avoid losing a portion of your stake. Also, various users' total stakes in the platform would likely determine their governance privileges. As a result, users with the highest stakes in a network would be granted the privilege of validating network transactions. As a result, DeFi staking is currently regarded as one of the most profitable trends in the cryptocurrency space.
Yield farming is the practice of lending or staking your cryptocurrency coins or tokens to generate the highest possible yield in transaction fees or interest while minimizing risk. But, you might ask, what is the difference between yield farming, and providing liquidity?
Although both terms might sound similar, yield farming goes beyond simply adding your funds to a liquidity pool to earn a share of trading fees. In yield farming, you will need to actively move your crypto assets across platforms to maximize the best return on investment instead of simply attempting to earn a portion of the network trading fee, as in the case of just providing liquidity.
Similarly, when you provide your crypto asset to the yield farms, you are referred to as liquidity providers (LP). As a result, liquidity providers contribute coins or tokens to a liquidity pool, a smart contract-based decentralized application (DApp) containing all of the funds.
For example, suppose a yield farmer deposits 5,000 USDT into a DeFi protocol, thereby providing liquidity to the platform; the protocol will reward the yield farmer for depositing the USDT. Then, the yield farmer deposits the rewarded USDT into a DeFi liquidity pool that accepts the USDT received and gets rewarded with yield. The process is continued indefinitely across several platforms and pools to maximize returns.
Yield farming is a bit complex for beginners because it involves moving funds across DeFi platforms multiple times per week to earn the highest possible returns. While it can be highly profitable, it is generally only recommended for advanced cryptocurrency users.
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