What Is DeFi and How Can It Help You Earn Passive Income?
Decentralized Finance is a new term that defines a phenomenon in the crypto industry where the community takes over the control of financial interactions between users. Decentralization means that there is no central authority that oversees what other people are doing with their money. Instead, all limitations and rules are determined by users.
Often, DeFi platforms use various governance methods to allow token holders to vote on what the network should implement next. This democratization makes it more engaging for crypto investors to work with DeFi projects even if they do not yet produce any profits. The hope and belief alone make it worthwhile to invest in these unique projects that defy the norms of traditional finance.
DeFi investing, on the other hand, is an interesting approach to utilizing your capital by supporting unique projects that you like. Many investors keep their money in promising DeFi platforms just because they believe in their vision of the future for finance in general.
Every single product in this domain is built upon using smart contracts which are special agreements that are made in the digital space and can be effortlessly audited by anyone. This system ensures that everyone abides by the same rules and does not want to become a bad player. DeFi investing is all about finding the right platform that offers the right type of returns and pushes the industry toward a better tomorrow.
You can build a strong stream of crypto passive income by using various ways of investing in the DeFi space:
- Use DeFi yield farming strategy to stake your tokens and receive percentage-based returns. Some staking programs pay out quarterly, semiannually, or annually. While it may look like a deposit, the underlying method of using DeFi to earn interest is quite different and comes with its own set of advantages and disadvantages.
- Participate in governance and help the project to improve and gain traction. People who are interested in seeing their assets appreciating should also help the platform they are invested in to grow and expand. Many decentralized projects live and die by their governance model. You may participate in decision-making and join the community to personally affect how the project changes over time.
- Learn how to make money with DeFi by trading on decentralized and centralized exchanges. It is possible to use automation and copy trading to improve your returns. Bots trading tokens issued by these platforms can generate passive income if you use a good strategy.
How Smart Contract Technology Makes DeFi Investment a Breeze
One of the biggest draws for contemporary investors is transparency which is exactly the focus of any DeFi platform. Investors flock to these decentralized organizations to put their capital into something they have direct control over. Governance is just a big part of what makes a DeFi platform democratic and attractive to many.
Smart contracts are digital agreements that may carry a variety of features and functions depending on what a platform wants to do with it. Since all of these smart contracts are published on the blockchain ledger, it means that people who invest in them have direct access to the information about the current state of affairs.
With blockchain crawlers and explorers improving in usability and convenience, many retail traders without any technical expertise can easily read the publicly available information and make their investment decisions after some thorough research.
The smart contract functionality is quite versatile allowing platforms to focus on a large variety of products and services often far superior to what tradfinance can offer. The biggest issue still lies within the confines of the security problem:
- To make everything run faster DeFi platforms have to implement measures that relax security features and allow for quicker transaction processing.
- With less emphasis on security, many networks suffer from external and even internal attacks causing loss of funds and pauses in service.
- On the contrary, improving security features and allowing for meticulous inspections of every transaction lead to significant decrease in speed.
The trade-off is quite apparent and often becomes an important contested point for many proponents and opponents of the DeFi industry. Nevertheless, smart contracts are a powerful tool that can be utilized to provide a wide range of different solutions for all DeFi users. Here are some examples of interesting things that can be done using smart contracts:
- DeFi liquidity pools allow users to pull their funds together and increase trading volumes on various platforms to ensure that assets can be moved freely. You can learn how to make money on DeFi liquidity pools quickly and invest together with thousands of other users. Smart contracts make the process transparent and allows participants to see the performance of each individual pool. Liquidity providers are also compensated for their investments.
- DeFi lending platforms are unique services that give users a credit line that is issued automatically based on various parameters. The best thing about DeFi is that many features are novel. Some platforms provide loans with expiration periods of less than a minute to facilitate fast-paced trading and cross-network transactions.
- Smart staking is also the fruit of decentralized finance. A stake can be used to facilitate a wide range of performance metrics on the network. For example, Ethereum makes their stake holders into validators. Other platforms may use staked funds to finance the development process or increasing liquidity. The best thing is that you can effortlessly monitor every aspect of yield farming with staking.
How to get into DeFi?
Despite being the cornerstone of the whole crypto industry, decentralized finance is not easy to get into for a layman. People without prior exposure to the concept of cryptocurrency often feel intimidated by the long list of requirements for the initial setup. While it is not something technically advanced, the inexperience and the anxiety before committing to something out of one’s comfort zone is what prevents people from investing in the first place.
DeFi may sound foreign and mysterious to many people accustomed to the ways of tradfi, but it is quite easy to start investing.
- Create a new crypto wallet address. Since the vast majority of contemporary decentralized finance platforms are deployed on Ethereum or Cardano, you don’t need a Bitcoin wallet. MetaMask is a good choice for Ethereum-based DeFi apps.
- Buy ERC-20 tokens from a centralized or decentralized exchange. ERC-20 is the token standard for Ethereum. If you want to work with other networks, you will need to purchase corresponding tokens.
- Choose the right protocol to use. The range of DeFi projects that an investor can start supporting is quite large. It is necessary to research the DeFi space in general and pick platforms that will generate the best returns and allow you to achieve consistent results.
- Use any portfolio management tool to track the performance of your investments. Since many retail crypto traders prefer working with multiple platforms simultaneously, it can be quite challenging to keep track of everything.
How to Choose the Right Strategy for Your Needs and Goals?
The process of selecting the right way to invest in crypto can be very difficult for people without any prior exposure to the industry. While it is possible to find something that suits your risk tolerance level, achieving a good balance is hard. Investments in decentralized finance products are associated with relatively high risks and many pitfalls that you won’t be able to easily identify.
Diversification should be among your top priorities. However, asset allocation strategies in the crypto industry are different from what many are used to after working with tradfi for decades. For starters, you may want to use different asset classes to achieve a good balance between profitability and risks.
Instead of buying multiple tokens, you might want to spread your portfolio across multiple DeFi platforms using only ETH. On the other hand, the idea of diversifying investments by putting money into different types of financial products is also good. Many retail traders use automation systems to generate passive income with crypto while focusing on accumulating a large portfolio with several types of coins.
Let’s talk about some important aspects of investment management in the crypto industry and DeFi platforms.
Avoid obvious scams
The biggest issue with the crypto industry is the proliferation of various fraudulent websites and scammers. For inexperienced investors without any technical knowhow, differentiating blatant lies from truth is often close to impossible. Being very skeptical about many sudden investment opportunities is a good habit.
Many people became victims of scammers who often use elaborate schemes and can deceive even seasoned retail traders. For example, the recent issue with people using the DeFi Smart Mining platform that connected to your wallet with a browser extension was a big deal in the crypto community. Since many newcomers often learn about how to make passive income with crypto from influencers and friends, they think that mining is the only way to earn money in the industry.
The biggest type of mining in the DeFi space is liquidity mining which is simply pulling funds together with other investors to provide liquidity to their favorite platform. The latter rewards users who stake their funds and generate liquidity. It is a straightforward relationship with users and their product. Anything else must be carefully scrutinized.
Choose the right investment period
The best passive income in crypto is when you buy tokens, stake them, and take them out after a long period during which bulls pushed the price to the moon. It is a dream of any contemporary crypto trader. Unfortunately, things don’t usually work out as well as in our dreams. You must remember several risks strongly associated with investing in a DeFi project:
- Tokens may lose value while locked on a platform. This risk is the most significant one and must be seriously considered. Using various technical and fundamental analysis techniques to predict future trends is hugely important for any investment in a DeFi project.
- Smart contracts may have critical vulnerabilities. Even the best development team won’t be able to identify all risks before deploying updates. If it happens while your tokens are locked in or when you start working with a platform, it can severely affect your bottom line.
- Understanding returns. While the best DeFi interest rates may look incredibly seductive, you must remember that many factors come into play when it comes to calculating the value of your returns. Interest can be paid out with newly issued tokens or by inflating the ecosystem. Learn more about how such high interests are achieved.
Since many risks may affect the performance of your investments, it is quite important to lock your funds for a very specific period. Carefully compare potential returns with and without staking. Think about rewards that you receive for participating in liquidity pools or lending out your assets. While looking good on paper, these investment methods may not be as efficient as others like using bots or staking in PoS blockchain networks.
Do not risk too much
The golden rule for investment is to never use money that you cannot afford to lose. While this tip is usually reserved for personal finance in general, it is very relevant for people who are interested in putting money into decentralized finance.
Many newcomers see large numbers and incredibly generous rewards and think that they must put everything they have in these investment programs. However, DeFi platforms are not created as get-rich-quick schemes. If they look like something that is too good to be true, chances are they operate like MLMs or outright scams.
On the other hand, living without any backup plan or some emergency fund to fall back on can be very frustrating and financially damaging. You need to focus on providing for your family or taking care of your personal situation before starting to invest.
Even if you do have an emergency fund that covers up to six months of living expenses, you still must think twice before putting all your eggs in one basket. DeFi platforms may look very promising and lure in users with high returns, but they often omit potential risks. It means that you need to look through the pink-tinted façade and consider every DeFi project as just another financial asset.
Finding the right balance and achieving the right level of risk is the main goal of any reasonable investor. Here are some important factors to consider:
- Any passive income with crypto should be estimated with potential price changes in mind. Use various analytical techniques to predict how prices will change by the time you will be able to withdraw tokens.
- Use only a certain portion of your portfolio to invest in DeFi platforms. The crypto industry has many other interesting investment opportunities that you should explore to diversify and hedge against risks associated with the DeFi space.
- Focusing on just staking or liquidity mining is not a good idea if you want to build a diverse portfolio. Try investing in several different DeFi platforms that have unique products never overlapping with each other.
- If you ever find yourself in a situation when you cannot withdraw funds that you desperately need, try to sell your stake or locked in holdings to other investors. While not the best solution, it can work.
The latter is the final and most undesirable thing to do for any investor. You won’t be able to sell at a good price even if someone will be willing to pick up your assets. Such deals also involve forfeiture of your credentials. What you need to avoid selling off your assets is to focus on protecting your personal financial situation.
Make sure to never go above your threshold for investments. If you have to tap into funds that you are trying to save or use as an emergency stash, it will eventually negatively affect your wellbeing.
Other means of building passive income with crypto
Learning how to make money with DeFi is quite useful. Fortunately, you don’t need to be an expert investor to use decentralized efficiently. Nevertheless, you must remember that there are many risks associated with putting your money into still developing financial instruments. Add other investment methods to your portfolio and balance it out.
- Automation. Using bots to automate various technical analysis strategies is a great way to build a secondary income stream. Bots are excellent for the crypto industry where markets operate around the clock and orders take fractions of a second to be executed. If you have a good strategy that generates reliable signals, automation is a great addition to your portfolio!
- Copy or social trading. Some automation vendors like WunderTrading provide a wide range of services to their clients. This particular service provider has a special marketplace where users can choose from a selection of experienced retail traders. If you believe that they can do better than the market as a whole, you can start following them to copy all their investment activities.
- Staking. Cardano and Ethereum are two large blockchain networks offering their users a way to become validators by staking native tokens ADA and ETH respectively. Staking on the Ethereum network can be expensive since you need to stake at least 32 ETH to run a node. However, it can be a reliable source of funds for investors interested in earning money passively.
- DCA buying. Distributed cost average is a great approach to acquiring resources. Many investors prefer using this method to buy financial assets cheaper on average and slowly accumulate them in their portfolios expecting that they will appreciate with time.
The importance of technical analysis
While many believe that staking and other forms of passively investing in DeFi are completely different compared to trading, one thing that investors must remember is that tokens fluctuate in value over time. It means that you still need to conduct a thorough technical analysis before committing to investing in any digital asset.
Tokens that you stake or use to participate in liquidity mining may increase in price providing you a sizeable profit. However, they can also decrease in price causing significant financial distress and losses that you cannot quickly prevent.
Hedging is a good way to protect your portfolio from these risks, but you should also make estimations about the future of the market and potential changes that may take place by the time your tokens are released.
Technical analysis does not provide a guaranteed prediction, but it is still something to consider when making an important investment decision.
The final tip for crypto investors is to split your investments into multiple categories and dedicate some of you funds to each category. Invest in DeFi, stake some tokens, run several DCA bots, and use other forms of automation.
The main takeaway
Decentralized finance is a great ecosystem that opens up a whole new class of financial assets for millions of contemporary investors. However, you should never put everything you have in a promising DeFi platform. Diversify as much as possible and focus on building a balanced portfolio.