How to make passive income with crypto?
Your bank pays you a quarter percent while some cryptocurrencies will pay you 6% or more to lock your funds in any particular Decentralized Finance (DeFi) protocol. If you are not afraid to see the value of your token drop by 20% or more, then DeFi yield is your next cryptocurrency investment. Yield paying DeFi cryptocurrencies and the possibility to make passive income are one of the main reasons why investors switch from Bitcoin to the field of altcoins led by Ethereum.
What is DeFi, yield farming and how to make passive income?
DeFi is financial services running on public blockchains, primarily Ethereum. DeFi tokens allow you to earn interest, borrow, lend, buy insurance or simply trade. Yield farming is a reward program that takes place in the DeFi cryptocurrency field. If you want to compare it to traditional investment, it’s like the yield on bonds or dividends. Anyone with a Coinbase or Binance account can easily find out which tokens pay yield.
“Investors should focus on the fundamentals of the project, not just the yield it pays” said Eric Nguyen, CEO of Spore Research. If you decide to hold certain tokens for a long time, then exploring a yield-paying system is an option. But deciding on coin investment based only on the return provided will be problematic because there are still some shortcomings to be aware of. One major issue is that the annual rate of return may be high, but the available staking period is very low. For example, you can reach 200% annual percentage yield (APY) in 15 days, assuming it’s compounded daily. In actuality your coin balance will only increase maybe 4.6% in those 15 days.
What are the risks of yield farming?
Some of the risks are:
- Liquidation Risk: the possibility of zero balance. It happens when the price of your possessions has dropped beyond the price of your loan which causes a liquidation penalty. Liquidation can happen when the value of your belongings drops or the price of your loan increases.
- Smart Contract Risk: DeFi runs on smart contracts. They are codes stored on the blockchain that activate if certain conditions are met. Yield farming is controlled by smart contracts that remove the middlemen in traditional finance. Smart contact risk is high as malicious hackers can cause harm to them. A smart contract failure in DeFi happened when the Yam token price dropped from an all-time high of $167.66 to around $0.97. This drop was caused by a bug that was found on the smart contract.
- Price Risk: When it comes to yield farming, price risk is a big challenge. Tokens could go to $0 overnight. No mater how big of a profit you make, if the token drops in the market, you will be affected. Another example of price risk is loans. If the value of your possessions is less than a certain price, the platform will liquidate the borrower before he/she has a chance to repay the loan.
- Gas Fees: Increasing gas fees are one of the risks associated with high-yield farming as the number of transactions has increased significantly. More people use the decentralized exchange Uniswap to exchange their tokens using the Ethereum network. During a peak of the DeFi season, gas fees reportedly increased 100 times. If gas fees rise, this means high-yield farming may be unrealistic for ordinary investors. However, Ethereum 2.0 was launched with the Layer 2 extension feature, which is expected to solve the problem of high gas fees on the Ethereum network.