A beginner’s guide to earning passive income with DeFi

Key takeaways

• Unlike traditional finance, which relies on intermediaries such as banks and credit agencies, DeFi operates on blockchain technology, offering financial services like lending, borrowing and trading.
• DeFi offers various ways to earn passive income, including staking, yield farming and lending. Each method has its own risk-reward balance.
• DeFi carries risks such as market volatility, technical vulnerabilities in smart contracts and evolving regulatory environments. 
• DeFi income is taxable in most jurisdictions, with earnings from staking, lending and trading subject to reporting. 

Imagine the traditional financial system as a massive walled city. Inside, everything is controlled by a few powerful institutions — banks, investment firms and credit agencies. 

These institutions act as gatekeepers, deciding who gets access to the services and wealth within. If you want to save, invest or borrow, you have to go through them. The rules are strict, the processes are slow, and there are fees at every turn. Not everyone is allowed in, and even those inside may find themselves limited by the system’s rigid structure.

Now, suppose stepping outside those walls and finding an open marketplace buzzing with activity. This is decentralized finance, or DeFi — a space where there are no gatekeepers, no barriers to entry and no centralized control. 

This article discusses how this new landscape works, why it’s shaking up traditional finance, and how you can use DeFi to generate passive income through strategies like staking, yield farming and lending.

What is DeFi?

DeFi shakes things up. Unlike traditional finance, which relies on banks and other institutions to act as intermediaries, DeFi cuts out the intermediaries. It’s a system built on blockchain technology, where financial services like lending, borrowing, trading and investing are managed by smart contracts, self-executing agreements with the terms directly written into code.

DeFi’s roots trace back to Bitcoin, the first decentralized digital currency network. But it wasn’t until Ethereum launched in 2015 that the true potential of DeFi started to emerge. 

Ethereum’s platform allowed developers to create decentralized applications (DApps) that could automate complex financial transactions. Over time, these DApps evolved into a wide array of services, from decentralized exchanges (DEXs) to lending platforms, all operating without a central authority.

The key components of DeFi are smart contracts, DApps and the blockchain itself. Smart contracts are the backbone, enforcing agreements without the need for human intervention. 

DApps are the user-facing tools that interact with these contracts, providing services similar to what you’d find in traditional banking but without the traditional barriers. And the blockchain, particularly Ethereum, acts as the secure, transparent ledger where all these activities are recorded.

DeFi opens doors by providing financial services without requiring an account, credit score or even an identification document. It’s also more transparent — anyone can audit the code behind DeFi projects, which is a far cry from the opaque practices of traditional banks. Plus, DeFi operates 24/7, offering a level of accessibility and efficiency that traditional systems simply can’t match.

This also makes DeFi especially appealing for those looking to earn passive income without the usual paperwork and bureaucratic hurdles found in traditional finance.

Did you know? In just a few years, the total value locked (TVL) in DeFi protocols surged from under $1 billion in early 2020 to over $100 billion by 2021. 

Top DeFi strategies for generating passive income

Now that you have a grasp on what DeFi is and why it matters, let’s dive into one of its most exciting possibilities: generating passive income.

Delegated staking

Delegated staking is one of the simplest ways to earn passive income in DeFi. It involves locking up your cryptocurrency in a blockchain network, but instead of directly running a validator node, you delegate your tokens to a validator. 

The validator helps maintain the network’s operations, and in return, you earn rewards, usually in the form of additional tokens. Think of it as earning interest on a savings account, but instead of interacting with a bank, you’re supporting a decentralized network through someone else’s validator.

In the DeFi space, delegated staking is common on proof-of-stake (PoS) blockchains like Ethereum (after the Merge), Cardano and Polkadot. Unlike traditional finance, where interest rates are set by banks, staking rewards are generated by the network and distributed to participants in proportion to the amount they’ve staked. 

When you delegate, you’re contributing to the network indirectly, while the validator handles the technical work of validating transactions and securing the blockchain.

Getting started with delegated staking is straightforward:

1. Choose a blockchain network: Decide which network to stake on, like Cardano and Polkadot.
2. Select a staking platform or validator: You can either stake through exchanges like Binance or Kraken or directly through compatible wallets like MetaMask or Trust Wallet, where you can choose a validator to delegate your tokens.
3. Deposit your tokens: Transfer your tokens to the staking platform or delegate them through your wallet.
4. Start earning: Once staked, your delegated validator will begin earning rewards for you, which are typically distributed regularly — e.g., daily or weekly.

The key benefit of delegated staking is that it provides a stable return rate without requiring you to run a validator node yourself. You can simply delegate to a validator and start earning passive income, making it a more accessible option compared to becoming a validator. 

Additionally, delegated staking generally carries lower risk compared to more complex strategies like yield farming, which involves higher volatility.

However, some networks require your tokens to be locked for a set period, meaning you can’t access or trade them during that time. And while staking rewards are predictable, the price of the underlying asset can still fluctuate, which may impact your overall earnings.

Yield farming

Yield farming, also known as liquidity mining or providing liquidity, is a more dynamic and potentially more lucrative DeFi strategy. It involves providing liquidity — essentially depositing your crypto assets — into a DeFi protocol to earn rewards. Yield farming typically happens on DEXs like Uniswap or SushiSwap, where users lend their assets to liquidity pools that facilitate trading on the platform.

In return for providing liquidity, you earn a share of the transaction fees generated by the platform, along with additional rewards, often in the form of the platform’s native token. Yield farming can offer higher returns than staking, but it comes with more complexity and risk.

Participating in yield farming usually involves these steps:

• Choose a platform: Commonly used platforms include Uniswap, SushiSwap and PancakeSwap.
• Select a liquidity pool: Look for a pool offering attractive rewards. Common pairs include ETH/DAI or USDC/ETH.
• Deposit your tokens: Provide equal amounts of both tokens in the pair to the liquidity pool.
• Earn rewards: As your assets contribute to the pool, you’ll earn a share of transaction fees and possibly additional tokens.

Yield farming can offer significantly higher returns compared to staking, especially when participating in newer or niche pools that might offer more attractive yields. Additionally, yield farming provides flexibility, allowing you to move your assets between different pools to chase the best possible returns.

However, yield farming also comes with certain risks. One of the main concerns is impermanent loss, where the value of your deposited tokens can fluctuate, potentially reducing your returns compared to simply holding the tokens. There is also the risk associated with smart contracts, as bugs or vulnerabilities in the code governing the pools could lead to a loss of funds.

Did you know? Yield farming can offer incredibly high returns, sometimes reaching over 100% annual percentage yield (APY) during peak market conditions. 

DeFi lending

DeFi lending is another powerful way to earn passive income. It works by lending your crypto assets to borrowers via decentralized lending platforms. Unlike traditional lending systems, which rely on banks to mediate loans, DeFi lending uses smart contracts to automate and secure the process. Lenders earn interest on the funds they provide, while borrowers typically put up collateral to secure the loan.

Getting started with DeFi lending is relatively straightforward. First, you’ll need to choose a lending platform, such as Aave, Compound or MakerDAO. 

Once you’ve selected a platform, you transfer your tokens to the platform’s lending pool. As borrowers take out loans from this pool, you earn interest on your deposited assets, typically paid out in the same cryptocurrency you provided.

One of the key advantages of DeFi lending is that loans are collateralized, meaning borrowers must provide collateral, which helps reduce the risk of default. Additionally, you earn continuous interest as long as your assets remain in the lending pool, with no lock-up periods restricting your access to funds.

However, as always, there are risks to consider. Despite the collateral, extreme market conditions could lead to borrower default if the collateral’s value drops significantly. Moreover, if the value of a borrower’s collateral falls below a certain threshold, it could be liquidated, potentially impacting the overall health of the lending pool and your returns.

Popular DeFi platforms for passive income

When it comes to generating passive income in DeFi, choosing the right platform is crucial. Not all DeFi platforms are created equal, and your experience — along with your earnings — can vary widely depending on where you decide to invest your assets. Now, let’s dive into some of the DeFi platforms that are popular for generating passive income.

Uniswap

Uniswap is one of the leading DEXs and a pioneer automated market maker (AMM). It allows users to trade tokens directly from their wallets while earning fees by providing liquidity to various pools.

Uniswap’s main attraction is its liquidity pools, where users can earn a share of trading fees by depositing token pairs. In terms of the benefits, you can expect high liquidity and a broad range of supported tokens. Its simple interface is also beginner-friendly.

Returns vary depending on the trading volume in the liquidity pool you’re participating in. Popular pools tend to offer more stable but moderate returns.

Aave

Aave is a decentralized lending platform that allows users to lend and borrow a wide range of cryptocurrencies. It’s known for its innovative features like flash loans and its extensive asset support.

Aave offers both variable and stable interest rates, giving users flexibility in how they earn.

The platform also supports a variety of tokens, including some not available on other platforms. Aave’s lending and borrowing options are among the most diverse in DeFi. Its flash loans are particularly attractive for advanced users looking to execute complex strategies.

Interest rates on Aave fluctuate based on supply and demand, but they generally offer competitive returns, especially for stablecoins.

Compound

Compound is another major DeFi lending platform where users can earn interest by lending their assets or borrowing against their crypto holdings. It’s one of the most established platforms in the DeFi space. Compound automatically adjusts interest rates based on market conditions, ensuring that lenders receive competitive yields. It also supports a wide range of assets.

The platform is known for its transparency and user-friendly interface, making it easy to track earnings and manage assets. Like Aave, returns on Compound depend on the platform’s supply and demand dynamics. It’s particularly popular for lending stablecoins, which tend to offer consistent returns.

SushiSwap

SushiSwap is a DEX similar to Uniswap but with added features, such as yield farming and staking. It’s community-driven and focuses on rewarding users who actively participate on the platform.

In addition to liquidity pools, SushiSwap offers a “SushiBar,” where users can stake SUSHI (SUSHI) tokens to earn a portion of the platform’s trading fees. SushiSwap provides more opportunities for earning through staking and farming, making it a good choice for users looking to diversify their income streams within one platform.

Also, returns can be higher on SushiSwap due to its yield farming options, though these come with higher risks compared to standard liquidity provisions.

What’s the best DeFi platform?

It depends. As you’ve seen, Uniswap is ideal for those looking for simplicity and stability. It offers moderate returns with lower risk, especially in well-established liquidity pools. 

Similarly, Aave and Compound are key players in the lending space, providing competitive interest rates and a wide array of supported assets. Aave features flash loans and rate flexibility, while Compound is recognized for its user-friendly interface and transparency.

SushiSwap offers a more varied experience with additional earning opportunities through yield farming and staking, which can lead to higher returns but also comes with increased risk. 

As such, in choosing the right platform, consider what aligns best with your risk tolerance, desired returns and how hands-on you want to be. Whether you’re providing liquidity, lending assets or staking tokens, these platforms offer various pathways to earning passive income in the DeFi world.

Risks of earning passive income with DeFi

With fewer intermediaries, the power of compounding interest and unmatched accessibility, DeFi has become an attractive option for those looking to maximize their earnings in a more flexible and efficient financial ecosystem. However, with these opportunities come several risks that you need to be aware of.

• Market risks: The crypto market is known for its volatility, which can significantly impact the value of the tokens you stake, lend or provide as liquidity. For example, during the May 2021 crypto market crash, the value of major cryptocurrencies like Bitcoin (BTC) and Ether (ETH) dropped by over 30% within days. This kind of volatility can lead to impermanent loss in yield farming, where the price of tokens in your liquidity pool changes dramatically, potentially leaving you with fewer assets than you initially deposited. 
• Technical risks: DeFi platforms operate on smart contracts, which automatically execute transactions. While designed to be secure, they’re not immune to bugs or vulnerabilities. One infamous example occurred with The DAO hack in 2016, where a vulnerability in a smart contract allowed attackers to drain over $50 million in ETH from the decentralized autonomous organization. Similarly, in 2021, the DeFi platform Cream Finance suffered a flash loan attack that led to the loss of $130 million in user funds. 
• Regulatory risks: The regulatory environment for DeFi is still evolving, and changes in regulations could have a substantial impact on participation and profitability. In 2021, China imposed strict regulations banning crypto transactions and mining, which affected the global crypto market, including DeFi users. 

Additionally, the United States Treasury has started enforcing stricter compliance rules for cryptocurrency transactions, including requiring tax reporting for crypto exchanges. As governments pay closer attention to DeFi, new taxes, tighter Know Your Customer (KYC) regulations, or even bans on certain activities could affect DeFi platforms and users, as seen in regulatory crackdowns.

While risks are inherent in DeFi, there are strategies to minimize them. One approach is to diversify your investments by spreading assets across different DeFi platforms and strategies, reducing the impact of any single failure. 

It’s also crucial to use reputable platforms that have undergone thorough audits and have a strong track record of security and reliability. 

Staying informed about the latest developments in the DeFi space, including regulatory changes, platform updates and market conditions, is another key strategy to protect your investments. 

Additionally, incorporating stablecoins into your strategy may help mitigate the risk of volatility, as their value is pegged to stable assets like the US dollar. However, be cautious, as even stablecoins can experience fluctuations or issues.

Did you know? In 2022 alone, over $3 billion was lost to DeFi hacks and exploits, including smart contract vulnerabilities and flash loan attacks. Despite the promising growth of decentralized finance, its reliance on complex code and lack of regulation make it a prime target for hackers.

Tax implications of passive income from DeFi

How DeFi income is taxed can vary significantly depending on where you live. In general, most jurisdictions view DeFi earnings as taxable income, whether it comes from staking rewards, interest earned from lending or profits from yield farming. Taxable events in DeFi typically include:

• Staking rewards: The tokens you earn from staking are often considered taxable income at the time they’re received.
• Interest earned: If you lend your assets on a platform like Aave or Compound, the interest you earn is usually considered taxable.
• Trading and swapping: Any gains made from trading tokens or swapping them on a DEX like Uniswap are also taxable events.

Reporting DeFi income can be complex due to the variety of taxable events and the fluctuating value of cryptocurrencies, but there are strategies to simplify the process. First, it’s essential to keep detailed records of every transaction, noting the amount of cryptocurrency received, its value in your local currency at the time of the transaction, and the specific nature of the transaction, such as whether it’s a staking reward, interest payment or trade.

To further streamline the process, you can use crypto tax software, which automatically imports your transaction history and calculates your tax obligations, making it easier to file your returns accurately. 

Additionally, because tax laws related to cryptocurrency are constantly evolving, it’s crucial to stay updated by regularly checking for changes from your local tax authority or consulting with a tax professional who specializes in cryptocurrencies. By following these steps, you can ensure that your DeFi earnings are reported correctly and in compliance with current regulations.

The future of passive income in DeFi

In the midst of record-breaking crypto adoption rates, the future of earning passive income through various DeFi strategies looks promising. You can expect increased security, more user-friendly platforms and improved regulatory clarity, making it easier for both beginners and experienced investors to participate. 

New innovations, such as cross-chain platforms and enhanced staking protocols, will likely expand earning possibilities even further. As DeFi evolves, its ability to democratize financial services will only grow, providing more people with the opportunity to generate passive income in this brave new world.

Earning passive income through DeFi provides a flexible and accessible alternative to traditional finance, offering unique opportunities such as staking, yield farming and lending without the usual intermediaries.

While the potential for high returns is significant, so too are the risks — such as market volatility and regulatory uncertainty. However, with smart strategies like diversification and staying informed, DeFi is and will continue to be a rewarding space for passive income.

Written by Bradley Peak