It seems that we have not yet managed to recover from the great fall in which we have been immersed since the beginning of this year 2022. It has been a quite difficult year to be able to generate profits by buying cryptocurrencies, since the geopolitical situation is not good at all. But it's no excuse, because the Defi They don't rest. We are going to see in this cryptocurrency training how we can generate passive income with our cryptocurrencies through 3 ways to do it.
1. Cryptocurrency loans (Lending)
The first strategy of this cryptocurrency training is cryptocurrency loans. Better known as Lending in English, they allow us to deposit our crypto assets on crypto lending platforms to act as borrowers in exchange for a regular interest payment. Payments on these loans can be made daily, weekly or monthly. It is a good way to generate passive income in our crypto assets because at the same time we are also allowing other people to access cryptocurrency loans to create investment strategies in Defi. The most popular platforms for cryptocurrency Lending are protocols such as Aave o Compound. We can find different types of crypto loans:
Comparison between traditional loans vs crypto loans. Source: Gemini.
Guaranteed loans
Collateralized loans are the most popular. We will need a deposited cryptocurrency that will be used as collateral for the loan. Most platforms require overcollateralization, meaning that borrowers can access only up to a certain percentage of the deposited collateral. It is normally below 90% of the loan value. The lower the loan-to-value (LTV) ratio, the lower the interest rate. We will also have less risk of suffering a liquidation of our loan.
Explanation of the ratio between the loan and the value of the asset. Source: Nexo.
Cryptocurrency Line of Credit
Some platforms offer a line of credit for cryptocurrencies, rather than offering a traditional loan with a predetermined term, . This is a type of secured loan that allows users to borrow a certain percentage of the deposited collateral, but there are no set repayment terms. In turn, users are only charged interest on the funds withdrawn.
Unsecured loans
Unsecured loans are not as popular within a cryptocurrency education, but they work similarly to personal loans. Borrowers must fill out a loan application, pass an identity verification and complete a creditworthiness test to be approved. These loans are the ones with the highest risk of loss for lenders, given that there is no guarantee to liquidate in the event of non-payment.
Examples of unsecured loans. Source: Mint-Intuit.
Flash loans
Flash loans are usually available on cryptocurrency exchanges and are instant loans. That is, cryptocurrencies are borrowed and returned in the same transaction. These loans are the riskiest of all, they are usually used to take advantage of market arbitrage opportunities. A clear example would be a purchase of cryptocurrency at a lower price on one exchange followed by an instant sale at a higher price on another exchange, all within the same transaction.
Explanation of how a flash loan works. Source: BlockImpulse.
2. Lock our cryptocurrencies in Staking pools
Let's see the second option that we will teach you in this cryptocurrency training. Staking is the main security mechanism used by blockchains that use PoS (Proof of Stake or Proof of Validation in Spanish), such as Ethereum, Avalanche or Solana. By locking our tokens on a blockchain, we help make those blockchains more secure. In exchange, we get a small percentage of the new tokens generated plus a portion of the transaction validation fees.
Explanation of how staking works. Source: Medium.
This option of generating passive income is possible with blockchain tokens such as ETH, AVAX, SOL or DOT or with protocol tokens such as CRV, SUSHI, UNI… However, protocol tokens do not have the function of securing the network. Defi protocol tokens provide incentives for holders who lock their tokens long-term and allow voting in the governance of the protocol. Profitability depends on the protocol, ranging from 5% on ETH to 13,5% on Polkadot. The biggest drawback we can encounter when locking our tokens in staking pools is the locking times, which can vary from one protocol to another. Currently, one of the most famous DeFi protocols for staking is Lido. By locking the tokens on their platform, we get a staked-token (like stETH), which we can use in other DeFi applications.
Different blockchains to stake Lido. Source: Lido.
3. Provide liquidity (LPs)
Let's see the third and final option to generate passive income from this cryptocurrency training. Providing liquidity is one of the most important processes within the decentralized exchange (DEX) landscape. Without liquidity, the DEXs and protocols of the crypto ecosystem could not function. A liquidity provider, also known as a market maker, is someone who provides their cryptocurrencies to a platform to aid decentralization. In exchange, they are rewarded with the commissions generated by trades on that platform, which can be considered a form of passive income. It is important to note that the assets provided are locked on the platform for as long as the user decides to provide liquidity.
How can we provide liquidity?
In order to provide liquidity, a protocol may seem like an odyssey at first glance, but by following a few simple steps we will see how simple it is in the end:
- A new pair of tokens is first registered, thereby creating a new market for that pair of tokens. This creates a liquidity pool (better known as Liquidity Pool) for this token pair, to which users can provide liquidity.
- Once the liquidity provider (LP) provides liquidity to the pair, it receives LP tokens representing the amount of liquidity it has provided.
- From there, when an operation occurs associated with a specific Liquidity Pool, a commission of 0,3% is charged on the operation to the user who performs it. These commissions are distributed proportionally among the holders of the LP tokens that have provided liquidity to the pool in question.
Operation of liquidity pools. Source: Chainlink.
One of the benefits that providing liquidity to protocols provides us is the possibility of withdrawing the cryptocurrencies that we have contributed whenever we want from the liquidity pools. On the other hand, as we have seen previously, in Staking pools they sometimes have an unlock period from the moment we request the unlocking of the tokens. Finally, there are risks of impermanent losses (inpermanent loss translated into English). This means that our position in the liquidity pool may momentarily drop in value during market fluctuations, as the balances of each asset fluctuate. In this sense, choosing pools with high liquidity will reduce the risk of impermanent losses. However, they usually offer lower returns.
Calculation of impermanent losses with respect to price variation. Source: Finematics.
Conclusions from this cryptocurrency training
After reviewing this cryptocurrency training on ways to generate passive income, we want to remember that we must closely monitor the protocols that provide liquidity or block our cryptocurrencies. One of the main factors to take into account is the liquidity of the pools where we are going to deposit our assets. High returns may seem sweet but also dangerous, given that these pools may not always have enough liquidity to allow us to liquidate our tokens. We also recommend that when you go to unlock your tokens in staking pools, depending on the unlocking period they have, analyze a graph to predict the right time to unlock our tokens in order to take advantage of unlocking them when they are appreciating. You can consult the page Staking rewards to learn more about the blockchain ecosystem with available staking pools.