How to earn passive income in a decentralized way in cryptocurrencies
First, let’s focus on the words “decentralized way”. What does that mean? It means that your money is not managed by a single entity (a “centralized” entity) like crypto exchanges such as Binance or Coinbase, or by a company or investment fund.
In a decentralized entity, your money is managed by “smart contracts” (which means algorithms) but most importantly, choices such as choosing the next roadmap, charging fees, solving problems, or suggesting improvements are made by the community. This brings a lot of advantages: this entity is led by customers for the good of customers, not greedy stockholders or insiders!
This is much more reassuring for users. However, it also has drawbacks, such as occasional scalability problems (not being able to manage all the requests) and lack of speed and accountable people when there are problems.
Now, let’s dig into this topic! Everything that will be mentioned is part of the big family named “DeFi”, for “Decentralized Finance”. So, as we have seen, to simplify it is a finance without banks or companies, but managed by customers for the good of customers! Sounds interesting, doesn’t it?
Here, you play the role of the bank. You deposit your money to allow someone to borrow it against interest rates. Everything is secured with algorithms and a collateral (a guarantee of money that will be paid to you if the borrower defaults).
The most well-known protocols are Anchor (up to 20% APY yield on a stablecoin) for Terra blockchain, Aave for Ethereum blockchain and Alpaca Finance for Binance Smart Chain (BSC) blockchain. It is controversial to talk about the BSC blockchain in a topic about decentralization, but that is another debate…
Here, you help secure the blockchain. In most of the new blockchains (not all), the calculation and validation process is called Proof-of-Stake (PoS) instead of Proof-of-Work (PoW) like in older blockchains such as Bitcoin or Ethereum.
- In PoW blockchains, to partake in the validation process, you need computing power (the famous “mining farms”).
- In PoS blockchains, to partake in the validation process, you only need to hold cryptos. It is based on confidence: the more cryptos you have, the more you ensure that they will be well-validated, otherwise you will lose your money.
In the staking earning, you lend your crypto to a PoS “validator” (this is the delegation process). A PoS validator is an entity that participates in the validation process by holding big amounts of coins on the blockchain network, and you will help them have even more cryptos, to validate the blockchain calculation even more.
- Technical part: Indeed, with PoW or PoS mechanisms, a validator is randomly chosen on the network. However, the more computing power you have (for PoW), or the more cryptos are held on the blockchain network (for PoS), the more likely you are to be selected by the network and be given the associated reward after block validation. That’s why a validator wants lots of your cryptos.
In exchange for the loan of your cryptos, the validator will give you a part of its rewards, because whenever you partake in a validation process, you are rewarded with the crypto that you helped secure (this is Bitcoin mining for example). You can withdraw your money from a validator at any time.
To summarize: you lend your cryptos to someone who really needs them, and they thank you with passive income!
Here, you help decentralized exchanges work properly.
A decentralized exchange allows you to exchange money (USDT against BTC for example) without using a centralized exchange (Coinbase, Binance…) that has your private key (that means your wallet password). When you have your own private key, you are the only owner of your cryptos : that is the advantage of using decentralized solutions.
- Technical part: In a decentralized exchange, you connect your wallet to a browser extension with your own private key, and that extension (like Metamask) will connect to the decentralized exchange website such as SushiSwap or PancakeSwap.
When you are a liquidity provider, you lend your cryptos to a pool of liquidity: this will allow users to exchange cryptos that are in that pool, thanks to you. In exchange, you earn the trading fees of the swaps that are distributed among all the members like you, who have lent their cryptos to the pool. You can withdraw your money from the pool at any time.
We have seen three of the main ways to earn passive income in cryptocurrencies with decentralized methods: lending, staking and providing liquidity.
I am not a professional. This article may contain errors, do not hesitate to add interesting content in the comments! Furthermore, this is not an investment advice, do your own research!
Thank you for reading, see you soon!