Decentralized finance (DeFi) is experiencing a boom fueled by interest from both the crypto and banking communities. But despite the excitement, the industry remains relatively young and is still going through a process of maturation. DEXes are innovating on their liquidity models, traders are experimenting with new trading venues and liquidity providers and market makers are looking for ways to maximize their profits.
DeFi is also introducing new income sources not available in traditional markets, including liquidity mining and yield farming. These methods are similar to depositing cryptocurrency for an APY, but offer the potential for higher returns and less risk. In this article, we will explore the details of these two methods of earning passive income and examine the benefits that come with them.
The primary way to earn passive income from DeFi is by providing liquidity to a specific project. By doing this, you can receive the project’s native token in exchange for your participation. This is known as “liquity mining,” or “yield farming.”
Unlike centralized exchanges, which use limit orders to facilitate trades, many DeFi protocols do away with this middleman model and rely on automated market making (AMM) to create liquidity pools for digital assets to be traded. These are essentially pools of tokens that participants constantly supply in order to facilitate trades. AMMs work on a constant product construct to identify the price range for a particular token, and they are an integral part of the global DeFi ecosystem.
One of the most popular examples of a DeFi protocol that uses this model is dYdX, which provides a venue for traders to trade perpetual futures. Built on StarkWare, a layer-two scaling network for Ethereum, dYdX is currently one of the most popular DeFi platforms, with a daily volume of over $1.2 billion USD.
But despite this significant volume, dYdX does not generate much revenue for its operators. This is due to a combination of factors, including high gas and service fees charged by the Ethereum network. As such, dYdX has created a partnership with an established exchange to offset these costs and increase its profitability.
Another example of a DeFi protocol that uses this strategy is Aave, which does about $5 billion USD in borrowing per day on Ethereum. Like Maker, Aave is able to do this by taking advantage of the low volatility of the DAI token and its ability to be used as collateral.
The emergence of AMMs has dramatically improved the liquidity of DeFi Market Making, but it is important to note that they do not necessarily have the predictive capabilities required to be profitable in traditional financial markets. As a result, unsophisticated parties are unlikely to be able to make money from this business model. This is one reason why category 3 pairs — those that have not been added to an AMM’s portfolio yet — have largely dominated the DEX landscape, with Uniswap and Sushiswap regularly accounting for 70 – 80% of total DEX trading volume.