How to earn interest on Crypto?

Updated on 30 July, 2022 12:11 PM
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    With the growing uncertainty around crypto markets, fixed income instruments in the space have started gaining popularity. These instruments, although safer, come with their own set of risks. These are not completely risk free. Although, there will be lesser chances of day-to-day fluctuation in prices and interest rates, there is the fundamental third party risk involved.

    Before we go any further, it is important that you understand how are these returns generated by these institutions. It will not only help you in understanding the crypto market better, it will also make you more aware about the type of risks involved.

    How is fixed yield generated in crypto?

    There are 4 major ways in which returns can be generated in the crypto space. Note that this list in no way is exhaustive. In the crypto space that is ever-evolving, there are new concepts proofs and ideas coming up every day - some of these ideas are more efficient than others in generating yield for the end consumer.

    1. Staking
    2. Providing Liquidity
    3. Lending
    4. Margin Funding

    Now, let’s try to understand what each one of these terms mean.

    What is Staking?

    Staking as a concept is very fundamental to a lot of the blockchains out there. It actually comes from the popular consensus mechanism - proof of stake. To understand what it means and how is money involved in resolving transaction hashes, you should read our article about what is proof of stake.

    In brief, proof of stake is a novel approach to validate transactions on the blockchain that requires the validators to deposit (or stake) some tokens in order to get a chance to validate the transactions. Imagine it as a competition between validators - whoever stakes the largest amount of tokens for the longest time wins. Unlike proof of work - where the winner of the competition has to invest in an expensive operation of setting up mining rigs, proof of stake is somewhat simplistic in its approach

    Now, coming back to staking. Blockchains such as Tezos, Cosmos and now Ethereum (via ETH2 upgrade) allow validators to stake their tokens in order to get rewards. On ETH2, there is a minimum stake to get started. Validators would have to stake a minimum of 32 ETH to be able to stake. This is a significant amount. However, for retail investors, staking pools would be a viable opportunity to park their funds for long term and benefit from the passive yield.

    What is a Liquidity Provider?

    A liquidity provider is a partner to a decentralized exchange (DEX). A lot of decentralized exchanges use automated market-maker systems to allow the trading of illiquid pairs with limited slippage. Liquidity providers basically provide liquidity to these exchanges in the form of token pairs - like an ETH/USDC token. What this essentially means is - the LP would deposit some USDC and some ETH with the decentralized exchange. This would allow the exchange to ensure that the trades on the platform that involve these 2 tokens get fulfilled.

    For providing this liquidity, the exchange would incentivize the liquidity provider, thus allowing them to earn on their idle tokens. All major decentralized exchanges like Uniswap allow investors to become liquidity providers in exchange for a small reward.

    What is lending in crypto?

    Lending in crypto works similar to lending in the traditional financial markets, with some minor caveats. Just like any peer-to-peer lending platform in traditional finance, there is a lender, a platform, and a borrower. The mediatory platform is expected to connect the lender and borrower and to ensure that the smart contracts are honored.

    Just like traditional finance, the lender is rewarded for lending their tokens. The percentage APY that is earned by the lender is called supply APY. The borrower is expected to return those tokens with a small fee and the platform is expected to take a certain fraction of the fees as a cut for their services. Of all the different strategies explained in this article, lending is perhaps the most simplest strategy that has fundamentally been unchanged for the last many many centuries.

    You can earn anywhere between 0.5-15% APY by lending on platforms such as Aave and Compound

    What is margin funding?

    This is perhaps one of the more interesting avenues to generate yield in a relatively safe and more secure manner. In traditional markets and in crypto markets, margin funding is the practice of giving loans to traders who participate in leverage trading.

    Let’s understand margin trading.

    When you have a solid hunch about a trade, you would want to trade all the capital you have and more on that single trade. This would essentially allow you to maximize your returns for that trade. Let’s take an example. Imagine Sam, a gifted trader who has a very high conviction that ETH would increase in price by 10% very soon. Sam has $1000 to their name, but getting a $100 return on such a high conviction trade is not very lucrative to Sam. Sam wants to take a position of $5000 instead. A 10% rise on $5000 would allow them to earn $500 on this single trade - which is a much more lucrative offer for Sam.

    But they only have $1000 to their name. Where would they get $4000 from?

    Enter - margin funding. Sam gets the rest of the capital funded by some institutional investors. This would allow Sam to trade with much larger capital. In return, the institution is rewarded with some yield on their capital

    This is one of the safer practices currently prevailing in the industry. Players such as Flint generate yield using this method and offer stable yield on BTC, ETH, SOL, MATIC, and stablecoins like USDC and USDT. You can read more about how flint generates returns to understand about it better.

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