How to generate yield on your crypto
In my last article, I covered the top 25 cryptocurrency FAQs. In this follow-up I’ll discuss the the two approaches to earning yield on cryptocurrencies: Centralized Finance (CeFi) and Decentralized Finance (DeFi). Both have their pros and cons which investors must carefully consider. If used appropriately, both can generate a reasonable income stream without having to sell the coins generating the yield.
CeFi apps-Centralized Lending Exchanges
CeFi options include centralized lending exchanges such as Blockfi.com, Celsisus.network, and Nexo.io. These services are considered centralized because they’re managed by a single corporate entity. When you use them, you deposit your coins in their vaults, allowing them to lend and deploy your coins to financial institutions (collateralized lending) and DeFi applications (discussed below). You must trust that these companies will act responsibly with your coins. While your funds are not insured like cash in banks, these companies follow the latest in crypto security protocols and have insurance that protect against hacks and breaches. Be sure to read the fine print on exactly what is protected and how much. Collectively, they have almost $40B in assets under management (Celsius: $10B, Nexo $12B, Blockfi $15B) and have been in operation for 2–3 years with no loss of customer funds. Earning yield with CeFi is much easier than with DeFi (discussed below).
Yields vary by coin and can be enhanced if you hold the native tokens of the exchanges (CEL token for Celsius, and NEXO token for Nexo). Expect annual yields of 2%-12% depending on the coin and how many native tokens you hold. Note that the published yields change periodically (weekly for Celsius, monthly for Nexo).
CeFI apps-Centralized Trading Exchanges (CEXs)
Your other CeFi option is to stake your coins on a major crypto trading exchanges such as Coinbase, Kraken, or Binance. While these companies are best know as places to buy/sell crypto, they can also stake (deposit to earn yield) coins on your behalf on the underlying blockchains. For example, you can use Kraken to stake your Ethereum on the Ethereum Proof-of-Stake (PoS) blockchain (aka Eth 2.0). These companies typically do not lend your coins out via collateralized lending like the aforementioned CeFi lending exchanges. Annual yields vary by coin, but expect annual yields of 2%-12% depending on the coin. You can avoid CeFi staking altogether and stake the coins on your own if you’re willing to learn the block-chain specific technical details of how to do so.
DeFi Apps — Overview
If you don’t want to give up control of your coins to an entity, you can invest your coins in any of a number of DeFi applications. DeFi apps are considered decentralized because they’re not controlled by any single entity — they’re decentralized and operate as pure distributed software. Among the most popular DeFi apps are Uniswap, SushiSwap, AAVE, and Compound. (See DeFi Pulse for a full list.) These apps allow you to deposit your coins into their software protocols while maintaining control of the private keys that back your coins; you just need to give the DeFi apps permission to add your coins to their lending or trading pools(CeFi apps require you to send your coins to addresses that those companies control.)
Uniswap and SushiSwap are coin exchanges that allow anyone to swap tokens and earn income by serving as market makers by depositing their coins into swap pools. AAVE and Compound are lending/borrowing protocols that allow anyone to lend and borrow coins in a decentralized/anonymous fashion. Expect annual yields in the 1%-12% range depending on coin and market conditions. Note, Using DeFi apps is not simple and can be confusing for those new to crypto. CeFi apps are the easiest on-ramp if you’re just getting started.
DeFi Apps — AMMs
Many of the top DeFi apps provide yield by serving as decentralized coin exchanges (DEXs). Uniswap is the most popular DEX; it allows users to swap Ethereum and Ethereum ERC-20 tokens in a decentralized fashion. AMMs work by pooling coins provided by anonymous liquidity providers (LPs). These liquidity pools power the coin exchanges.
One of the most popular pools on Uniswap is Ethereum-USD Coin (ETH-USDC). To earn yield, you must deposit an equal dollar amount of ETH and USDC. In exchange for the deposit, you earn your share of all fees (.3% per trade) generated when users swap from ETH to USDC and vice versa. Sushi Swap has an identical pool, but the fee is .25% per trade (shared amongst all LPs) plus and additional .05% (in SUSHI tokens) to SUSHI token holders. Expect annual yields in the range of 1%-12% depending on coin and market conditions
Earn Yield and Avoid Market Volatility with Stable Coins
For those who want to generate more yield than they can get from a bank account while minimizing exposure to cryptocurrency volatility, a stable coin strategy should be used. By converting your fiat currency to stable coins like USDC (backed 1-to-1 by actual U.S. dollars in banks) and USDT (backed by fiat currency, cash equivalents, and other assets), one can deposit these stable coins in a CEX or DEX and generate 2–12% annual yield while avoiding pricing risks. Pricing risk is avoided because the value of these coins has historically been one U.S. dollar (give or take a cent or two). This dollar peg remains in place even during market volatility due to arbitrage opportunities presented when their value dips below $1.
Risks — AMM Impermanent Loss
AMMs have a unique risk called impermanent loss. Impermanent loss involves losses a liquidity provider incurs vs. not providing liquidity at all (hodling). For example, you could deposit $1,000 worth of ETH and $1,000 worth of USDC in Uniswap or just keep those coins outside of Uniswap (hodl). After, say, 6 months, the initial $2,000 worth of ETH+USDC outside of Uniswap would be worth $2,500 if ETH price increased 50% over that time ($1,000 USDC + $1,500 ETH). If that $2,000 worth of ETH+USDC were instead deposited in Uniswap at the start of the 6 months, your portfolio could be valued at more or less than $2,500 depending on how much trading fees you collected during that time. If you collected little to no trading fees, your deposited coins would be worth less than $2,500 — this deficit is called impermanent loss. (Less than because you’ll end up with more USDC than ETH as users swap USDC for ETH as demand for ETH rises. The increase in USDC you own does not make up for the ETH.) It’s an impermanent loss because you only experience the loss if you withdraw your coins from Uniswap. As time goes by and more fees are generated, your impermanent loss could turn into a profit.
Risk
The biggest risk with earning yield on your crypto are smart contract and other software risk. AMMs like Uniswap are just smart contracts that run on Ethereum nodes. Any software defect could provide an avenue for hackers to steal funds in a pool. Even coins staked by a reputable CEX like Coinbase have risk because the underlying blockchains where the coins are staked could have smart contract and other software risk that could allow a hacker to steal coins. To prevent loss of funds, DeFi apps undergo audits by many reputable firms prior to upgrades, and their code is open to the public to inspect. Bug bounties exist to reward white hat hackers who find and reveal bugs. The open source nature of blockchains minimizes staking risk as the global community of developers inspect the code and provide feedback. CeFi apps partner with world-renown crypto security firms like Bitgo, Fireblocks and Anchorage to secure their billions in assets under management.
Summary
This article provided an overview of the various ways individuals and institutions can generate yield on their crypto. While there are risks associated with centralized and decentralized lending, the rapid growth of this sector, in terms of assets under management and users, is a strong indicator that this alternative to traditional banking is not only here to stay but may become a serious alternative to yield generation for individuals and institutions worldwide.
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