If you deposit your cryptocurrency on a decentralized finance platform ("DeFi") platform, you can earn an additional return (over and above any gains in the value of the cryptocurrency). You also have the option to put stablecoins (i.e., cryptocurrency pegged to the U.S. dollar or another currency) on various DeFi platforms and earn a return. People are often surprised or even skeptical to hear this, which is not surprising given that only 3.5% of ETH wallets have even used smart contracts on DeFi platforms. I wanted to write this article to address people's surprise and skepticism explaining why it is possible to earn a return by putting your tokens on DeFi protocols.

There are hundreds of DeFi platforms on which you can earn a return (and sometimes also receive their tokens as well).

The Difference Between Centralized Finance and Decentralized Finance

• CeFi v. DeFi

In order to explain why you can earn a return on DeFi, it's necessary to understand the difference between centralized finance ("CeFi") and DeFi. Centralized finance is the financial system we currently have in which centralized financial intermediaries, such as banks, brokers, and insurance companies, are integral to providing financial services. Decentralized finance is a reimagining of our financial system without centralized financial intermediaries, where financial services are provided through smart contracts on blockchain transparently, trustlessly, and permissionlessly. DeFi is transparent because the blockchain is public and anyone can access it (at least in the case of Ethereum, the primary DeFi network). DeFi is trustless and permissionless because all you need to interact with a given smart contract (say, to get a loan) is an ETH wallet that can interact with DeFi protocols - you don't need to create an account with the platform and they don't need your personal information the way that CeFi institutions do. Once you try DeFi, you will see why this technology will change the world once it is streamlined and accessible to all people - you just navigate to the DeFi platform's website and you can immediately get a collateralized loan, swap your tokens, etc. - in seconds. It's seamless, easy, and fast. Compare that to trying to buy crypto on a CeFi exchange (e.g. Coinbase) or trying to get a loan from a bank (good luck).

• DeFi Platforms Pay Token Holders to Deposit Their Crypto on the Platform to Facilitate Provision of Financial Services Through Smart Contracts

Here's the rub. Centralized financial intermediaries play an important role in facilitating the provision of financial services - e.g. if you want to sell a security but there are no buyers for that security at that time, a centralized exchange will make a market for you and create liquidity for your asset. If there is no centralized entity on a DeFi platform, how can DeFi protocols ensure that at any given time, there's liquidity for sellers who want to sell their tokens or that, if I want to borrow a loan in a certain cryptocurrency, there is someone willing to lend me that cryptocurrency? It was a conundrum. The innovation in DeFi to address these issues was to incentivize people holding tokens to place their tokens into liquidity pools by sharing the fees earned by the platform with the tokenholders who staked their tokens in the pool. For example if you hold both ETH and USDC (a stablecoin pegged to the USD), you could deposit your ETH and USDC into the liquidity pool on popular DeFi exchange Uniswap, and every time someone uses that liquidity to swap their tokens, you receive a pro rata cut of the fees. In the case of the issue of making sure there's always a lender for various types of cryptocurrency, DeFi platforms incentivize token holders to offer their tokens for loan by sharing with the token holders the interest earned on the loans.

The reason you earn a return by depositing your tokens on DeFi platforms is because DeFi platforms pay tokenholders to assist them in providing financial services through smart contracts (such as making loans, making markets, etc). Also, some DeFi platforms also give depositors or users their governance token as an additional incentive to deposit or interact with their platform. A governance token gives you the right to vote on matters relating to the protocol, like a shareholder votes on certain matters relating to the applicable company. Governance tokens can be very valuable so receiving them can significantly increase your return. DeFi platforms tend to give governance tokens to early adopters of their platform (which means you need to know about the platform and use/deposit very early on, which can be riskier than depositing on a mature platform). But, by way of example, SharedStake is a DeFi platform that is still granting governance tokens (worth around $85 at the time of writing) to people who stake on their platform. If you have ETH and want to earn a very good return on it, this post outlines the steps to earn a return on your Ethereum on DeFi platform SharedStake.

Token holders earn money on DeFi protocols as an incentive for assisting the protocol in providing financial services.

Suggested Strategies to Earn on DeFi Protocols

One topic that will be covered by this blog is different strategies to earn a return on your cryptocurrency using various DeFi protocols, so follow me if you would like to read my posts covering these strategies. A simple strategy to earn a return on several types of cryptocurrency (including Bitcoin*, Ethereum, Link, etc plus many types of stablecoins) is to deposit your cryptocurrency in the appropriate vault on Yearn. Yearn is a platform on the Ethereum network that takes deposits of various cryptocurrencies and stablecoins from users and deploys them on DeFi platforms to earn maximum yield while minimizing risk. Yearn is also capital efficient because your ETH fees will be much lower if you are investing in DeFi platforms through a Yearn vault, sharing those fees with all the other depositors, rather than paying those fees 100% yourself. Yearn is what is known as a yield aggregator. I will be making a post with more details about how to use Yearn so keep an eye out for that. It can be intimidating and confusing if you have never interacted with DeFi platforms before.

Another strategy if you want to get more fancy and maintain your exposure to BTC, ETH or other altcoins is to deposit them on a DeFi lending protocol such as Aave, borrow stablecoins, and deposit those stablecoins on Yearn or another DeFi platform to earn a return. Just be aware that if your collateral (your Bitcoin, Ethereum, etc) drops in value too much, you could get liquidated (i.e., your collateral will be sold to cover your loan) so you need to keep an eye on your collateralization ratio and be sure to add collateral or repay your loan if there is a drop in the value of your collateral.

*Note: In order to be deployed on the Ethereum network, your Bitcoin must be tokenized or wrapped since Bitcoin is not an ERC-720 token built on the backbone of Ethereum. There are several platforms through which you can wrap or tokenize your Bitcoin. I intend to do a post on this topic, but in the meantime, check out this post regarding the various types of wrapped Bitcoin. I personally use Renbridge because it is not centralized.

About the Author: Harvard grad who formerly worked in the finance industry is passionate about DeFi and was inspired to write this blog covering the basics of DeFi, liquidity mining, farming, and tips and tricks and mistakes to avoid for DeFi newbies. My goal is to increase the number of people using DeFi by making it more accessible. 

Register for Publish0x to earn rewards in crypto for reading or blogging!