The Crypto Space: Passive Income for Rational People?

Ethereum coin standing in front of coin stacks

This is not financial advice. I hold no such accreditations and urge you to at all times seek the opinions of a financial advisor. This article is intended to give a greater understanding of how aspects of the crypto industry works, not to tell you where to put your money.

Blockchain technology is a bright new industry in our turbulent times. Narratives abound about why it will be the next big thing or is doomed to fail, but if you fall into the camp of people who want to get involved or have already, it’s a good idea to understand as much about the space as possible. Maximising investments requires maximising knowledge.

To that end let’s talk about the ways that exist to earn passive income on your crypto. This article will spend a lot of time in the nuts and bolts, aiming to give you a solid understanding of what’s being talked about. There are already a thousand articles explaining where you can go to simply invest, and I’ve linked a few especially good ones.

Background

Economic bubbles are no new thing, but today it would appear to many that the economy is one giant one. From the stock market to real estate the old maxim buy low, sell high seems irrelevant. Buying high is all there is. Some commodities buck this trend, but potential price manipulation in those markets make future rises uncertain.

Not only is it hard to tell whether an investment is currently topped out and headed for a correction, the classic option of saving as a hedge has slowly become unfeasible. Historically, parking your money in a bank has been a safe way to earn a modest but not meaningless return. Today however a never ending need for economic stimulus has gradually driven interest rates into the ground, where they lie battered and bruised and unable to rise. This trend has followed us into the Pandemic era following the 2008 financial crisis, and we have not been able to return to normal rates of interest ever since.

So we’ve got a situation that makes saving impossible coupled with overextended price charts everywhere we look. This merry go round is not doomed to implode immediately, but historical data tells us it will at some point. Where then does it make sense to keep our money? Since this article is about crypto, let’s talk about the options that it holds.

Many will tell you bitcoin is stupendously overvalued currently, and I am not here to tell you to throw all your hard earned dollars at it at a price nearing $50 000 per coin. But the market is deeper than that, and much more mature than the one we saw in 2017 that was infamous for it’s ICOs (initial coin offerings) which went nowhere and ended in disaster for so many overzealous investors.

This time around, there is perhaps more hope for the rational investor.

One evolution in the cryptosphere has been the advent of DeFi (Decentralised Finance). Though in its infancy in the run up to 2017, the years since have provided time for extensive growth and understanding. Unlike bitcoin, DeFi applications are not attempting to revamp a monetary order, and instead focus their efforts on providing alternatives to the traditional banking and financial centres, using the power of blockchain and cryptography to establish trust.

If you’ve dipped a toe into DeFi, then you know there are myriad ‘coins’ floating around under various tickers, jostling for attention. DeFi projects are built upon a previously existing blockchain network; think Bitcoin, Ethereum or Litecoin, so they are not cryptocurrencies in the way that many people think of the term. Ethereum is by far the most popular DeFi platform for developers at this time with a vast array of projects using it’s network. So let’s take a look at these projects, how the assets they issue work and how they differ from their parent platform.

Tokens can exist in two forms: security and utility, and the distinction is important. Holding a security token is a lot like holding a traditional company share and comes with the promise of profit if the project succeeds. A utility token on the other hand has a specific purpose for existing, and performs an important role in the operation of the project’s network. Because a utility token has a primary role beyond simple investment, it is not classified as a security by regulators, and is therefore subject to less stringent rules. A governance token is a type of utility token which also confers voting rights upon the holder, adding further to the concept of decentralisation as each person with a stake in the network has a say in how it’s developed and run.

Utility tokens are a bit like holding a share with extra benefits and their unique status of having a function means that there are unique ways to reinvest them for profit.

Staking and Yield Farming

Though the end result is similar for both these methods, the mechanism is quite different. To understand why, you need to have a basic understanding of how blockchain works.

Proof-of-work and proof-of-stake are the validation systems used by blockchains. If you’re at all familiar with bitcoin then you probably already understand proof-of-work: miners compete with each other to solve complex equations and thus form the next block in the chain. Their reward is all the transaction fees for that block and in the case of bitcoin the block reward, or brand new bitcoins. In a proof-of-work blockchain there is no need for staking.

Under a proof-of-stake model some token holders ‘stake’ their assets in pools, and the right to collect the transactions for each block is assigned on a probabilistic basis depending on how much of the asset is held in the pool. If the pool holds 10% of staked assets, it has a 10% chance of collecting the reward, if 5%, then 5% and so on. And there you have it, that’s staking. You collect a portion of the transactions as a thank you for providing your tokens to perform an essential process of the network.

Staking your tokens is usually simply a matter of finding the website of the project you want to stake with and following their instructions. It’s even possible to stake tokens that are held offline in cold storage in some cases.

Yield farming is not based on validating transactions, so can be applicable to both validation systems. Instead it’s all about providing liquidity for trading, as well as for borrowing and lending. Having enough liquidity floating is essential to facilitate these processes and without it, young projects would have a very difficult time attracting new users. Borrowers would also struggle to find enough of the asset out there that they wanted to borrow. Yield farming is the catch all term used to describe putting up your tokens as collateral for liquidity, and the mechanics can be quite complex.

Yield Farming protocols:

  • Compound
  • Aave

Lending

Now that we understand how we can make ROI in the DeFi space, it’s time to look at the same concept from a more traditional, centralised perspective. That’s right, centralisation in crypto. Oh the horror!

Centralised platforms which offer crypto borrowing and lending services are also quite fledgling in nature, but nowhere near the extent of DeFi, in which some products are barely months old. Lending in crypto is a far more ‘bank like’ experience than staking or yield farming, in which the institution is a trusted third party which handles what is done with the assets you decide to hold with them. This usually takes the form of lending out to other customers your assets as loans. While lending platforms are not banks for obvious reasons, the business model is very similar.

Centralised lending platforms include:

  • BlockFi
  • Celsius,
  • Crypto.com
  • Nexo

It’s also possible to have a savings account with many cryptocurrency trading platforms such as Binance and Phemex that sits alongside your trading accounts, though these will generally have less options in terms of assets to loan and interest rates to choose from. However, the rate of interest can still be quite attractive and can be a great option for traders specifically who want to earn interest on assets they’re not using, without having to go through the inconvenience of transferring between platforms and potentially not having access to their funds at short notice. For investors, a dedicated platform is probably more reliable and a more flexible way to earn.

While it may seem to some purists that reintroducing a middle man to the crypto experience doesn’t make sense, in practice that’s not the case. For starters, it allows you to earn interest from assets which wouldn’t otherwise have access to such a feature, namely bitcoin and stablecoins. In addition, many people are not technically savvy enough and don’t have the time to become so in regards to properly understanding the decentralised models we went through above. The level of research required to understand if the asset you’re staking or yield farming with is reliable is not insignificant.

Companies which specialise in crypto lending are also inherently accountable to their customers, giving a greater sense of peace of mind. BlockFi, for example, is based in and regulated by the United States. Teams are transparent, there’s access to customer service, and each company has entire teams of security experts dedicated to ensuring that funds remain safe. All this makes them the better option when it comes to most retail investor’s interests.

We’ve mentioned a few companies which offer these services, but going through the ins and outs of each platform would take a couple thousand more words than this article has time for, and since many people out there have done it better than I, I will simply direct you to this article which has a fantastic write up on each of the main available options.

Risks

We’ve already mentioned the fledgling nature of cryptocurrencies and how that impacts their risk assessment. It’s not a factor to take lightly. There is still a lot of uncertainty in this space, and the volatile nature of price only ups the level of anxiety many feel. Let’s take a look at some of the reasons to be sceptical and to always keep in mind when making any financial decision.

Government regulation is an inherent risk since many nations are still formulating their responses to the phenomenon they’re faced with. While the public may not find out for many years what the final roadmap will look like, there will come a time when there is greater regulatory activity in the space.

In my view, this is not something to be feared per se. There is an extremely strong narrative out there these days that governments cannot be trusted and while that’s certainly true to some extent, the fact remains that government regulation is an essential part of how society operates. While we may at times get frustrated at the forms this takes, a referee is preferable to a free for all.

Regulation in and of itself is not necessarily a risk, but it does create uncertainty about what things will look like moving forward. When deciding to invest in crypto assets it would serve the investor well to keep an ear to the ground about developments. The fear of unknowns however can often be paralysing and not entirely helpful.

Perhaps the biggest risk narrative around crypto. While we don’t quite live in the wild west of 2017 any more, there’s no way to claim that shoddy business practice and outright fraud isn’t still a thing. It’s just become less common and potentially easier to spot.

Some crypto fraudsters have been held to account, but others have not. Even if the perpetrator is caught compensation is a long shot at best.

In the case of utility tokens, risk of fraud is especially relevant. DeFi is based on smart contracts which are terms of agreement written into lines of code. When swapping tokens on a decentralised exchange (DEX), these smart contracts are used to identify the tokens to make sure you receive exactly what you asked for. The problem is, malicious parties can create a random smart contract and post it to DEX under the same name as a legitimate project, potentially tripping up inexperienced investors. With no central authority, limited regulation and the anonymous nature of the blockchain, mistakenly spent funds can’t be recovered.

Bank accounts are usually ensured by governments to protect savings up to a certain amount in the case of failure. This isn’t the case for crypto based assets. While you can put your funds with a platform like BlockFi and enjoy increased confidence over the decentralised options, there is still a real risk that the assets you hold on it, or even the platform itself, collapses entirely.

Bitcoin is famous for its price volatility and since the whole market is pegged to some extent to the price action of bitcoin, that applies across the board. While it’s easy to look at the recent run and get excited about the potential, it’s important to look at the preceding years to realise that while you may be earning excellent returns in terms of your asset, the price of the asset versus your country’s currency may not be doing so well. Are you willing to keep earning interest in bitcoin denominated terms while the price fluctuates through a years long bear market? If not, you should probably think twice.

This is mitigated somewhat by using stable coins as your investment vehicle since they are pegged (generally to USD) to a fiat currency value. However even these are not risk free, as anyone who has kept up with the Tether FUD can tell you. A company issuing a stable coin must hold assets equal to the value of what they’ve released, but there’s not guarantee that this will be the case in 100% of cases as the Tether controversy has illustrated.

I hope through this article you’ve come to understand the inner workings of the modern crypto landscape a little better, and that it has helped you in your journey of understanding the ways you can make this exciting industry work for you.

Researcher and writer on topics that interest me and may interest you too. This blog is a tool for my own understanding.