A Complete Guide to Making Passive Income With Lending

A simple transaction is at play here: a lender supplies their assets to the lending pool. The borrower comes in and takes out a loan from that pool by providing collateral. The interest that the borrower pays goes to the lender, making the transaction ideally profitable for both the lender and the borrower.

Naturally, the more assets are borrowed from the lending pool, the higher the interest rate that lenders get, right? Well, it all depends on how the market is performing at that instant. And when it comes to the interest rate that lenders accrue from participating in lending pools, it also varies according to what is known as the utilization ratio.

Thus, there are several factors that influence the interest rate that you can get from merely supplying your capital to a lending pool. How does it work? On what conditions does the interest rate depend? And is lending even a profitable passive income strategy in crypto?

We’ll answer these and many more related questions in this article.

Understanding How Lending Pools Work

We’ve already explored how lending pools work in a simple yet abstracted process above.

How Lending Works

How Borrowing Works

Utilization Ratio and How It Works

This kind of dynamic between lenders, borrowers and even liquidators ensures that the lending pools are able to support the transactions regardless of what the market conditions are. And to ensure that there is always enough liquidity so borrowers can borrow and there are always sufficient borrowers for lenders to supply their funds to the LP, a formula is used. In its simplest form, it looks like this:

Utilization Ratio = borrowed capital/total capital

Here the utilization ratio refers to how the LP is being utilized. If the total amount of borrowed capital exceeds the total capital available then the utilization ratio will exceed the value 1, and hence there won’t be enough liquidity available for new borrowers to borrow capital.

However, if the borrowed capital is 0 (that is no borrows on the LP are taking place) then the utilization ratio will also go to 0 making it almost impossible for lenders to deposit their capital. Just imagine, if there are no borrowers present, then what’s the point for a lender to supply their capital?

But why must these things matter? They matter because for any lender to supply their assets, the LP needs to have enough utilization that they are making healthy returns on their assets. Otherwise, they can end up locking their capital without generating any meaningful returns.

The interest rate that you get on your deposited capital varies according to the market conditions. If there is a high demand in the market for borrowed assets, then the rates would be increased to ensure that the utilization ratio remains stable.

On the other hand, if there is low borrowing in the market then the interest rates will be decreased to incentivize borrowing. In the first case, a lender is earning more interest on their lent capital and in the latter case, they are earning less.

Can I Make Passive Income From Lending and Borrowing Protocols?

Lending protocols allow you to put idle capital to work by easily supplying them to a lending protocol and start earning interest. In addition, you are also entitled to governance tokens that are value-accrual tokens. However, interest that you get from supplying liquidity is dependent on how the market is performing. That said, since the top lending protocols have been used for such a long time (in crypto terms), they are quite reliable when it comes to generating passive yield.

Yield Farming LP Tokens

How Much Passive Income Can I Make From Lending?

Here are some supply APYs for assets across Aave and Compound.

You’ll find similar lending protocols on other chains as well. However, remember that since Ethereum is the biggest market out of all of these, you are more likely to get stable APYs when you lend on Ethereum. The profitability of your lent capital will depend on the market conditions. And since the APYs are going to remain more-or-less the same across different protocols, you can choose the ones that work best for you.

How To Get Started With Lending on Compound?

In this section, we’ll quickly explore how you can get started with lending across different protocols today. We’ll be focusing on Ethereum only and will consider Aave and Compound to explain. If you have already played around with their interfaces then you know that lending is a fairly simple job on these platforms as their UI is quite easy to navigate.

Once you’ve enabled your wallet, you will be able to supply the assets to the pool. Once supplied, you will see your active positions in the pool at the top of the page like this.

And when you access your wallet (in this case, MetaMask), you will be able to see the LP tokens (in this case, they are cUSDT).

The process is very similar for lending on Aave as well, once you get the hang of it.

How To Get Started With Lending on Aave?

Once your transaction is approved, you will be able to see the aTokens (i.e., aUSDT in this case) in your wallet. You will also be able to see your existing position and the APY that you’re earning at the top of the page.

Once you’ve lent your assets on either of these (or even both) protocols, you will start accruing interest on them as time passes. As the market goes through its cycles, your APY might rise and/or fall subject to how the market actually performs.

Now the question arises — after supplying assets on lending protocols, what else can you do with the tokens that you get in return (cTokens in case of Compound and aTokens in case of Aave)? For the users who wish to compound their yield, they will have to figure out ways to use the derivative tokens that they get to generate more yield. Here are some strategies you can use to do exactly that.

How Can I Use My LP Tokens From Lending Protocols?

The derivative LP tokens are just like your underlying lent tokens. The only difference is that they are accruing value and hence you might see the price increase over time. There are a few different ways in which you can use them.

Loop LP Tokens to Compound Yield

This is made possible using a feature that we’ve already mentioned above: composability. Composability lets you create money legos (using one protocol’s issued token as a base token on another protocol). These money legos then help compound your yield over time.

Just imagine — if I repeat this process three times then I’m already earning 6x the yield that I was earning when I just deposited my assets once, using leverage. However, you would have to consider the gas fees it takes to execute, and exit this strategy — a low-cost chain or layer-2s might be more feasible.

Supply LP Tokens to Curve

When you provide liquidity on Curve, you get CRV tokens. You can use these CRV tokens in different ways to further boost your yield on Curve itself. One way to improve your yield is by staking (locking) your CRV tokens to get a share (currently, 50%) of the trading fees that go to veCRV holders.

The veCRV holders are those who have locked their CRV tokens and have received veCRV tokens in return. The veCRV tokens are responsible for boosting your CRV rewards. Using veCRV tokens, you can also participate in governance decisions on the Curve platform. When you supply your cTokens or aTokens to Curve, you can find different ways of boosting your overall rewards, which helps in compounding your overall yield whilst increasing your exposure to a wide variety of assets.

To put your assets in these protocols requires more active participation within the market than a passive income strategy would warrant. You need to constantly monitor your positions on Curve. Also, this strategy is a bit more advanced and is often used by more seasoned DeFi users. If you are just someone that is looking to generate some passive income through lending, then you do not need to worry about relying on these strategies.

Risks With Lending Protocols

Lending protocols are the base of the DeFi ecosystem. Together with AMMs, they are responsible for maintaining the liquidity needed to support the entire ecosystem. The derivative tokens that lenders get from lending to these platforms are used across a variety of different protocols.

Composability Risks

You can imagine the composability risks that can arise from this. If the base layer protocols go down for some reason and some assets are affected, then wherever those assets are being used also get affected making it quite risky for the entire ecosystem.

But composability risk is a known risk in DeFi. And while some protocols have opted for different ways of hedging against that risk, an event where the entire ecosystem collapses hasn’t really happened.

APY Risk

In addition to this, the APY risk also exists. What is that? We know that the utilization ratio of any lending/borrowing platform takes into account the amount of capital that has been borrowed. And the amount of capital that is borrowed depends on the market conditions. If the market suddenly starts dumping and we enter a bear market then there are good chances that the amount of borrowed capital would reduce in volume. And to incentivize borrowers to keep borrowing, the interest rates will have to be reduced. This in turn will affect the APY that lenders are making on their assets.

On the contrary, let’s consider a scenario where the market suddenly starts pumping. When this happens, all users enter the market and some of them (seeing plenty of opportunities) start borrowing assets to leverage. As more assets are borrowed, the utilization ratio also increases and almost gets to a point where it gets to being 100% utilized. But 100% utilization can lead to cases of bank-runs. Imagine this: if all the available capital in the lending pool is borrowed, then the lenders cannot withdraw their capital at all. To avoid such cases, the interest rates need to be increased so borrowers don’t keep borrowing from the pools. This balancing of the interest rate is done by the smart contract itself and is a dynamic process.

The APY risk here is mainly that which arises from the changing market conditions. But things can start looking really bad when your interest rate keeps fluctuating reacting to a highly volatile market.

Liquidation Risk

The third type of risk which is probably one of the most worrisome is that of liquidation. Liquidation happens when the value of the collateral that you supply decreases from when you supplied it. Let’s consider an example here to understand this better. Suppose you deposited 50 ETH to borrow a loan. Now, after a few days, the market starts dumping and your ETH loses 3% of its value. Thus, your collateral has now dropped down to 48.5 ETH. Since your collateral has reduced, so should your borrowed loan amount right? In most cases no.

A loan from any lending/borrowing protocol is typically overcollateralized, which means you are depositing more collateral than the loan that you are taking out. This is done to ensure that these instances don’t happen that often. However, crypto is a highly volatile market and these instances can happen if not that often. Let’s take an example of when they do happen.

Continuing with our above example, let’s say that there is a huge market crash and ETH loses 48% of its value, making your collateral worth 50% less than what it was worth initially. Suppose you are neither able to pay the loan back nor able to pump your collateral back up supplying more ETH. In that case, a liquidator will buy your collateral at a discounted price (compared to the market) in return for liquidating your loan. Moreover, the lenders would also want to get out to save their capital. The lending/borrowing activity in this case would eventually reduce to 0. This would create a scenario where neither the borrowers nor the lenders would want to participate in the market.

Closing Thoughts

Lending pools are definitely one of the best ways of generating passive income within DeFi. If you lend your capital to any reputable pool like Compound or Aave not only do you get consistent returns (the only fluctuation comes from the market), but you can also use the derivative tokens across a variety of different protocols to compound your yield.