A Complete Guide to Making Passive Income With Lending
DeFi

A Complete Guide to Making Passive Income With Lending

2 months ago

CoinMarketCap Alexandria takes a look at how to generate passive income by lending out your crypto assets.

A Complete Guide to Making Passive Income With Lending

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Lending protocols are crucial to the entire crypto industry. They are money markets responsible for bringing together two categories of users in the ecosystem: lenders and borrowers.
For a user who wishes to borrow additional capital (could be a non-volatile crypto asset such as a stablecoin) against their existing capital (could be a volatile crypto asset such as ETH), they can do so with the help of these protocols.

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.

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Understanding How Lending Pools Work

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

The lenders supply their capital to a pool where the borrowers are able to borrow them by providing collateral. The pooled funds from lenders are aggregated using a smart contract. The smart contract further helps determine the interest rates, the deadline of loan repayments and so on. As of writing, the top three lending & borrowing protocols by market cap are currently managing over $600M worth of volume everyday.

How Lending Works

When lenders supply their tokens to a liquidity pool (LP), they are issued LP tokens in return which are minted by the smart contract and are representative of the underlying supplied tokens (they can be pegged 1:1 or can be value-accrual tokens that steadily increase in value as interest accrues). After some time, when the lender wants to withdraw their tokens, they can simply return their LP tokens and get the original tokens in return. Naturally, the lenders in this case will only supply their capital to the LP if they see that there is a chance to make a profit.

How Borrowing Works

Similarly, when a user wants to borrow a loan against the lending pool, they supply as collateral the supported tokens. These tokens are either deposited within the LP or they are kept in the borrowers’ wallets but the LP is able to seize them in case the borrower fails to repay the loan. In the case they do fail to pay the loan back, then a liquidation will occur — the protocol steps in to pay the loan back and gets the borrowers’ collateral at a discounted price for doing so.

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.

While these rates do fluctuate, lending protocols today are considered one of the more reliable ways of generating yield. However, this is often offset by the governance subsidy that you get while using these protocols. Whenever you use a lending protocol such as Compound (that is a DAO) you get the governance token in return (which in this case is COMP). These are value-accrual tokens and you can use them to participate in governance decisions in the protocol.

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

In fact, the LP tokens that you get after you’ve supplied liquidity to a protocol can also be used across different DeFi applications. When lending/borrowing was first becoming popular, the utility of the LP tokens were not well-defined. You could hardly use them anywhere. The only income that you were generating in that case was coming from the interest that was being charged from the borrowers. However, now you can easily make income from using the same LP tokens by “farming” them in other protocols.
In that case, on top of the yield from lending your assets, you also use your LP tokens to generate even more yield. This process is known as compounding and the DeFi feature that enables this is known as composability. Since lending protocols occupy the base layer of the DeFi stack, other protocols sit on top of it and utilize its LP tokens to help users generate compounded yield.
Compound interest is known as the eighth wonder of the world and is very powerful in growing your stack, especially when the underlying asset increases in value too. However, be aware of impermanent loss (IL) in LPs that require two equal amounts of crypto assets supplied (e.g. 50% ETH, 50% USDC). Put simply, if you wish to avoid IL, only supply to single asset LPs. For more information, check out our article on how to reduce the impact of impermanent loss.

How Much Passive Income Can I Make From Lending?

You can earn anywhere from 2% to 8% APY on your lent assets depending on the type of protocol you lend on, the asset that you lend and the duration for which you lend your assets. Aave, Maker and Compound are three of the top leading lending protocols according to market cap.

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

Source: Aave
Source: Compound
These APYs are further taken into consideration the borrowing rate at any given instant in the market, and hence are subject to change accordingly. While these APYs do change, they remain more or less in a range. In addition to these protocols, there are several other protocols that you can use to generate income on other chains as well. Consider Solana for example. You can now lend a variety of tokens on Solend to earn yield. Their top-performing lending token as of writing is their native SLND token which generates 18.69% APY.
Source: Solend

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.

To lend your assets on Compound, head to compound.finance first and select “App”. Once you have entered their webapp, you will be able to see both supply and borrow markets with their respective APYs. Remember to connect your wallet if you are unable to see the markets.
In this example, I’ve supplied some USDT to Compound and have been earning a yield. You can scroll down to see which assets you’d like to supply to. When you have selected the token, simply click on it and a new screen will pop-up asking you to enable permission (remember that this transaction requires a gas fee).

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?

Head to app.aave.com and connect your wallet to start supplying your assets to the LP. Aave offers a wide variety of markets to which you can supply your markets. If you click on the “Ethereum Market” dropdown in the top-left, you’ll be able to see all the markets.
For this example we’ll select the Ethereum market and select USDT as the asset that we supply. However, in Aave V3, more chains are supported, including: Arbitrum, Avalanche, Fantom, Harmony, Optimism and Polygon. When you click on “Supply”, you will be asked to enter the amount that you wish to supply to the market. Once entered, you’ll be asked to approve the transaction which will require you to pay a gas fee.

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

The first method is that you can swap your existing LP tokens with other tokens on 1inch. In this case, I’ll swap my cUSDT back to USDT.
I can use the USDT that I just got here and put it back into Compound or even Aave and compound my yield. I can then repeat the process, known as “looping” as many times as it is feasible (and I have the required gas to pay for it) and keep compounding my 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

The second strategy would be fairly common too. You can use the tokens to provide liquidity across two or a three-pool reserve on Curve. In this case, we can supply both our aTokens and cTokens across different pools on Curve itself, making the process quite simple.

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 of them is staking (locking) your CRV tokens to get a share (currently, 50%) of the trading fees goes 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.

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