Where does interest come from in crypto?

Where does the interest come from in crypto?

You may have seen some eye-catching numbers regarding how much interest you can earn in crypto. Rates often easily outpace the highest APY you can earn with traditional banks. Some platforms even allow you to deposit your tokens, sit back and earn rates as high as 8-10%. But what is going on under the hood, and where does the interest come from?

This article will explore the most common ways to earn interest on the blockchain: staking, lending, and providing liquidity. We'll also go over the pros and cons of each and detail how you can earn interest with these strategies.

Earning Interest in Crypto by Staking

One of the most exciting things about crypto is not just investing in revolutionary technology but also participating in the ecosystem. One of the best ways you can do that is through staking, which is the most popular way to earn interest with crypto.

Staking refers to "locking up" your tokens in a staking pool to help run the network. Staking pools, also called validators, are responsible for updating the blockchain with new blocks. Each time a block is produced, a staking pool is randomly selected to be the block producer.

The more tokens a pool has, the better its chances of being selected to produce each block. Therefore, when you contribute your tokens to a pool, that pool a better chance of being chosen to validate blocks.

Each time a staking pool produces a block, it receives rewards in the blockchain's native token. Those tokens are then split proportionally among the pool's contributors.

Each blockchain's staking rewards are different, but it's common to see rates between 5-15% APY. 

How to Earn Interest by Staking Crypto

There are a few different ways to stake crypto. You can stake through an exchange, through a private wallet, or you can do something called 'liquid staking.'

Let's go through each option.

Stake Through An Exchange

Almost every major exchange supports the staking of at least a few tokens. With no technical knowledge required, staking on an exchange is usually as easy as clicking the 'stake' button.

The pros of staking through an exchange: it is effortless and usually only requires a single click.

The cons: the exchange takes a cut of your staking rewards, cutting into your earnings.

How to Earn Interest With DeFi

While staking through a centralized exchange does pose some advantages, it doesn’t allow you to get the full DeFi experience. Exchanges take a cut of the rewards you earn, and they don’t give you full control over your tokens.

For users who want to take the next step, sending your tokens to your own private wallet allows you to use DeFi applications and stake directly with a validator. Earning interest in DeFi is pretty straightforward, and can be achieved in a few different ways.

Staking In Your Own Wallet

Staking through your own private wallet gives you more control over your tokens and allows you to receive the full APY. Some of the most trusted wallets in crypto include MetaMask, Ledger, Exodus, and Keplr specifically for Cosmos-based blockchains. While it does require a small amount of technical knowledge, staking is still pretty simple. This process may vary slightly depending on which token you stake and which wallet you use, but it can usually be completed in just three steps:

1. Setting up a private wallet that supports staking.
2. Sending tokens to it.
3. Choosing a staking pool and delegating your tokens to it.

Once you've staked your tokens, you can sit back and watch the rewards roll in!

Pros: you retain complete control of your tokens and don't have to share the staking rewards with anyone.

Cons: you have to manage the keys to your wallet, and your tokens are subject to a lockup period that could last days, weeks, or even months. Tokens are subject to lockup periods.

Liquid Staking

Liquid staking refers to sending your tokens to a smart contract that stakes them for you. In return, the smart contract gives you a derivative token that can be redeemed for your original tokens anytime. Popular liquid staking options include Lido Finance and Rocket Pool.

For example, if you stake Solana's native token, SOL, with Lido Finance, you will receive stSOL in return. When you want your original tokens back, you can send them directly to Lido Finance, and you will receive your SOL.

While this may seem like an extra step, liquid staking offers a few key advantages.

Pros: You can use your derivative tokens to make further investments, such as lending or providing liquidity. Many liquid staking options also allow you to bypass lockup periods and retrieve your staked tokens immediately.

Cons: added risk and possibly losing some of your staking rewards. Every time you use a smart contract, you take on some risk. For example, smart contracts can get attacked and drained by hackers or could even freeze funds due to a bug. 

Furthermore, reward rates vary among liquid staking providers, so you may lose out on rewards that would have been yours if you staked through a private wallet.
 

Earning Interest in Crypto by Lending

After staking, lending may be the second most popular way to earn interest in crypto. Lending crypto is a straightforward investment strategy: contribute your tokens to a lending protocol, and earn a steady APY.

Tokens in a liquidity protocol are pooled together and made available to borrowers. To receive a loan, borrowers must deposit collateral greater in value than the loan they wish to receive. This is called an overcollateralized loan, and this practice helps make lending a relatively low-risk investment.

Borrowers also pay fees for the right to borrow funds from the protocol, which are paid directly to the protocol's lenders. If a borrower is ever in danger of defaulting, their collateral gets liquidated, and the lender is made whole.

Lending is also a simple strategy that can be completed in just a few clicks. Popular lending protocols include AAVE and Compound. For a list of the most widely used lending protocols on each blockchain, visit Defi Llama.

How to Earn Interest by Lending Crypto

Once you have tokens in a private wallet, investing with a lending protocol can be achieved in just two steps:

1. Connect to a lending protocol
2. Deposit your tokens into the pool

It's as simple as that! Once you have contributed your tokens to a lending protocol, your rewards begin to accrue. Most lending protocols pay rewards daily, so you can compound your rewards as frequently as you prefer.

It is worth noting that not all lending protocols pay rewards the same way. The most reputable lending protocols pay rewards in the asset you lend. So if you lend ETH, you earn ETH, and if you lend WBTC, you earn WBTC.

However, some lending protocols pay rewards in their own platform's token. If this is the case, it's essential to understand the tokenomics of the lending platform to determine if you think the native token has legitimate value.

Earning Interest in Crypto by Providing Liquidity to an Exchange

Providing liquidity is a similar process to lending crypto. However, instead of being used for lending, the tokens you provide are used to facilitate trades on a decentralized exchange, or "DEX."

Here's how it works:

Liquidity providers deposit their tokens into liquidity pools. These pools are comprised of 2 or more tokens. For this example, let's consider This ETH/WBTC pool on Uniswap.

Uniswap's ETH/WTC pool enables traders to swap ETH for WBTC and vice versa on the Uniswap DEX. Users who swap tokens with this pool pay a small fee. That fee is paid directly to the pool's liquidity providers.

Fees are paid daily, and each liquidity provider is paid proportionally to their contribution to the pool. For example, if a user owns 1% of the tokens in the pool, they receive 1% of the daily reward payout.

How to Provide Liquidity to a DEX

Providing liquidity to a DEX is the most complex investment in this article. However, it still only takes three steps.

1. Choose the pool you want to provide liquidity to.
2. Add both tokens in the pool to your wallet.
3. Connect to the exchange, and deposit your tokens in the pool.

When choosing a liquidity pool to invest in, it is usually best to contribute to a pool with a pair of tokens that remain stable relative to one another. This strategy helps mitigate risk due to impermanent loss.

It's also wise to consider the tokenomics of the asset your rewards are paid in. It's essential to earn rewards in a token with real value; otherwise, the token could plummet in value.

How Savings Account Alternatives Earn Interest With Crypto

Most savings account alternatives earn interest under the hood using one of the methods detailed here. Sometimes they even will use a combination of multiple methods.

The advantage of these accounts is that they take away all the complexity and the decision-making process. They allow users to deposit funds and earn interest without having to think about it or have any technical expertise.

These accounts will take a small percentage of the earned interest in exchange for this service. While you don't make quite as much as if you execute the investments by yourself, this is still a worthwhile investment for most people. These accounts offer a simple, valuable product by reducing the complexity and making earning interest easy.