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Traditional financial institutions decide to whom to provide services, how to manage depositors’ money, and to whom to report customer information. Anyone who is not satisfied with these points can switch to DeFi. What is it and how do you make a passive income in this field? The service https://exchangesumo.com has gathered all the necessary information in a detailed guide for beginners.
What is DeFi?
Decentralized Finance or Decentralized Finance (DeFi) is a group of projects that offer conventional financial instruments, but in a decentralized environment. They are built on blockchain, most often Ethereum. Users of decentralized financial services themselves act as custodians of their money and have full control over the assets.
Distinctive features of DeFi projects include:
- Compatibility and open source. Thanks to this, all products of the ecosystem can communicate at a technical level.
- This means that decentralized financial services can be accessed by absolutely everyone who has the Internet.
- Financial transparency. At the user level, information remains confidential, but within the market, it is transparent to all participants.
DeFi includes decentralized exchanges, credit and leverage markets, tokenized physical assets, predictive/betting markets, payment networks and so on. Representatives of this sector are MakerDAO, Compound Finance, Dharma, Synthetix, Uniswap, Bancor and so on.
DeFi services are gaining popularity even despite the scalability issues of the Etherium network on which most of them are based. To assess the growth of this sector, just take a look at the graph presented on the DeFi Pulse portal.
Here you can see how the amount of funds set aside for the ecosystem has grown. It has more than tripled in one year. It now stands at $587.3 million. That’s why DeFi can’t be ignored.
Which DeFi project can be used to make passive income?
Decentralized finance, like centralized finance, makes it possible to earn from lending. The user can lend his money and receive passive income from it. However, in DeFi the rate will be higher than in a bank, since there are no intermediaries.
One of the most popular projects in this sector is Compound Finance, which we will consider. It ranks third in the DeFi Pulse rating.
What is known about this project? Compound is a transparent, autonomous money market that allows you to seamlessly earn interest or borrow assets without relying on a counterparty. Instead of lending to specific people, users provide liquidity to the marketplace. Other participants then borrow from that market.
The interest rate is not fixed and changes frequently. It fluctuates in real time based on supply and demand. When liquidity is sufficient, the interest rate is low. As liquidity decreases, the interest rate rises, stimulating new supply and repayment of loans.
The site specifies an annual interest rate. At the same time, the reward is charged for each Ethereum block. This means that every ~15 seconds the lender’s balance increases by 1/2102400 of the specified rate.
To get a stable income, it is recommended to lend stabelcoins. The most popular coin in this sector is DAI. Its value is almost always equal to $1. Etherium tokens act as collateral. DAI coins on Compound are renamed cDAI. Simply by holding cDAI, users earn passive income in decentralized finance.
To get 1 DAI from MakerDAO, you have to pledge $1.5 in ETH. An annual interest rate must also be paid for the ability to issue new coins. Stability fees are charged in MKR. This is not very profitable for Compound lenders. Therefore, it is recommended to buy cryptocurrency on the exchange.
It is worth noting that the Maker protocol was recently updated from Single Collateral Dai to Multi-Collateral Dai. Therefore, many venues are now using the SAI designation. The old version of the coin will be decommissioned within a few months.
Instructions for those who want to earn passive income on Compound
Now let’s get specific and look at an example of how you can exchange fiat money for cDAI.
Creating and setting up a Binance account
For our example, we chose the cryptocurrency exchange Binance. If it does not suit you for some reason, read this article. In it you will find the top 10 exchanges that can replace Binance.
To register at the exchange, you need to go to the link https://www.binance.com/ru/register.
Here’s what you need to do:
- Specify a valid e-mail address.
- Make up a password. It must be at least 8 characters long, including capital letters and numbers.
- Specify a referral ID. Here you can enter the referral ID, if it is known, or leave the field blank. It can be already filled in, if you have followed the referral link.
- Read the terms of use of the exchange and agree to them by checking the box.
- Click the “Create Account” button.
After sending the registration form exchanger will require passing the captcha-test. Here it is non-standard. The screen will display the logo of the cryptocurrency with the missing element. The puzzle must be put in place using the slider, moving it to the left/right.
The next step is to confirm the email address. If there is no email, you need to check your spam folder before you send it again. In the received email you need to click on the “Confirm registration” button. After this the account will be activated.
Log in to your account using your username and password. After that, it is recommended to enable 2FA. Here authentication by SMS is possible. In this case, you need to enter the phone number and a code from the message, which will come within a minute. However, this option is not secure enough. Because the fraudsters can use the scheme SIM swapping. It looks like this:
- Fraudsters collect information about a person (e.g., through phishing);
- as soon as the attackers find out the phone number, they request a new SIM-card from the cellular operator (for this purpose, the previously collected information is reported);
- the cellular service provider deactivates the old SIM card and issues a new one;
- Fraudsters receive a code via SMS message, log in to the account and transfer money to their accounts.
To protect your account as much as possible, it is recommended that you enable Google Authentication. To do this, download the Google Authenticator app from the App Store or Google Pay and install it. After that, a QR code will appear on your computer screen. It should be scanned with the help of the installed application. Google Authenticator will generate 2FA codes on your mobile device, which cannot be redirected as SMS. The system will ask you to save the generated code on paper. It will allow you to restore Google Authenticator if you lose your phone.
Installing and configuring MetaMask
In our example we will use MetaMask. It is a browser wallet, where you can store not only Ethereum, but other ERC-20 tokens as well. MetaMask is installed as an extension to Chrome, Opera, Firefox or Brave.
To install MetaMask, go to https://metamask.io/.
Here you should click “Get Chrome Extension” or select another browser. MetaMask will redirect you to the site where you can download the extension.
After installation, the “fox” icon will appear in the upper right corner of the browser. Click on it, read and agree to the proposed terms of use. After that you will need to make up a password for your wallet and click “Create”.
Next, the system will generate a seed phrase. It will consist of 12 code words. You will need this phrase in case you forget your password. It should be copied and saved in a safe place. For example, you can copy the seed phrase to a file and then transfer it to a flash drive. If this file is lost as well, you can forget about the funds stored in the wallet.
Buy ETH on Binance
This year Binance exchange started accepting funds from VISA and MasterCard. Moreover, fiat funds (RUB, USD, EUR, UAH, KZT and others) can be immediately converted into cryptocurrency (BTC, BNB, ETH or XRP).
To do this, go to “Wallet” and “Buy Cryptocurrencies”. Then the following form will appear.
Here you need to specify the available amount and fiat currency, as well as the required cryptocurrency (in our case ETH). Then enter the card details and confirm the transaction. The fee for such exchange is 3.5%, but not less than $10.
This procedure does not take long. However, it can only be completed by users who have verified their identity. To do this, go to “Verification” and select “Profile”. Next, you must specify your full name, date of birth, and residence address. The next step is to choose a document – passport, ID-card or driving license. It must be photographed with a webcam or phone camera. A selfie picture will also be required. Verification will take 1 – 3 days.
ETH withdrawal to the MetaMask wallet
After buying ETH tokens, they must be withdrawn to the MetaMask wallet. To do this on the Binance exchange, go to “Wallet”, “Exchange Wallet” and “Withdrawal”. Here you need to specify a specific coin (ETH in our case), the amount (at least 0,02 ETH), and the address of the recipient. Where to get it? The recipient’s address is the address of your MetaMask wallet. To find it out, you need to go to the wallet menu. Then you have to click on three dots and select “Copy Address to clipboard”.
The copied address must be pasted into the “ETH recipient address” field on the crypto exchange. After confirming the transaction, the funds will be transferred to MetaMask. This will require 12 block confirmations for ETH.
Is it possible to simplify the exchange of fiat money into Etherium? To get ETH, it is not necessary to register on any exchange. After all, the cryptocurrency can be bought with the help of an exchanger. Go to https://exchangesumo.com and choose the appropriate destination. This, for example, can be Sberbank RUB to Ethereum (ETH). The service will select exchangers according to your direction and sort them at the best rate.
ETH to DAI exchange
The next step is to use the service DEX.AG. It collects information from 11 decentralized exchanges and looks for the best price.
By default, the service is set to buy DAI for ETH. So you only need to switch to “Sell” and enter the amount to be exchanged. Don’t forget to leave some ETH to pay for gas. After entering the amount, you need to click “Find trades”.
A list of decentralized exchanges where you can exchange ETH for DAI will appear on the screen. Select the first platform and click “Sell Now”. The MetaMask prompt will then appear. Since this will be the first time the account interacts with the selected DEX, the transaction will have to be sent twice.
To send the transaction, press “Confirm”. Confirmation will take a few minutes. You can see the status of the transaction in your MetaMask wallet by clicking on the specific transaction and the diagonal arrow to the right. Then you need to click “Sell Now” again and confirm the transaction. Now the account will have DAI tokens.
DAI to cDAI conversion and interest receipt
Now you can move on to the last step. You need to go to the Compound Finance website and click on the “APP” button. Then the service will prompt you to choose an available wallet.
Select MetaMask from this list and unlock the wallet. Then select DAI and click the green “Enable DAI” button. The transaction is confirmed as in the previous case.
Next you will see a green “Supply” button and a purple “Borrow” button. Click “Supply” and enter the amount you want to borrow, or “Max. After entering the amount, click “Supply” at the bottom of the pop-up menu. Confirm the details of the transaction.
Congratulations! You are now earning a passive income with DeFi.
Risks for DeFi investors
Decentralized finance is one of the fastest growing areas. Investors choose DeFi projects because of their accessibility, ease of use, and high returns. However, decentralized finance, like centralized finance, comes with some risks. Let’s take a closer look at them:
The user may forget the seed phrase or copy it incorrectly
As mentioned above, if the user forgets the wallet password, he can restore access to it using the seed phrase. However, if it was saved incorrectly, the funds cannot be recovered. That’s why it’s important to copy the seed phrase carefully and save it in a safe place.
In addition, it is worth thinking about what can happen in an emergency. For example, there may be a fire or flooding. Therefore, it is better to have several copies of the seed phrase on different media and keep them in a safe.
Seed phrases can be stolen
A copy of the seed phrase can be stolen physically or digitally. Then attackers will not have any obstacles to take possession of the funds in the wallet. One safe is not enough to keep the data safe. Investors should be wary of phishing emails and fake websites.
There may be flaws, bugs, or vulnerabilities in MakerDAO that affect the DAI
MakerDAO takes risk seriously, using the system to manage risk in smart contract lending as well as in the programming process. Several independent audits of the platform code have been conducted to identify bugs.
These measures are very important to minimize risks in the system, but they still exist. The development team has compiled them in the “Risks and Risk Mitigation” section of their technical documentation. There is also useful information about risks on their blog. In this regard, specialized teams create risk management models for the entire collateral portfolio. This ensures that the system is stable even during times of high market volatility.
Let’s take a look at one risk that is known but cannot be eliminated at this time. For example, MakerDAO uses a set of off-chain price channels to determine the price of Etherium in the chain. The smart contract finds an average value between all channels, which is then applied to almost every Collateralized Debt Position (CDP) function. These price channels can be manipulated by attackers or the smart contract itself can be subject to a bug or undetected vulnerability. To date, there has been no such attack or error.
Compound may have flaws, bugs, or vulnerabilities that affect cDAI
The Compound code has been audited several times. The most recent audit, conducted in August 2019 by OpenZepplin, did not identify any critical errors. However, some risks were found in the design of the incentive structure. Trail of Bits performed a Compound V2 update in May 2019. It was also formally tested in partnership with Certora.
Protocol developer Compound Labs, Inc. currently controls the admin address for Compound. The admin address has the power to support additional assets, update the price band, interest rate models, and the risk model of the protocol. Although the developers plan to fully decentralize this and transfer control to the community, the admin address now introduces possible vulnerabilities (as community member Amin Suleimani put it) to the integrity of Compound’s functions. It should be noted that there have been no such vulnerabilities or attacks to date.
Investor can die by making cryptocurrency inaccessible to heirs
We are not asking you to think of the worst. However, you do need to consider this scenario as well. Think about how loved ones will be able to access your wallet if something happens to you. There is no perfect solution here. You will have to come up with a plan that works for you.
The tax authorities may be interested in the borrower’s income
The legal status and circulation of cryptocurrencies in many countries is not regulated. Despite this, tax officials believe that taxes should be paid on it. To avoid being fined, you have to pay personal income tax and file the appropriate return. If this option is not suitable, you can look for ways of unofficial withdrawal of income (exchange of cryptocurrency for cash, withdrawal from a cryptomat, AdvCash card, and so on).
Conclusions
Don’t let the DeFi risk section scare you. After all, any investment (even a bank deposit) is risky. An investor should only take the proper precautions to mitigate the risks. Also, it is not advisable to invest more than you are willing to lose.
Innovation is happening at breakneck speed in the DeFi world, with new products and services being launched every day.
