Zain Jaffer is a real estate and property tech investor who sold his mobile ad startup Vungle in 2019 to private equity firm Blackstone.
Most people work their day jobs or side hustles to earn active or passive income. Some investors however are able to earn passive income from the yield they derive from their investments. Some of the more popular forms are dividend yield from certain shares of stock, or treasury yields on the longer duration bonds.
One relatively recent development is earning yield by staking crypto. Before I dive into it, let me explain briefly what blockchains are and how some of these can produce yield.
The easiest way to explain what a blockchain is, is that it is a network of independently run servers that carry synchronized transaction ledgers. These transaction ledgers can carry sequential payment, balance, and other financial data. In the traditional financial system, we let centrally owned banks like Bank of America and Wells Fargo handle those payment and balance transaction ledgers. In a blockchain, we let independent people running servers carry these balances.
The crypto they earn from doing this pays for their capex, operational expenses, and gives them profit. In other words, these different parties earn from running and maintaining the blockchain network, and are thus disincentivized from inserting fraudulent transactions.
The assumption here is most people want to just do things honestly. As long as there are a majority (51%) of these server owners running the network, using the exact open source code, the consensus to say that a particular transaction is valid or not will be the same. Those who deviate are assumed to be doing incorrect work, and will be booted out of the network, and will thus stop earning crypto from it.
The oldest and granddaddy of all cryptos, which is Bitcoin, is a Proof of Work (PoW) network. It works differently from Proof of Stake (PoW) networks like Ethereum, Solana, and others. In a PoW network like bitcoin, the first to validate a transaction by first solving a mathematical problem is the one who gets rewarded the bitcoin. The others who fail to do so do not. The Bitcoin currency they earn often gets bought, sold, and traded, in a centralized exchange (CEX) like Coinbase, Kraken, Binance, and others.
PoS networks like Ethereum and Solana work differently. In the case of Ethereum, one is required to “stake” 32 ETH (spot price at https://coinmarketcap.com/currencies/ethereum/). At current prices, this Ethereum is worth several thousand US dollars. Staking is basically offering a valuable asset (like Ethereum, Solana, etc) as collateral. The server operator is allowed to be part of the network in exchange for this staked collateral. As long as the server does not perform any illegal or unauthorized operations, such as validating false financial transactions, they get a cut of the transaction fees (e.g. Ethereum “gas fees”) that users pay. If they do something unauthorized or illegal, that valuable staked collateral is forfeited or “slashed.”
This means that investors who are part of a “staked pool” who form the 32 ETH can divide the share of transaction fees they collect.
Some bigger parties such as Coinbase, Rocketpool, etc sell tokens that represent this staked ETH and give the yield to the token holders.
Other sources of crypto yield include earning from a Decentralized Exchange (DEX) liquidity trading pair, where you deposit Crypto A and its trading partner Crypto B (or Stablecoin B). In return for providing liquidity to the DEX, you are rewarded with a share of the profit from trading that particular pair.
One risk associated with this move is impermanent loss [https://crypto.com/university/what-is-impermanent-loss/] associated with a spot price change of the pair tokens. Basically when you initially deposit the pair, the value of both is the same (in equal amounts). However because of uneven demand during trading, once the pair is pulled out the ratio may be different and the spot price of each will definitely change. Thus although your pair may have earned its fair share of transaction fees, you may also end up with more of the token that is worth less than the other token in the pair you deposited.
There is also earning interest (APY) from lending to a DEX, which does not require a trading pair. One risk associated with this is if borrowers borrow all of the deposited assets, thus preventing the lender from regaining back the assets unless these are replenished or replaced.
If the exchange itself is hacked, that is another risk. However that is also a risk even if you are just keeping your crypto in your wallet. Another is if there is a time lock on when you can withdraw your funds, which may prevent you from taking advantage (or preventing loss) because of spot price movements.
In the future, as more people jump on the crypto bandwagon, these yield bearing PoS tokens could become a significant source of staked yield and eat into the share of passive income from instruments like dividend stocks and treasury bonds.
But we are still very early in the adoption cycle. More people will have to jump into staked or loaned crypto yield before this becomes a significant source of passive income for many people.