A Beginner's Guide to Earning Yield on ETH

Last year’s successful Ethereum Merge was a significant accomplishment that instilled confidence in the crypto community. This year, advancements to the Ethereum network, like the Shanghai upgrade, enable new opportunities and options for those earning yield.

But for individuals new to crypto, transforming from a passive ETH HODLer to an active yield generator can be intimidating without a thorough understanding. For the new crypto user, earning ETH requires learning new terminology and processes.

This article provides a beginner's guide to earning passive income on ETH and gives examples of current yield-generating strategies.

• Basics of Earning Yield

• Ways to Earn Yield

Basics of Earning Yield

Earning yield on ETH is the practice of using decentralized finance (DeFi) protocols or central exchange programs to generate returns on ETH in the form of additional ETH or cryptocurrency. Participants can earn variable yield by depositing ETH into a staking pool, lending protocol, or liquidity pool and gaining fees on its use while it is locked up. Allocations can also be made to fixed-yield products and strategies that offer a more predictable return.

Many of these processes involve using instruments of DeFi to generate returns on ETH. Smart contracts, programs of code stored on the blockchain, automatically execute complex transactions when predetermined conditions are met without the need for a financial intermediary like a bank.

Expected yield returns are usually annualized. The two most commonly used measures are annual percentage rate (APR) and annual percentage yield (APY). The difference is that APY accounts for compounding interest, interest accrued on both the principal and the accumulated interest from previous periods, but APR only calculates interest on the principal.

Ways to Earn Yield

There are many ways to earn yield on ETH. Strategies can be used to earn variable yield through staking, liquid staking tokens, lending, and liquidity providing or fixed yield using Defi protocols or central exchanges. Simplified yield-earning strategies are available through products like Index Coop’s dsETH, icETH, or asset managers’ vaults.

Below, we’ll review these three ways to earn yield.

Variable Yield

Variable yield can be earned through staking, liquid staking tokens, lending, and providing liquidity.

There are three major variable yield-earning strategies:

• Staking: Staking is the process by which network participants agree to set aside a certain amount of cryptocurrency, usually in a “staking pool,” to become an active validating node for a blockchain network. They earn rewards for allocating equity to backstop a cryptocurrency via staking. For example, Rocket Pool operates as a decentralized staking network, allowing users to pool their assets together to run a validator node on the Ethereum 2.0 network. Centralized exchanges like Coinbase and Crypto.com offer staking pools in-house.

• Liquid Staking Tokens: A liquid staking token is a token that represents the right to participate in a proof-of-stake (PoS) consensus mechanism and earns rewards for validating transactions on the Ethereum network. These tokens can be bought, sold, and traded on cryptocurrency exchanges, making them "liquid." Currently, Index Coop’s dsETH provides exposure to this strategy via Lido’s wstETH, Rocket Pool’s rETH, and StakeWise’s sETH2.
• Index Coop’s Diversified Staked ETH Index (dsETH): An index token of the leading Ethereum liquid staking tokens. The index methodology weights the component tokens according to their degree of decentralization.

• Lending: Lending allows users to deposit ETH into platforms that then loan them out to borrowers in exchange for collateral plus interest. Lending platforms reward depositors with yield on their lent ETH from interest paid on loans by borrowers, much like how banks pay interest savings accounts for the privilege of lending out funds. Popular lending platforms include Aave, Compound, Euler, and Maker.

• Providing liquidity (LPing): Liquidity providers (LPers) deposit cryptocurrency into liquidity pools available on “automated market makers” (AMMs), DeFi’s version of traditional market makers. AMMs are “automated” because they allow assets to be traded automatically using liquidity pools instead of relying on willing buyers and sellers. These AMMs charge a fee every time someone trades one of the token pairs in a respective liquidity pool. A portion of those fees is then distributed to the LPers, based on the amount they deposited into the pool. Some popular AMMs are Uniswap, Curve, and PancakeSwap.
• Importantly, while variable yield often offers higher returns than less-risky fixed yield, successful operators must constantly monitor rates and adjust strategies according to the best yield opportunities, which can shift at any time

Fixed Yield

Earning a fixed yield is another option for those looking to earn passive income. Fixed yield strategies are much more conducive to long-term growth; the interest rate does not change throughout the maturity period. Benefits of fixed yield include:

• Predictability: Yield rate remains the same throughout the maturity period, impervious to the volatile crypto market. For accounting and tax purposes, fixed-yield products offer more certainty when assessing their minimum profit margins.

• Safety: Reinvestment Risk is removed as fixed-rate yield opportunities do not provide interest payments throughout their maturity periods or terms.

• Simplicity: For those who are uninterested in frequently adjusting strategies to ascertain the best returns, fixed yield products simplify strategy. Fixed yield products offer true passive income; since rates do not change for the entirety of a maturity period, those who allocate do not need to actively manage their positions.

Right now, there are a few options to earn fixed yield:

• Notional Finance is a borrowing and lending protocol that created its fixed-rate money market. Lenders can lock in fixed yield for up to one year, which comes directly from what borrowers pay to lock in their borrowing rates. The underpinning mechanism, fCash tokens, functions similarly to a zero-coupon bond, as the tokens trade at a discount before maturity. Users can exit the position early by closing out the remainder of the term at the current market rate.

• Element Finance is a protocol for fixed and variable yield markets. It allows users to split a yield-generating position’s underlying asset (e.g., ETH) into a principal token and a yield token that trade at a discount and offers a fixed yield rate if the token is held until its redemption date.

Yield Products

Those looking to maximize yield may be interested in yield products, like leveraged yield products and asset managers’ vaults, which expand upon typical ways of earning passive yield accrual. These products tend to be higher risk and higher return than variable and fixed income strategies due to the involvement of more yield-earning strategies and variables that affect each.

Deciding between yield strategies requires time, knowledge, and often active management of the chosen position. Yield products extract the guesswork out of selecting a specific protocol by instead offering exposure to a predetermined automated strategy. These automatically managed strategies can provide passive income:

• Index Coop’s Interest Compounding ETH Index (icETH): A leveraged yield product, icETH provides token holders with amplified exposure to staking yield on ETH via a continuous cycle of borrowing ETH for stETH and swapping for more stETH. Those who are more risk-averse or prefer not to use leverage would be well served by dsETH.

• Vaults of Asset Managers: Asset managers like Yearn and Balancer allow holders to deposit ETH and other tokens into pooled “vaults” and automatically allocate to optimize returns. In this way, the vaults act like hedge funds, using pooled funds to earn active returns. For example, several vaults act as liquidity pools and distribute yield among vault contributors proportional to the size of their contribution.
• There are many factors to consider when it comes to generating yield on your ETH. While no solution may be a perfect fit, understanding the different strategies available will help ensure the most significant opportunity for effective wealth creation over time.
• For inquiries regarding yield opportunities in Index Coop products, please reach out to institutions@indexcoop.com.

About Index Coop

Index Coop is a decentralized autonomous organization (DAO) that powers structured decentralized finance (DeFi) products and strategy tokens using smart contracts on the blockchain. We offer a suite of sector-structured products, leverage and inverse products, and yield-generating products. We aim to create products that are simple to use, accessible to everyone, and secure. Our products are built on Index Protocol and Set Protocol, twice-audited, self-custodial DeFi tools that allow for creating and managing Ethereum-based (or ERC-20) tokens. Among users, partner protocols, and our composable products, Index Coop maintains one of the largest partnership networks in the DeFi ecosystem.

How to buy Index Coop products with fiat currencies:

• First, you’ll need to create an Ethereum wallet like Argent, Metamask, or Rainbow.

• Next, you’ll set up your new wallet and connect your bank account.

• Once you’ve deposited fiat currency in your wallet you can exchange it for Index Coop products like Diversified Staked ETH Index (dsETH) or the Interest Compounding ETH Index (icETH)

You can also buy dsETH tokens directly via a decentralized exchange like CoW Swap or DefiLlama.