Although much of the crypto content on X and YouTube gives the impression that most people are trading, the majority of token holders don’t trade. Instead, they’re playing the long game.

They invest and hold onto their tokens rather than engage in frequent trading. This is evident in the Bitcoin market, where out of the 19.5 million Bitcoins currently in circulation, a mere 2 million are active on exchanges. The rest are securely stored away for the long haul.

The advent of decentralized finance (DeFi) has ushered in many opportunities for passive income generation without the need for active trading. A prime example is lending crypto to decentralized exchanges (DEXs) in exchange for liquidity provider (LP) tokens.

While crypto is lent to a DEX, it earns a proportion of the transaction fees as yield and can be withdrawn at any time in exchange for the return of the LP tokens. This system is desirable to those who want to hold their crypto for long periods and still earn from it, irrespective of market fluctuations.

However, as with any situation where there is a reward, there is also a risk. When crypto is out of the direct control of its owner, it becomes vulnerable to unauthorized use or theft, echoing the adage, “Not your keys, not your crypto.”

High-profile collapses, such as the failure of FTX, laid bare the extent to which funds can be misused. Although authorities have eventually caught up with those involved, the owners of the crypto stand to lose a significant portion of their original holdings. The bull market may be long gone by the time it’s returned.

Even when the people running the organization that the crypto has been loaned to don’t misbehave, there is still the risk that it can be hacked and the user funds can be drained. So far, in 2023, over $1.3 bn of funds have been lost due to hacks and exploits.

At present, the insurance policies holders can take out to cover their losses in the event of losing them is patchy and expensive. There is also no guarantee the policy will pay out, leaving investors with a lingering unease about potential losses, even with the most trusted DEXs.

One strategy to mitigate these risks involves using LP tokens as collateral for a loan. This doesn’t fully safeguard the value of the crypto loaned to the DEX, but it can cover around 70% of it, assuming a loan-to-value (LTV) ratio of 70%.

Although this isn’t a perfect solution, this approach offers immediate liquidity and protection against DEX hacks. In such a situation the loss would primarily impact the borrowing and lending platform, not the individual investor.

While this isn’t the primary purpose of allowing people to use their LP tokens as collateral for loans, it highlights the flexibility of DeFi. You can use it to create a de facto insurance policy for yourself at much lower rates than exist at present, safe in the knowledge that there is no legal battle ahead to try and get the policy to pay out.

Of course, using LP tokens for a loan as insurance against loss would also depend on the balance of interest versus yield. It would defeat the purpose of loaning your crypto in the first place if the interest paid on the LP token loan was higher than the yield your crypto loan earned.

The allure of generating passive income through DeFi, particularly via DEX lending, remains strong, but investors need to be acutely aware of the risks involved. Leveraging LP tokens as collateral represents a creative fusion of DeFi’s adaptability with a measure of financial prudence, a testament to the evolving landscape of cryptocurrency investment strategies.