Centralized exchanges like Gemini and Coinbase offer Earn accounts to Crypto holders. Earn accounts allow the exchanges to loan crypto to banks and protocols to earn interest. The entity facilitating the loan takes a cut and passes on the rest of the interest to the Crypto holder. Earn accounts typically pay users in the Crypto deposited and are auto compounding.
Earn accounts risk defaults on the loans they issue to banks and protocols. To mitigate the risk centralized exchanges often have insurance policies.
Methods to earn interest including staking, liquidity pools, farms, and vaults require the initiation of a Smart Contract. Like any other program, Smart Contracts can contain bugs that may lead to loss of funds. To mitigate the risk, smart contracts are often audited by third parties.
Validators in a Proof of Stake (POS) network are rewarded for processing transactions and providing security to the network. The minimum deposit, lock up periods, fees, and interest rates vary by cryptocurrency.
Operating validators maximizes interest from staking, but users can participate in staking without having to manage a validator. Some cryptocurrencies allow holders to initiate a smart contract with validator operators to lend their cryptocurrencies to be used to stake. The operators receive interest from transactions and pass along a percentage of the interest to the lenders.
Operating a validator requires technical expertise, computing power, and assurance that the hardware never goes offline. If a validator goes offline, the operator will lose their opportunity to earn interest and may potentially pay a fee.
It is possible for validator operators to run away with user's funds or to try to tamper with records. In either event, the smart contracts used to stake will use the funds locked in the protocol to pay out users.
In a traditional exchange the business operating the exchange is responsible for having cash on hand to facilitate buys, sells, deposits and withdraws. The exchange charges a transaction fee and adds it onto their profits.
In decentralized exchanges there is no central organization providing the money, instead individual users can deposit as much as they want to help process transactions. User’s deposits are gathered into a “liquidity pool” and the pool receives the fees from the transactions they are helping process.
Users can withdraw their funds from liquidity pools at any time and receive interest on their initial deposits.
Anyone can create a cryptocurrency, list it on decentralized exchanges and launch a liquidity pool. If the person is malicious, they could steal the pool. This can easily be avoided by focusing investments on top tier cryptocurrencies.
Beyond theft, a pool can face a bank run. A bank run is when depositors rush to withdraw their funds all at the same time. The last out may have trouble withdrawing their funds. In the event of a complete collapse of the protocol the coins may become worthless before many users are able to sell it.
A bank run can be mitigated by providing liquidity to large pools. If a pool is large its less likely to be influenced by any one individual or group.