As a proponent of dividend investing, I am a big fan of earning passive income and the compounding results that reinvesting this income can have on your portfolio over time. I'm also a crypto investor, so Ethereum's (ETH -1.93%) transition to proof of stake (PoS), which gives everyday Ethereum users the ability to generate passive income from their holdings by staking Ethereum, was music to my ears. Let's take a look at the ins and outs of earning passive income with Ethereum and why this makes the second-largest cryptocurrency more appealing than ever.  

An artistic representation of the Ethereum symbol.

Image source: Getty Images

Easier than ever

An Ethereum holder can earn staking fees by running their own validator node to process transactions and to help secure the Ethereum network. However, one needs to own and commit 32 ETH, or ether, tokens to do this, which at a cost of about $32,000 can be prohibitive for many investors. In addition to the upfront cost, running a validator node comes with other barriers to entry, because setting one up takes some technical know-how, and a validator needs to be online "as much as possible" to process transactions and to keep the network running efficiently, accord to the Ethereum Foundation. Furthermore, running a validator comes with some risk, because a validator who acts improperly can have its ETH "slashed" as a penalty, and can even lose their entire 32 ETH in a worst-case scenario. The good news is that a number of services are making it easier than ever for retail investors and more casual crypto users to generate staking rewards on their investments with smaller amounts of ETH and with less active involvement.

Coinbase's Ethereum 2: set it and forget it 

For example, Coinbase (COIN 8.59%), which is the second-most popular crypto exchange in the world (after Binance), allows its users to convert its Ethereum into "Ethereum 2", which is essentially staked Ethereum on Coinbase and is identical to Ethereum in price. Ethereum 2 currently earns 3.86% annual interest on Coinbase. and Coinbase pays out these staking rewards on a daily basis. This rate can fluctuate over time depending on how much Ethereum is staked.

The Ethereum network itself currently has nearly 15 million Ethereum staked, and pays out 4% interest. It should be noted that once you convert Ethereum to Ethereum 2, you will not be able to sell it or withdraw any of the rewards until after Ethereum's Shanghai upgrade, which is expected to take place some time in 2023. This is something that investors should be aware of, but I view Ethereum as a long-term investment, so I do not view this as a major concern.

To alleviate this lack of liquidity, Coinbase also offers a derivative called Coinbase Wrapped Staked Ethereum, simply referred to as "cbETH," a wrapped Ethereum 2 token that users can trade or withdraw from Coinbase. However, investors should be aware that the price of cbETH is not pegged to the price of Ethereum and can differ from the price of Ethereum. For example, at the time of writing, Ethereum and Ethereum 2 were trading in lockstep at $1,295, while cbETH is trading at $1,255. Coinbase's offerings are essentially seamless in my experience, and are good options if you don't want to hold Ethereum in your own crypto wallet. I strongly prefer the simplicity of just holding Ethereum 2 instead of cbETH.   

Lido Finance: Jump into the pool

Lido Finance, the largest Ethereum staking pool, allows users to convert their Ethereum to Lido Staked Ethereum (LSTETH -1.85%) and earn 5.1% interest on it. Using Lido's liquid staked Ethereum derivative gives investors the benefit of earning interest while also maintaining liquidity with the ability to trade their Lido Staked Ethereum. The price of Lido Staked Ethereum can differ from that of Ethereum, but the gap has narrowed over time, and Lido Staked Ethereum currently trades in close conjunction with Ethereum, with a price of $1,291 at time of writing compared to $1,295 for Ethereum. This is a good option for investors who feel more comfortable keeping custody of their own holdings in their own wallets and not giving a centralized entity like Coinbase control.    

What I like about Lido Staked Ethereum is that it gives investors the opportunity to earn a compelling interest rate while giving them exposure to the potential upside in the price of Ethereum and the ability to sell if need be. 

Overall, I like the fact that both services allow users to access staking rewards with no minimum investment (compared to the 32 ETH needed to run your own validator), relatively little effort, and with less risk of slashing. Everyday Ethereum investors now have several options for generating income with their holdings. A yield of 3.86% (with Coinbase) to 5.1% (from Lido Finance) is competitive with some of the market's most popular dividend stocks. Using these types of services comes with various risks such as not being able to sell your assets if need be (when using Ethereum 2) or the possibility that the price of your holdings could stray from the price of Ethereum (when using Lido Staked Ethereum or Coinbase Wrapped Staked Ethereum).

My approach is to keep some of my Ethereum as normal Ethereum so that I can use it to buy non-fungible tokens (NFTs) or engage in other activities, while holding the rest in Ethereum 2 to earn the 3.86% yield and watch rewards come in on a daily basis while maintaining the peg to the price of Ethereum. This is a nice way to make your crypto holdings work for you and compound your investment over time. I enjoy adding this passive income from Ethereum in my crypto account to the quarterly payments I receive from my dividend stocks, and believe that this further enhances the appeal of Ethereum as an investment.