Solving the Pool Selection Problem in DeFi
How SoDeFi Score Helps to Narrow in on best DeFi opportunities
Difficult Choices in DeFi
Whether you’re a newcomer to the DeFi scene or a seasoned user, making decisions about which projects and pools to engage with or invest in can be a daunting task. Navigating this landscape successfully requires a deep understanding of the industry’s jargon, proficiency in wallet management and transactions, and a keen awareness of the inherent risks in DeFi.
Given the dynamic nature and constant evolution of the space, the array of choices can feel overwhelming. Currently, selecting where to provide liquidity often involves scouring platforms like DeFi Llama to find the highest-yielding pools or relying on social media and Telegram channels to follow the crowd. However, this approach can be frustrating, with high-yield opportunities disappearing rapidly and community recommendations sometimes leading to uninformed decisions or even outright fraud.
Over the past three years, I’ve actively engaged with and researched the DeFi space, experimenting with various protocols and investment pools — some successful, others not so much. Drawing from this experience, I’ve developed my own methodology to navigate and invest in DeFi successfully.
To address this challenge, I’ve created the SoDeFi Scoring Methodology, leveraging data and statistics for a truly data-driven approach. The goal of the score is to identify the most promising yield opportunities at each level of Total Value Locked (TVL). In the upcoming post, I’ll share this methodology in detail.
Growing Number of Projects and Pools
Before delving into the methodology, let’s first acknowledge the sheer scale of the selection problem for the typical DeFi user. According to DeFi Llama, there are currently over 350 projects available for interaction — whether collateralizing, lending, borrowing, or bridging tokens across various blockchains. This list is continually evolving, with new protocols launching to address fresh use cases and offer innovative products and solutions.
Choosing between competing projects is a challenge, but diving into the selection of DeFi pools can be an even more intricate endeavor. The sheer volume of available pools can be overwhelming, and staying abreast of new additions can leave anyone’s head spinning. As of the current writing, DeFi Llama lists over 10,000 pools with APYs greater than 0. This figure encompasses stablecoin pools — where all tokens are stable coins (algorithmic or asset-backed) — as well as a myriad of combinations involving non-pegged tokens.
Despite the somewhat subdued sentiment in DeFi over the past two years, the number of pools has increased by nearly 20%. Notably, the majority of this growth stems from non-stable coin pools, while the number of stablecoin pools has remained relatively stable. Anticipating a resurgence in the crypto market in 2024 after a two-year bear market, I expect this pool count to further escalate.
Two Types of DeFi Investment Opportunities
The first crucial step in selecting DeFi pools is gaining a clear visual representation of the available options. My preferred features for assessing each pool are the current Total Value Locked (TVL) and the average 7-day Annual Percentage Yield (APY). These metrics not only provide a standard view for any DeFi user but also offer insights into the capital deposited by other users and the corresponding returns each pool generates.
The two graphics presented below offer visualizations for stablecoin pools and non-stablecoin pools. To streamline the data, we’ve normalized it by excluding pools with less than $5 million in TVL for non-stablecoin pools and less than $3 million in TVL for stablecoin pools. Additionally, we’ve further normalized the 7-day APY by removing outliers — any APY that deviates more than 3 standard deviations from the mean.
Post-normalization, diving into the visual inspection of the data reveals two prominent observations. Firstly, when examining TVL, the majority of pools tightly hug the x-axis and are below the $10 million mark. Secondly, focusing on APY, pools are predominantly divided into two categories: large TVL pools offering modest APY and smaller, more speculative pools boasting higher APY.
This clear bifurcation sheds light on the current landscape of DeFi. The largest pools typically represent well-established, long-running entities in the space, such as Ethereum staking pools, major stablecoin Curve pools, or leading Uniswap pools. As market leaders, these pools often refrain from offering substantial incentives to attract new capital. On the other hand, smaller pools rely on incentives to entice new capital to their projects.
Given the nascent stage of the DeFi space, the primary source of returns for DeFi yield stems largely from incentives rather than trading or protocol fees. This dynamic may shift as the space matures, with on-chain economic activity playing a more significant role in generating returns.
Zeroing in on Most Promising Pools
Given the distinctive nature of DeFi pools, a crucial question arises: “What is the best methodology to select where to invest or provide liquidity?” The answer must strike a balance, optimizing for sustainable yield generated by DeFi pools. Opting for the largest pools might be the safer choice but would miss out on excess returns. Conversely, selecting the highest-yielding pools presents challenges, as they tend to be riskier and more volatile.
The optimal solution lies in a middle ground, targeting pools that offer the highest yield at each level of Total Value Locked (TVL) over a 7-day period. This is precisely how the SoDeFi scoring methodology operates. For each pool, the algorithm calculates a daily percentile rank for both TVL and APY, combining them for a joint score. The algorithm then averages this score over a 7-day period. In essence, the scoring methodology rewards pools that generate the highest APY at each level of TVL, addressing the previous challenge. Importantly, it penalizes pools with high APY but low TVL and those with high, unsustainable APY that vanishes as the pool’s TVL grows.
The visual representation below showcases the result. The two histograms depict the number of pools within each bin of SoDeFi Score (SD Score) ranges. The algorithm effectively narrows down pools with the most sustainable yield by assigning the highest score to very few pools at the top of their respective percentile ranks. Examining the APY histogram, you can observe that the methodology assigns a low score to pools with the lowest APY, placing them to the far left of the chart.
Taking a closer look at the results, the algorithm assigned low scores to the lowest Total Value Locked (TVL) ranked pools, effectively eliminating those with very small TVL and fleeting Annual Percentage Yields (APYs). Now, let’s delve into the most intriguing aspect — the ranking algorithm effectively positioned all pools with the highest TVL at each level of APY.
Examining both charts represented by the dark purple color, DeFi pools that fell into the largest TVL grouping and highest APY group received SoDeFi Scores (SD Scores) above 80. This strategic scoring ensures that the algorithm identifies and rewards pools offering the combination of substantial TVL and high APY, a powerful indicator of sustainable yield.
In essence, the pools with the highest SoDeFi Scores act as a refined screen, pinpointing the most sustainable yield generated over the past 7 days. This scoring methodology provides a valuable foundation for a deeper dive into understanding these pools and assessing whether they align with the sustainable yield sought.
While the next step of the selection process involves evaluating the presented pools, the SoDeFi Score significantly streamlines the research effort by filtering out pools that don’t meet the sustainability criteria. I’ve programmed this analysis to run on a daily basis and share the highlighted pools in the weekly DeFi newsletter. Below, you’ll find an example of pools from the latest scoring round, and for more detailed information and access to the pools, you can refer to DeFi Llama.
As seasoned investors are well aware, past performance does not guarantee future results, and thorough individual research is imperative. While the SoDeFi Score provides a valuable historical performance metric, I caution users to conduct further research before making investment decisions.
Acknowledging that the SoDeFi Score relies on historical data, my next endeavor involves utilizing linear regression and other machine learning algorithms to assess the predictive power of this scoring methodology. I’m excited to delve into this analysis and share insights on its effectiveness in forecasting future performance.
In the meantime, I invite you to comment, share, and subscribe to stay informed about my progress. Your engagement is invaluable on this journey. Thank you for being part of the community, and as always — happy yield hunting!
