Earning passive income: DeFi and CeFi
I wanted to write this article for a long time, and it seems it is the right moment now when DeFi became significant and mature enough. And guess what happened, the idea of passive income is a large part of DeFi projects. It is funny because the crypto community came with the ideas against bankers, and the first thing we see everyone looking for passive income as a real banker.
It is funny that the crypto community came with the ideas against bankers, and the first thing we see everyone looking for passive income as a real banker
Decentralized Finance and innovation
Being a professional investor and trader for all my life, I philosophically look at it: all the underlying reasons and mechanisms of innovative financial system are still the same, but it is just banks and regulations going the wrong way. The crypto is not a solution for everything, but a smart response to the madness of the current financial system.
People still need to borrow and lend money, and they still need derivatives and hedge risks. Even the way the swap curve is being built now is the same as in traditional markets. Compared to the old system, there are no ridiculous margin spreads of banks nor huge costs of inefficient old-school companies.
Uber is doing the same thing as taxies before, but in a much better and efficient way, thanks to technology. The same way, DeFi will do banking and financial services without banks or even without fin-tech companies. On my opinion, many fin-tech companies were an intermediary step in the development of the financial industry.
Part of the banks transforming into the “banking” and the “banking” is turning into “decentralized finance.” However, it does not mean that the mathematics behind the instruments or motivation of people will be different.
Is DeFi passive income risk-free?
No. Passive income is a reward for a passive risk!
Generally speaking, any return is a reward for risk. Even when someone puts money on the government bond, there are risks he is paid for. It is a very complex topic, and I am not going to write a boring lecture about risk management. My point is that the majority of the people don’t understand the risks they are exposed to. It is also extremely difficult to say the fair reward for certain risks, like DAI credit or Ethereum technical risk.
My point is that the majority of the people don’t understand the risks they are exposed to
Diversification: don’t put all your eggs in one basket.
In other words: don’t make everything dependent on only one thing. At the moment, makerDAO specific risks are dominating the market. Nobody can say what is the fair reward for accepting DAI’s tail risk (the risk that DAI will be bankrupt and all your coins will cost zero). Is a 5% reward enough, or maybe 10% is a fair reward? Nobody can say how much of that reward is attributed to particular DAI risk and how much is attributed to general market risks (Ehtereum blockchain, etc.)
It makes perfect sense to own different stable coins as well. Ideally, we want to see a stable coin with diversified risks backed by several unique (non correlated) projects. Why? The answer was given by mathematics a long time ago: every risky asset has market risk and its specific risk. By increasing the number of risky assets in your portfolio, you are magically removing specifics risks and ending up with the market risk, which is unavoidable. The intuitive explanation is the following: specific risks are negatively correlated and offsetting each other. The beautiful illustration of this effect you can find in any investment book:
The good news is that your expected return is not sacrificed so much by the diversification!
Sources of passive income
What is the difference between:
- putting DAI into a floating rate deposit and
- selling somebody insurance against the default of DAI?
The rough answer: the credit risk of the deposit provider!
Indeed, option A has at least two risks: the default of DAI and the default of the deposit. Option B has the risk of the default of DAI only*.
So imagine I can get 5% on the deposit, and I can get the insurance for DAI for 4% a year. It means that the project that provides me the deposit should have a 1% probability of default. If I believe that 1% is too little, I am not compensated enough by 5%, and I should sell DAI insurance receiving 4% a year.
*It is not a very strict analysis to make my article more readable, but the point is here. For example, to be strictly correct, we should also consider the insurance provider’s risk; however (in a simple technical implementation), it is deficient.
Fantastic opportunities of DeFi: pyramids, black swans and untransparent risks
Decentralized Finance is a truly amazing and deregulated area that is growing fast, but there are many risks, including pure scams. There is nothing easier than to build a pyramid that looks like another project that pays high yield. As long as the inflow is going faster than outflow (benefits paid), it can seem like a successful company. I am sure we will see big scandals very soon.
Of course, open code helps to prevent scam to a certain extent, but there are no guarantees.
The general rule is the more simple the primitives of DeFi, the fewer risks it exposed. The more uncorrelated simple blocks you have in the system, the less fragile the system is. And here, I would recommend reading Nassim Taleb on antifragility.
There is nothing easier than to build a pyramid that looks like another project that pays high yield
Flash loans and attacks
Recently we have seen such an exciting instrument as flash loans that were already used to crash several projects. We read this news very positively, the more small crashes we have now, the less probability there for a sizeable destroying event (as Taleb would say, a “black swan”). And because of this small crashes, the system will be less fragile or even anti-fragile.
Balanced portfolio. Summary.
I firmly believe that deep investor in DeFi should have a balanced portfolio of diversified risks. Take several instruments, understand what you are being paid for. In the end, not optimize the return only, but a full risk-return profile of your portfolio.
And let’s all enjoy fantastic opportunities of Decentralized Finance, which have only been started to be born.
Take several instruments, understand what you are being paid for. In the end, not optimize the return only, but a full risk-return profile of your portfolio
About Opium Team
The Opium Team develops innovative financial products that use new technology to challenge the traditional financial sector. The team was founded by professional traders, portfolio managers, and world-class mathematicians who believe that innovation should change the most conservative sector of the global economy.
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