Earning Attractive Risk Adjusted Yield In Decentralized Finance (DeFi) — Review October 2020
By Philipp Kallerhoff and Thomas Kineshanko, co-founders, Protos Asset Management.
Protos has been investing in DeFi since 2019. Overall funds invested in DeFi since our last article grew from 1 Billion to 10 Billion. The number of available yield opportunities has also exploded.
DeFi gained a lot of attention for two reasons: high yields of up to 100% or more for providing USD stable coins and other blockchain assets. This is compared to US 10 year bonds are paying a mere 0.74% annually (down from 1.52% since our last article) and the S&P 500 Dividend yield is down to 1.68 (from 1.94% as of our last article). Two, DeFi networks actually earn real revenue, P&L can be calculated, and they share that revenue with users.
Although the DeFi market promises returns on USD stable coins up to 100% p.a. the market has plenty of risk that needs to be mitigated. Below is our take on the performance of the different strategies in DeFi and propose a profitable and safe approach to earning good yield.
Why is DeFi growing right now?
Decentralized Finance aims to provide the same financial services as traditional banking without any central authority or intermediaries. Without a central authority, DeFi allows everyone to engage with financial services like lending, borrowing or investing via peer to peer networks. As actors provide services to these networks like providing liquidity, they earn a share in the revenue generated by the network. In short, DeFi is growing because finance, a market that generates trillions in revenue per year, is being eaten by software and that is a massive opportunity to make money (while providing better services to users of financial services).
The figure below shows the different layers that have been built and are now contributing to the ecosystem. Notably, there are similar layers being developed on other blockchains such as Binance Smart Chain and Polkadot.
Where do the high yields come from?
First, DeFi is being used by early adopters and early adopters are willing to pay more (think Tesla’s first roadster). It’s the opposite of government debt or a large corporate and more like peer-to-peer loans that provide an interest rate of approx 5–8% even in traditional markets.
Secondly, in the race to own the huge revenue in internet finance, competing DeFi platforms started offering an additional incentive to grab market share. The backers of the platforms such as Venture firms like Andreesen Horrowitz are indirectly paying for these incentives in the same way Uber has subsidized rides for years. Compound was one of the first, offering additional COMP tokens for participating in the platform. Interestingly, these incentives can be stacked to earn even higher returns using a crypto-first folding mechanism. The folding can be done manually or using flash loans such as the ones provided by Instadapp.io. In effect, it is possible to fold any deposit 4 times (because the minimum margin requirement is 75%) and therefore multiply the interest up to 26.31% at the moment.
Total APY on invested capital = 4 x Supply APY + 4 x COMP distribution APY + 3 x Borrow APY + 3 x COMP distribution APY
Revenue being generated by DeFi networks
DeFi networks earn revenue the same way banks do, they provide a service and charge fees. In DeFi, you and I can be part of the bank, providing some service (governance, liquidity) and we get to share in the revenue of the service. This marks the critical distinction between most 2017 era crypto projects and DeFi.
The table below shows the revenue and token price change last 30 days before Oct 3, 2020. For example, the total annualized revenue of platforms like Uniswap are reaching over 500m USD.
Why are the farmed tokens worth anything if they are for free?
The value of a capital asset is the expected current sum of all future revenue that asset will earn.
So besides the lending or liquidity yield, platforms like Compound are offering additional COMP tokens for participating. These tokens have a value since they are so-called “governance tokens” and give holders a right to vote on decisions affecting the management of the protocol — such as technical updates or, importantly, how much revenue is shared with governance token holders.
Yield farming platforms have become decentralized autonomous organizations (DAOs). A DAO is an organization represented by rules encoded as a computer program that is transparent, controlled by the organization members and not influenced by a central government. All transactions and rules are recorded and maintained on a blockchain. Of course, the value of the DAO tokens can go up and down depending on the success of the platform. For example, the token of Yearn Finance (YFI) reached over 1 billion in valuation in less than two months, but has lost some value since then.
The value in DeFi tokens comes from other investors speculating on their future value, some of which comes from their expectation of earning revenue by holding the asset.
Where is the risk?
The risk is at least fourfold: smart contract risk, liquidity risk, stable coin risk, network design risk
- Smart contract risk
Includes that the code on chain might have errors and might lead to a complete loss of funds. For example, funds in the Parity wallet of about 150m USD were frozen, which showed the coding vulnerability in a smart contract (rather than a flaw in the underlying blockchain or cryptography). The only way to mitigate this risk is to perform audits on the smart contracts and perform test transactions.
2. Liquidity risk
To participate in decentralized exchanges or lending platforms, users need to deposit assets on both sides of the liquidity pools, for example on Uniswap. The liquidity might deplete quickly if there is a better exchange with better terms launching and this can lead to a liquidity event on the depleted pools. The mitigation strategy for this risk is for example to monitor the liquidity in these pools of capital and make sure to stay at a rather small percentage of the total volume and to diversify across platforms.
3. Stable coin risk
As stable coins are mostly pegged to the USD at the moment, but this peg might break. There have been numerous discussions for example about the peg of USDT, which is the most prominent competitor. So far, the major stable coins have held up with hard sell-offs in crypto. Although the pegs have not fully broken yet on the major stable coins, they sometimes experience a large annualized volatility above 20%. To mitigate this risk, again audits of the actual assets can be considered and the redemption mechanisms. Also the volatility of the stable coin is another indicator of the risk, where, for example, DAI has a higher volatility than USDC or USDT stable coins.
4. Network design risk
For a decentralized network to work well, incentives need to work well and even more critically, participants must be able to trust the incentives. For a simple example, hodlers of YFI tokens know the supply of YFI is capped and they feel confident that if network value grows, the value of their YFI will grow. A poorly designed network may attract initial liquidity and users but can come apart fast. Hundreds of new and many copy-cat DeFi networks have been launched so it’s critical to filter for quality of network design and token economics. We factor legal risk into this bucket in that a poorly launched network can make the underlying tokens securities and lead to potential problems for the network upon SEC or other regulator action.
Summary
DeFi has been on a tear as the liquidity on the different platforms increased to over 10 billion USD. The main drivers were the realization by the market that DeFi networks are generating substantial revenues and the yield being offered regularly over 100% p.a. Since the ICO hype in 2017 a lot of teams have built out their platforms that took maybe longer than expected, but now bears the result of a very broad infrastructure that is openly shared and can be copied easily. Innovation followed a hockey stick that took a long time to develop the basics like Maker DAO platform but is now increasing rapidly.
The yields can be narrowed down to only USD stable coins and therefore offer an interesting incentive beyond other interest bearing assets. The USD stable coins are either lend out or provided to liquidity pools that provide yields between 20–90% p.a. at the moment including incentives. These yields can also be diversified across multiple stable coins and platforms. This will not result in the maximum yield available, but offer some protection against the risks above, while the average yield is still around 30–40% p.a. This also includes limiting the counterparty risk, minimum size due to gas costs and maximum percentage of a liquidity pool.
Some of the main risks are controlling for the smart contract risk, liquidity risk, stable coin risk and network design risk. The mitigation is to understand the smart contracts controlling these platforms and stable coins as well as continuously monitoring the liquidity and flows between the platforms. Also the yields are changing frequently and new platforms are launching easily as the code is mostly available for free on Github, which makes DeFi yield an operational effort, which again needs to be automated.
