Yield Farming, Rising Gas Costs and Why It’s Better To Be Lucky Than Good
It’s only been about *checks notes* two weeks since my blog post musing about what it would take for the broader capital markets to notice DeFi.
As if on cue, a few tokens launched, products shipped and partnerships were announced and the DeFi ecosystem responded with a resounding HOLD MY BEER.
Yield farming is all the rage as DeFi has now reached the point where the potential of programmable financial services is becoming outwardly visible. That, and everyone notices a startup that’s got a $2B liquid market cap six months after its Series A.
DeFi now has everyone’s attention.
Gas Costs and Scalability Concerns
But a funny thing happened on the way to reinventing money and finance, because Ethereum doesn’t scale yet.
While most individual swap transactions are happening in the $1/tx range, the more complicated yield farming strategies that involve multiple protocols and multiple meta transactions can end up costing $20-$50 to implement or unwind. And this is at current gas prices when user metrics are miniscule. What will gas prices be if the Robinhood bros figure out Metamask?
Expensive transactions, weighed against the potential returns for retail sized trades, make yield farming cost prohibitive for most retail traders and the expensive transaction fees will eliminate most day traders. We haven’t even broached the still very wonky UX and introduction of new concepts like impermanent loss.
Ethereum’s scalability will get fixed through a variety of approaches, from ETH2 to L2 to better approaches to gas and smart contract optimization, but the yield farming incentives and inevitable frenzy aren’t going to wait for scaling to arrive. This is starting now.
So, on these key points, the ETH Killers and skeptics were right. Isn’t this a disaster for Ethereum? Won’t this trigger a mass exodus of developers and users to the scalable blockchains?
A Feature Or A Bug?
While we aren’t surprised to see the fruits of composable financial services beginning to emerge, there is some justifiable collective concern that we don’t yet fully understand what we’ve unleashed.
Securing smart contracts is hard on its own. Smart contract risk in the context of composability is something we don’t fully understand yet, and in this case a bug can create a catastrophic or systemic event. The average retail trader cannot possibly understand how to evaluate this risk. Even Crypto VCs have made this mistake in recent months.
More pragmatically, the increased composability led to robust discussions about how $COMP incentives could impact the $DAI peg. More concerning is the permissionless ability to create cascading leveraged positions.
As Dan Elitzer put it in his post at Bankless on Aquaponic Yield Farming:
There are likely to be hacks, exit scams, short-term asset price manipulation to cause liquidation cascades, and a whole host of other ways in which people (and likely some professional funds) lose a lot of money. With the natural interconnectedness of many of these protocols plus the massive financial incentives of liquidity mining to stack them as deeply as possible, it’s possible that the whole thing comes crashing down.
Even if that happens, it will be rebuilt. The promise of truly open, permissionless financial services is too great to die.
Confusing UX and exorbitant transaction costs that may have initially seemed like a bug will more likely end up a feature that acts as a governor to more rampant speculation. If one were to imagine the most likely scenario in which DeFi has some catastrophic event in the near term, it would be the combination of rampant speculation and cascading leverage before the smart contracts have been appropriately battle hardened.
DeFi Still Learning and Adapting
New-to-DeFi yield farmers predictably chased the immediate high-yield opportunities in BAT and USDT, with the Compound BAT pool reaching a lofty $311M. It only took the DeFi ecosystem less than 2 weeks to see how the incentives had skewed, changes were proposed, changes were discussed and voted on and then those changes were implemented. The desired outcome occurred almost immediately, with the cBAT the liquidity pool falling back to a more reasonable $29M.
It’s fascinating how quickly this decentralized governance process played out, ending up with the right incentives for DeFi’s long term health. This outcome would have been considered breathtaking execution for an operationally efficient centralized organization, but it’s a mostly decentralized set of actors who happen to be in pursuit of the same long term goals. Just as the composability of DeFi technology is starting to show out, so is the composability of the DeFi community.
Why It’s Better To Be Lucky Than Good
DeFi is maturing at an *astonishing* rate, but neither is it ready for mass adoption. New incentives are juicy enough to bring new large amounts of new capital to the DeFi economy, but the remaining hurdles will prevent the full brunt of retail in the near future. This should present enough of a hurdle that they stay focused on the shiny object that is bankrupt stonks, so that the DeFi ecosystem can continue to adapt and mature. And for where DeFi is today, that’s probably the best possible outcome. But for the ETH-killers and skeptics, there won’t be much solace outside of a few “I told ya so’s.”
