Yield Hacking in DeFi
Let’s discuss how to combine token valuation methods, passive income strategies, and yield hacks to maximize risk-adjusted return in Decentralized Finance.
Long Term Yield Hacking
The main idea here is to develop a thesis, build a portfolio of symbiotic investments around the use case, and compound your positions with passive income strategies like staking and liquidity provision.
Let’s consider the $600T derivatives market which represents a killer app for decentralized exchanges and oracles. As Chainlink and Synthetix feature tokenomic models that effectively capture value from this use case and reward it back to network participants to drive token demand/appreciation— they are ideal investment candidates for our derivatives thesis.
Additionally, we can speculate that synergies between their use cases would produce a high degree of correlation in their token values. For example, as Chainlink oracles enable a wider variety of Synths, trading volume should increase on Synthetix Exchange, increasing rewards available to SNX holders as well as demand for the SNX token required to claim them. Vice versa, increased trading on Synthetix requires increased usage of Chainlink oracles, increasing demand for the LINK token used to compensate node providers.
To compound these investments, users can stake SNX (currently ~ 53% interest p.a.) and use LinkPool to provide collateral for nodes and earn a share of their rewards.
Additionally, user can trade their sUSD minted from staking SNX into a variety of Synths to increase exposure (sETH) or hedge (iETH).
While sound tokenomics and synergies support long term investment theses, DeFi’s rapidly evolving marketplace is also ripe with lucrative short term opportunities, namely arbitrage.
Short Term Yield Hacking
By combining DeFi primitives like CDPs (Collateralized Debt Positions), Interest Bearing Liquidity Pools, and Derivatives, traders can lever up positions to make sizable gains on a variety of low-margin plays. With risk mitigated by low-cost capital and pseudo-anonymity, good and bad actors alike flock to DeFi’s Wild West for a piece of the pie.
“Yield Hacking” strategies (like those proposed below) can produce attractive risk-adjusted returns when timed and executed properly.
Flash loans, introduced by the lending and borrowing protocol Aave, take leverage one step further, enabling borrowers to take out completely uncollateralized loans as long as they repay within the same Ethereum transaction.
Since the ethereum network uses atomic settlement, smart contracts must be executed in their entirety, meaning if the trade does not result in enough profit to repay the flash loan, the entire transaction fails and the trade never takes place. It wasn’t long before yield hackers realized that with a little clever scripting, smart contracts can be designed to leverage flash loans for risk-free arbitrage (i.e., borrow funds, buy low on one exchange, sell high on another, pay back the loan, and extract the profits — all in a single transaction).
Now armed with nearly zero-cost capital, yield hackers and their armies of bots scoured the ecosystem for opportunities to manipulate markets, arbitrage inefficiencies, and exploit poor system design. Within a week of the trading protocol bZx enabling flash loans, attackers exploited oracle vulnerabilities to capture nearly $1M worth of Ethereum without putting up a penny.
The post-mortem revealed that the culprits likely targeted bZx as it relied on single exchange based price feeds, which they manipulated through pump and dump schemes to increase the spread and profitability of arbitrage. According to Chainlink CEO, Sergey Nazarov, using a single third-party exchange for your price feed is an easy way to paint a target on your back for attackers — bZx has since implemented Chainlink’s decentralized price feeds to neutralize this vulnerability.
Due to the trustless and pseudo-anonymous nature of DeFi, these “attackers” remain unidentified and unpenalized for their exploits.
Conclusion
Like the old Wild West, the new DeFi landscape is rich in both opportunity and risk. As open protocols proliferate new products, thesis-driven investors will refine valuation methods and earn passive income while yield hackers leverage low-cost capital to hunt and amplify opportunities for profit.
Only time will tell how the future of global finance unfolds, however, if there’s anything you can predict with utmost certainty, it’s going to be one hell of a ride.
Hope you enjoyed and thanks for reading!
Disclaimer: All of the information (above and linked) is for entertainment purposes only and is not to be taken as investment or financial advice. I hold long positions in the projects mentioned and abide by a no trade policy 3 days before and after publishing of this article.
