The best strategies to participate in and operate in decentralized finance. Decentralized finance (DeFi) is a concept that has received a lot of attention since the so-called DeFi Summer of 2020 because its usage, often measured in total value locked (TVL), has risen dramatically since that time. In the last year alone, TVL rose by over 240% to a current $209 billion in “value locked” within DeFi projects, according to DefiLlama. Not only has it become interesting for investors to get into promising DeFi projects through their tokens (hoping for capital gains), but also to use these platforms to generate a regular and steady income through various activities. And, it’s been even more attractive in bearish markets.
From TradFi to DeFi
Let’s start at the beginning by shedding some light on the transition (or disruption) from traditional finance, or TradFi, to DeFi. Explained simply, DeFi sets out to disintermediate processes traditionally run by banks and financial institutions like borrowing, lending and market making by cutting out the middleman. It allows investors to directly interact with each other on a peer-to-peer (P2P) basis by providing loans or liquidity for trading and assume those roles/functions in return for generating fees, albeit while also carrying the risks. “The disruption of the banking sector, which we have seen in the recent years driven by FinTech players, has now escalated to the next level with DeFi laying the groundwork for a peer-to-peer ecosystem” states serial tech entrepreneur and AltAlpha Digital crypto hedge fund co-founder Marc Bernegger. We will explore the DeFi business model and ways to participate in it shortly.
The elements involved in DeFi
Looking at DeFi as a whole, much like building a house, you have various layers that come together to form a new digital service offering.
Using the house as our example, the first layer, the underlying blockchain technology which could be Ethereum or Solana (layer-1 protocols), is like our basement or cellar. Depending on which blockchain is used, you will need to make certain trade-offs. This is known as the blockchain trilemma, a phrase coined by Ethereum co-founder Vitalik Buterin.
He continues: “Solana, as a blockchain, was designed for high frequency (financial) activity. Everything in Solana’s design is geared towards performance, choosing to prioritize speed over cost.” This gives you more color for the nuanced views developers and investors must take when deciding for an ecosystem. To tackle these challenges, developers are working on either creating new “base layer” blockchains to solve these constraints, which you see with Polkadot and their layer-0 approach or by introducing layer-2 scaling solutions on top of layer-1 blockchains like with Ethereum using zk-Rollups smart contracts for cost reduction.
Then, on top of our basement, we have our walls, which are the respective protocols, also known as decentralized applications, or DApps, that offer their service as decentralized exchanges (DEXs) such as Curve or Uniswap, lending protocols like Aave or Maker, derivatives liquidity protocols like Synthetix and more. A space that is constantly growing and developing.
How can you make money with DeFi?
Simply speaking, you can either invest in the DeFi projects/protocols by buying the respective tokens like SushiSwap (SUSHI), Aave (AAVE) or Maker (MKR) while expecting capital gains through price increase based on a superior platform offering, user and asset growth. Or, you can actually use these platforms as an “operator” and generate income from the various activities available.
You can also have your cake and eat it, too, by buying into high conviction projects and get some additional income through some of the following activities:
Staking. With staking, you are rewarded for participating in the consensus mechanism process, or how decisions are made, of a blockchain using your staked tokens like Tezos (XTZ), Polkadot (DOT) or ETH, de facto becoming a validator of the network. This is referred to as a proof-of-stake mechanism used by blockchains such as Tezos, Polkadot and soon, Ethereum 2.0 to secure transactions and the network. Notice how I use the “ticker” symbols when talking about the tokens and the platform names when referencing them as a protocol. With an increase of staked and, thereby, “locked” tokens, new concepts such as “liquid staking” have emerged, basically creating a derivative of the staked token, which then again becomes “liquid” and can be re-deployed while earning staking rewards.
Lending. Instead of receiving a loan from the bank, you can get it from a DeFi protocol, having fellow investors put up the funds or, in essence, peer-to-peer lending. In return, the investors receive part of the interest paid on the loan as their yield. Note that when you, for example, hold stocks with your bank, they are most probably lending those stocks, for which you are paying a deposit fee, to some financial institution like a hedge fund, again for a fee, which then can be used for short selling and other leveraged trades. Obviously, you don’t see any of that money.
Liquidity provision. When you buy and sell stocks on a traditional exchange, financial institutions act as intermediaries in coordinating trades, as well as providing liquidity through shares or cash. In the digital asset world, these activities have been disrupted by automated market makers (AMM) running and operating as decentralized exchanges on automated code. The missing liquidity is yet again provided by fellow investors who will receive income in the form of the fees generated by these liquidity pools. These pools consist of a variety of trading pairs such as crypto vs. crypto like BTC/ETH, crypto vs. stablecoins like DOT/Tether (USDT), or stablecoins vs. stablecoins like USDC/Terra (UST).
Yield farming. Imagine you lent money to a liquidity pool, such as SushiSwap, and started to receive your first rewards in SUSHI. You don’t want them sitting around. You could put them to work yet again through one of various opportunities and pile up more rewards. In short, yield farming is the activity of constantly putting your tokens to work — money doesn’t sleep — chasing higher and compounding yields across protocols, pools and others.
All these activities offer a respective annual percentage yield (APY) or fee share split which will vary depending on the platform like Curve or Compound, services such as staking or liquidity provision and underlying tokens like BTC or USDC used. These gains can come in the form of deposited tokens, referenced as “Supply APY,” as well as the platform’s native token, referenced as “Rewards APY.” For example, the SushiSwap protocol would give you SUSHI tokens and the Aave protocol AAVE tokens. Some of these platforms distribute governance tokens, giving owners the right to vote on the direction of the platform, such as receiving the optionality of becoming an activist investor.
What to watch out for
This could be an entire article in itself, so we’ll stick to some key highlights. First, use the house analogy to have a conscious awareness for your risk assessment across the layers and interdependency. With a focus on the protocols, or your counterparty risk, there are some specific levels you will want to review and ask critical questions on:
- Team. Is the team known or an anonymous group? What is their technical and practical background? Are there any large/well-known backers of the crypto community involved?
- Technical. Have there been any hacks, are there third-party smart contract audits available and do they have security bounty prizes posted?
- Tokenomics. Are governance tokens awarded? What is the current total value locked and how are growth numbers regarding assets and active users? Is the project run through a decentralized autonomous organization (DAO) with a community-supported model?
- Insurance. Is there a treasury to make investors “whole” again in the event of a hack? Are any insurance policies in place?
- Pools. What are the APYs — are they insanely high? — has the APY been stable, how much trading liquidity is within the pool, risk of impermanent loss, lockup periods or transaction fees?
When you actively “use” your tokens to generate income, you generally are “hot” on these protocols/exchanges and, therefore, much more vulnerable to hacks or counterparty risk. There are institutional providers, such as Copper, offering secure custody not only for buy-and-hold investors, but also for staking of tokens at a cost. These security and custody concerns are a key difference between investing in DeFi through buying tokens, which can then get tucked away into cold storage vs. operating a strategy which is constantly and actively generating income.