Why Decentralized Finance Has Extremely High Yield But Isn’t Mainstream “Yet”

Background

Decentralized Finance is a new term describing crypto currency related financial products and protocols. Oddly high returns ranging from 10% to 3000% or more have been made possible, and everyone under the decentralized world is equaled and qualified for all financial products. Nonetheless, as it might seem too good to be true, there are a number of unprecedented risks which may lead to completely loss of fund.

Before The Long Story, A Quick Takeaway

If you are not willing to bear the risks of the decentralized world but still wants a higher gain with cryptocurrencies, YouHolder is one of the platforms with 12% APR guaranteed that I have used before (successfully deposited and withdrew my money with the interests). Note that this is backed by a centralized company. Use it at your own risk. To use this platform, you will also have to pass KYC by submitting a photo of your ID.

Another way to earn high APR and also decentralized is ETH2.0 staking (estimated APY is 5%-20%, 12% now). The minimum to participate is 32 ETH (~23,000 USD now).

Disclaimer: I am not affiliated or partnered with with any of the products mentioned here. These are some advices I hope I knew when I first joined the space. I do hope that after my writing, more people would be able to understand and participate in this revolution of future technology with me.

First, Why Decentralized Finance?

There were times that I doubted if there is a real need for blockchain. Not just a buzzword that is not only slower and less efficient than cloud-based solutions but also cannot scale. Is there any specific application that can only be realized with blockchain and decentralized protocols?

Then, the new term “Decentralized Finance (DeFi)” started gaining tractions earlier this year. A total of 15 billion USD has been locked in DeFi applications within a year. What is “Total Value Locked”? It is the number of tokens locked in smart contracts in order for a user to participate in DeFi apps. A user must deeply understand what these apps are doing when he/she locks the money.

DeFi — The Decentralized Finance Leaderboard at DeFi Pulse

It then comes the initial reason for the invention of cryptocurrencies — to serve as the digital money where every transaction is fair and transparent. Anyone can open an account with just one click and enjoy the same rights regardless of race, nationality, age, gender, and financial positions. It should be indisputable that “financial product” is the type of application that makes the most of cryptocurrencies.

Soon after the dispute of Bitcoin with little capability of scripting comes Ethereum — the programmable blockchain that introduces “smart contracts”, allowing any custom logic to be natively applied to form various interactions of cryptocurrencies. It gave rise to cryptocurrency financial products when developers started to implement existing financial logics and strategies that maximize ones gain by opening more trading possibilities. It is the only application which blockchain holds an absolute advantage over other technologies “if” cryptocurrency is the future of money.

Demystifying Decentralized Finance (DeFi)

So what are the components in decentralized finance? Here we list a few:

  1. Stable Coin: A type of cryptocurrency with little price fluctuation. Usually 1:1 pegged to existing dollars such as USD. Examples include USDT, USDC, and DAI.
  2. Decentralized Exchange (DEX): A platform that lets allows users to exchange tokens through direct interactions with smart contracts. This minimizes the risks of funds stolen by malicious intermediaries. Examples include Uniswap and Sushiswap.
  3. Liquidity Provider: A type of user that provides liquidity to decentralized exchanges. Decentralized exchanges often face a problem: “how can I make sure that there are enough different types of tokens to be exchanged?” To solve this, they give financial incentives to those that are willing to put their tokens into a “liquidity pool” for others to exchange. Usually the gain is calculated from the trade volume of the provided token.
  4. Lending and Borrowing Market: Due to the high volatility of cryptocurrencies market, many users are willing to borrow money with high interest rate for leveraged trading. Another group of risk-averse people would be happy to lend money with the high rate. Examples include Compound, MakerDAO, and AAVE.
  5. Collateralized Debt: Use a cryptocurrency as the collateral to borrow another type of cryptocurrency. Usually the collateral ratio is higher than the value of an asset one can borrow. For example, to borrow 100 USD of asset A, one must deposit 150 USD of asset B. If the price of asset B drops below the collateral ratio (say 149 USD), asset B may be forfeited and the borrower ends up losing 49 USD.
  6. Flash Loan: This is a new type of loan that one can borrow money by just paying the transaction fee and not the collateral. This is only made possible because of the atomic characteristic in blockchain transactions. A transaction can either be valid (cause changes to the blockchain) or failed (nothing happens). If one can borrow money at the start of the transaction and return the money before the end, there would be no risk for the lender. Thus, the only cost of the borrower is the fee to submit the transaction. Example platforms include AAVE and dYdX.

These are really a lot to learn. I was a newbie that only knew how to develop smart contracts and had no knowledge in finance. It took me one month of intensive reading to understand and get familiar with all these.

What is NOT Good About DeFi

Now, after explaining the nice part in decentralized finance, here comes the naughty part :P

From my experience of trying different DeFi apps with my real Ether, here are the learnings:

  1. Always beware of the URL you are visiting. Double confirm that this is not some spammy, cloned website that will transfer all your funds away once you approve it to control your tokens. My golden rule is to find the company’s Twitter account (the one with the most followers). The official URL is often included in their bio section.
  2. The returns are usually fluctuating. Sometimes we are overly optimistic about the high APR shown in new DeFi apps. However, that may only last for a week and then drop sharply. No pushed notifications for the dropped return, you must remember and carefully monitor it.
  3. Count the gas price into your total earnings. You may think that frequently switching to DeFi apps with a higher yield is the optimal strategy. However, each operation on Ethereum has gas costs. Gas price on Ethereum can be really expensive. Sometimes even higher than your total interests gained! The gas price is also not a fixed value, it becomes higher when the network is more congested. Check the gas price here.
  4. Make sure which currency the high APR is paid in. When you see numbers like 3000% APR, usually the reward is paid in some new token with little or diminishing value. That means, although you have 3000% APR and the amount of your asset C becomes 30 times in a year, the value of asset C may be dropping from 1 USD to 0.000001 USD within a year, and you end up holding a lot of zero-valued tokens.
  5. Becoming a liquidity provider? Do you know the impermanent loss? Being a liquidity provider doesn’t guarantee all positive gains. To provide liquidity, you often need to deposit two types of asset simultaneously. If the two asset’s price ratio changes dramatically, you will bear more impermanent loss. Calculate your impermanent loss here.
  6. Remember all the different platforms you locked your tokens in. These DeFi applications I mentioned above are independent from each other. A single portfolio in one app does not show the other. One solution is going to another app that summarizes all the tokens you locked in different platforms, like Zerion (see below screenshot). However, if one of your tokens is not supported in this platform, you are not able to see it. Currently I didn’t find a single platform that properly shows all of my locked assets in different DeFi apps. I have to manually keep a record of which platform has how many amount of each token. The platform also doesn’t show your earnings as a liquidity provider.
from Zerion — Invest in DeFi from one place

7. Be careful with the security risks. DeFi as an emerging new technology opens up new attack factors, including the flash loan exploits, supply mint hacks, cascading effect (chain effect from one point of failure due to the composability of DeFi protocols), and more. Buggy smart contracts may also lead to loss of funds. It is reported that from January to October 2020, the amount stolen in US dollars, excluding recovered funds, exceeds $78.3 million. To compensate the risks, insurance platforms such as Nexus Mutual comes to rescue by introducing “decentralized insurance”, allowing the community to deposit in insurance pools. Users can purchase the insurances of different blockchain projects beforehand and get compensations when needed.

A Real Life Example

Let’s look at an example when I was using Sushiswap yesterday.

from Zerion — Invest in DeFi from one place

In total, I used 5 transactions to maximize my gain as a liquidity provider with the pair ETH/INJ on Sushiswap. I also checked with their Discord support to make sure that these are the minimum number of transactions needed:

From SushiSwap Discord support channel

In practical, you may need to perform a total of 8 transactions to participate:

  1. First, you need to transfer your token from a centralized exchange (or any other places where you bought the token) to your crypto wallet with a DApp browser that allows you to interact with the DeFi app.
  2. Visit Sushiswap (two URL popped up when I searched for this name, so it took me a while to understand the difference between sushiswap classic and sushiswap.fi) and find your token pair at https://sushiswap.fi/pairs.
  3. Before adding liquidity, you have to “approve” the token. After approving, you can finally “supply” the token, which gives SLP (Sushiswap Liquidity Provider) token in return as a proof of your stake.
from https://sushiswap.fi/pair/0xfb3cd0b8a5371fe93ef92e3988d30df7931e2820

4. Then, go to https://sushiswap.fi/onsen for extra bonus of this token pair. Again, you have to “approve staking” first.

from https://sushiswap.fi/onsen

5. After approving you will see this screen. You have to “stake” to get extra reward.

from https://sushiswap.fi/onsen

6. This is not the end. To receive your reward, you have to “click to harvest” which costs you another transaction fee.

7. Lastly, if you no longer wants to be a liquidity provider. You have to “unstake” first at the above page and then “remove liquidity”, which costs two transactions.

Total cost

The highest gas fee cost me 6.49 USD, and the total cost for 4 transactions is 6.49 + 1.62 + 1.07 + 2.71 = 11.89 USD. I haven’t even harvest my reward! Besides the actual cost, there are mental costs as well, because you have to make sure every parameter is correct before you sign the transaction.

from Zerion — Invest in DeFi from one place

The final dashboard of Sushiswap looks like this. It really creates a hazard with all the glossaries for someone that is new to this space.

from https://sushiswap.fi/omakase

Wrap up

Now you’ve learned the background of decentralized finance, the underlying components that made this possible, the risks involved and how to avoid them, and a real life example of being a liquidity provider on Sushiswap.

To sum up, decentralized finance is in its early stage of development. Although higher return than traditional financial products can be expected, the risks and the steps are so complicated that it creates a great barrier for it to go mainstream. One may end up losing fund accidentally just because of a single careless step. The gas costs and the mental costs when confirming each transaction are also considerable. But maybe the return is only high when few people understand and participate.

After experimenting with these DeFi applications, though not being very user friendly, I still firmly believe that it creates the value that was never possible before and will continue to improve in both usability and functionalities in the future.

Thank you for your time reading. Any suggestions are welcomed and feel free to point me out if anything is unclear. See you next time! :)

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