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DeFi continues to play a crucial role in the evolution of the financial sector for many reasons. For one, it is an open and permissionless system that is available to everyone.
Secondly, arguably more interesting is interoperability that helps DeFi companies scale products by leveraging other innovations in the industry.
When combined, powerful financial products are possible which has led to the commitment of many developers to the development of a DeFi ecosystem. For example, integration of stable coins in Compound, creating lending protocols.
Though today total value locked (funds managed by smart contracts) in DeFi protocols has grown to $9 billion, it's by far way less than the funds managed by its centralized counterparts (namely CEX crypto exchanges). The key reason is the long on-boarding process to understand DeFi financial primitives which discourage most crypto traders and wealthy investors.
In the traditional financial system, wealthy investors mostly rely on asset management firms to manage their funds. In the global economy, the importance of asset management firms is increasingly recognized. As per the US SEC government report, the value of global assets under management (AUM) stood at $69.1 trillion in 2016.
They make well-timed investment decisions on behalf of their clients to grow their finances and portfolio, saving time, and providing greater access to the financial market, which individual on their own could not have.
Can the DeFi ecosystem benefit from such a system while keeping its core value intact i.e. trustless and permissionless?.
One of the key reasons why wealthy investors or corporations use asset management firm services is that, for one, they are at the epicenter of global events; from politics to extreme weather, anything that affects markets. Given their expertise, they are able to channel the investor’s funds to better prospects. Secondly, they are in a better position to assess risk and accordingly diversify investor’s money and are able to quickly adapt to liquidation strategies proactively as the market place evolves.
Though the presence of asset management services in DeFi could be beneficial to attract wealthy investors. In traditional asset management firms, clients usually have to put their faith in the firm and their services are available only to wealthy businesses and individuals.
For crypto funds, an asset management protocol for DeFi should take into account the trustless (no central party), safe, and permissionless (open for all) characteristics of DeFi. Additionally, the DeFi developer should take into account the dynamic nature of cryptocurrency and technology. Here things change quickly putting greater pressure on the firms to respond to users evolving needs and safeguard users' funds. For e.g., increasing gas fees, rise in competing DeFi financial primitives, price volatility.
New advancements in the Ethereum network service-layer protocol have helped to scale DApp usage to the wider audience. Not only do these services provide enhanced user experience but also make dApp development accessible, easier, and cheaper for developers. Examples of such service-layer protocols are - Gelato Network, Furucombo which automate smart contracts execution.
Automated smart contracts have helped in the development of asset management DeFi protocols because they offer users streamlined experience by removing the complexity of manually monitoring and placing each transaction themselves. Using these automation services, developers can create an auto-rebalancing feature wherein user’s funds will be moved to the next greatest yield farming strategies automatically to maximizing profits.
Auto-rebalancing has one problem. It increases the number of interactions with the network, which does not come cheap. Each interaction would cost gas fees and may impact the user’s yield returns. This challenge can be solved by allowing all users to deposit their funds in a pool. As the value in the pool gets accumulated, the platform routes the fund in a single transaction to the respective strategy. This way users save gas fees in excess of 99% making yield farming accessible for all investor kinds.
This model is put in use by APY.Finance, a necessary step for Ethereum. Today the network is reaching the limits of its throughput and we need a more efficient way to handle these increasingly complex DeFi transactions. By pooling liquidity and then batching the movement of that liquidity to financial primitives, not only creates enormous gas savings but also reduces the number of transactions going out on the network. This reduces gas fees for everyone on Ethereum, not just users of the platform.
To secure user funds in the pool, the pool address can be a multi-signature wallet- no single ownership or keys can be burned - no one has ownership, and the smart contract manages the interactions. Additionally, developers can run rigors audits of their smart contracts to ensure safety from attacks or bugs.
DeFi protocols also employ a model similar to traditional mutual funds that allow DeFi protocols to be non-custodial. When users deposit their funds to DeFi protocols (e.g. lending), they receive interest-bearing tokens in exchange. These tokens accrue interest every Ethereum block (~15 seconds) and can be transferred to anyone. Whoever holds these interest-bearing tokens can redeem them for the principal plus interest at any time. Example of interest-bearing token: Compounds cTokens (e.g. cDAI, cETH).
However, good processes on their own do not ensure good outcomes. Another vital element to make asset management DeFi protocol a success is how they manage risk.
The rebalancing approach should also take into account the risk profile before strategy selection. Each strategy available in the platform library should pass through the following parameters - smart contract risk, financial risk, and centralization risk. Based on users' risk appetite, accordingly, funds should be allocated to the strategies.
The risk assessment of the strategy should be done by the community using a platform voting structure (governance model). By casting votes with governance tokens, users are able to feed quality information in the decision making process. Therefore, it is important that the wider community participates and does their research before casting the votes. Without accurate, up-to-date information, pool returns could be at risk.
We are seeing the adoption of such a model in Yearn.Finance and upcoming APY.Finance platform. Both protocols have different approaches to risk management.
In Yearn Finance, the platform offers users (yield farmers) with a wide selection of investment strategies to choose from, requiring users to make their own decision about strategies and risks.
APY.Finance differs from Yearn. Finance by simplifying the process of risk application by offering liquidity providers to invest in a single pool from where the funds are diversified to the strategies based on users pre-defined risk tolerance profile.
The risk scores on strategies are defined by the community through a governance structure.
These propositions in a DeFi asset management protocol can help extend DeFi use from DeFi novices to traditional institutional investors.
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