Earning Yield in Decentralized Finance (DeFi)

Yields in financial markets have reached historical lows. For example, US 10 year bonds are paying a mere 1.52% annually and the S&P 500 Dividend yield is down to 1.94%. To earn higher yield, investors are buying deeper into illidiquity and risk targeting non-government debt in emerging markets. Another space that is evolving is Decentralized Finance (DeFi) based on blockchain protocols, cryptocurrencies and smart contracts. 

Decentralized Finance aims to provide the same financial services as traditional banking without any central authority or intermediaries. Without a central authority, DeFi allows everyone to engage with financial services like payments, lending, borrowing or investing with high autonomy and fewer barriers.

The volume in DeFi has been growing fast over the last two years. According to DApp Total, the total value participating in this spaces as of Sep 30, 2019 is $997 million up from $219 million one year ago as shown in the figure below. The yield that can be earned in this new market can reach levels as high as 5% per month even without taking market risk toward the new field of cryptocurrencies.

Where can yield be earned in the DeFi space?

The DeFi space has many sectors like payments, decentralized exchanges, assets or derivatives. By far the most promising and fastest-growing applications are borrowing and lending. EOS Rex, Maker, Compound and InstaDapp, that are shown in the figure above, can be classified as lending platforms and they are driving a large part of the momentum in the space.

The platforms act as peer-to-peer lending platforms. Individuals can access a pool of lenders and get a loan without a centralized authority. A simple mechanism ensures that lenders are willing to offer loans without credit checks or history: collateral. In fact, since most of the platforms act in the trustless environment of blockchains, the loans are over-collateralized. For example, a loan on the maker platform has to be collateralized with at least 150% at which level also a margin call is initiated and assets are sold. In fact, the system was collateralized with 331% on Sep 30, 2019.

What can be earned in the DeFi space?

EOS REX, a resource exchange system, has surged to become the largest decentralized finance platform, with roughly $289 million in funds locked up since its launch in April 2019. 

EOS REX manages resources for the EOS blockchain and creates scarcity by staking EOS. To create this scarcity and to incentivize staking, EOS REX offers a yield. This yield was as high as 7.26% over the last 30 days to Sep 30, 2019. On the other hand, investors need to hold EOS on the platform, which has to be hedged using derivatives as described below.

Maker is the second largest DeFi platform that allows users to lock Ethereum into smart contracts as collateral in order to secure loans in its unique stablecoin call DAI. 1 DAI is maintained at 1 USD and therefore has the advantage of reduced market risk for the participants. For each DAI, at least $1.5 ETH has to be locked into the MakerDAO smart contract as collateral. If the amount of collateral falls below 150%, then the smart contract is auto-liquidated and the supplier of DAI is incentivized with a 3% yield (bust/boom spread).

Once the collateral drops close to 150%, the borrower has to options: either send the borrowed DAI back into the smart contract or increasing the amount of ETH. Assuming the borrower does not have more ETH, but wants to hold up the position, he can borrow DAI from other users that are better collateralized. To facilitate those trades several platforms have started like Compound or DyDx. These platforms allow to borrow, DAI at rates of 10.61% per year on DyDX on Sep 30, 2019, which is lower than the 13% forced liquidation fee and therefore incentivizes users. Since DAI is pegged to USD, investors do not face an immediate market risk, but potentially a risk from failing smart contracts (see below).

Another source of income can be participating in mining activities of blockchains. The role of miners is to secure the network and to process transactions, for example on the Bitcoin blockchain. For this service, miners are rewarded with newly-created Bitcoin and transaction fees. For example, buying a Bitmain Antminer S17e (64TH) generates 4.87% per month on the invested capital including the cost for electricity and hosting of 10 cents, but does not account for changes in global difficulty or bitcoin price. The bitcoin price can be hedged using futures traded at the CME and the difficulty by trading forwards with firms like Protos Asset Management.

Other sources of income in the DeFi space can be by participating in pools at decentralized exchanges like Uniswap or participating in auctions for derivative or asset platforms like Setprotocol. 

Where is the risk?

The platforms above are all acting in the cryptocurrency space that is regularly experiencing annualized volatilities above 100%. Therefore an investor should hedge out the market risk, while participating on these platforms. The market risk can be hedged using Futures, CFDs (contract for difference) or cryptocurrency exchanges (using lending facilities). The most flexible and fastest are probably CFDs that allow for taking short positions across the top 10 cryptocurrencies and margins of less than 10%. Above that CFDs on IG.com, for example, offer 5% per year for taking short positions similar to a risk free rate for taking short positions in future markets. In summary, taking a position in any of the above platforms with $1 million would need another $100 thousand to open a short position and to take off market risk. This position then generates itself 5% per year.

The other major risk is the counterparty risk towards smart contracts and platforms. The smart contracts store the cryptocurrencies for the DeFi platforms. If the smart contracts were found to be prone to attacks, this might result in a complete loss of stored funds. Examples are the Dao, which was a form of investor-directed venture capital fund, but users exploited a vulnerability in code to enable them to siphon off one-third of funds to a subsidiary account. Another example is Parity, where around $162 million in ether was frozen in digital wallets after a major hack. This risk will probably only be mitigated over time as more money is stored in these contract and hence providing enough incentive to hack them and only with time these contracts will prove to be safe.

Platforms include Compound, DyDX or Bitcoin mining hosts. These platforms might get hacked themselves or go bankrupt. This risk can only be mitigated thorough analysis of the technology and company processes as well as capitalization.

Summary

The Decentralize Finance (DeFi) is a fast evolving space with regular high yield opportunities of 5% per month or even higher. DeFi is providing services similar to traditional banking but in a trustless environment. The services are driven by lending and borrowing, but also mining, staking or participating in auctions or pools. 

The DeFi space has grown to a considerable size of almost $1 billion in assets generating these yields. The liquidity of the different platforms varies widely between days (Lending) to months (Mining) and the risk can only be partially mitigated using derivative contracts and counterparty analysis. However, the space has an enormous potential and provides attractive investment opportunities.