Making the DeFi Protocol Life Curve Work For You

Currently, the majority of DeFi investors are either losing money or getting very small returns. There are multiple reasons for this, with one of them being particularly fundamental.

To achieve positive and high returns in DeFi, liquidity providers must understand how DeFi protocols evolve over their lifetime. Most protocols follow a common growth pattern over time.

In the early stages, they offer high returns even on small investments. However, in the later stages, even substantial capital may not yield significant returns. This is not an accidental situation but a core factor of the supply and demand dynamics in the market that DeFi protocols follow.

Despite its fundamental nature, this issue can be overcome. There are multiple solutions, including manual and automated yield aggregators. To start, let’s explore the core dilemma of DeFi protocols.

The DeFi Dilemma

No DeFi protocol can generate money indefinitely. If you’ve been investing in DeFi for a while, you’ve likely noticed a change in many protocols that initially generated high returns.

Over time, these protocols usually see an increase in the capital they hold. However, this often results in a significantly lower APY on liquidity providers' investments.

This is due to the fact that the number of users for these protocols typically grows fast only in the initial stages. After some time, the growth in protocol usage slows down. At the same time, Total Value Locked (TVL) growth accelerates as the protocol ages and gains trust.

When the number of users remains relatively constant, the amount of fees that the protocol can take from them stagnates, as well as the total revenue for its liquidity providers.

As the protocol’s total revenue remains the same, the growing TVL means the generated fees must be distributed across a larger amount of capital. Consequently, each dollar invested begins to yield a smaller return. This balance dilemma between TVL and Yield is a problem that follows a similar pattern throughout different stages of a protocol’s life.

Protocols Life Curve

Every protocol generally goes through three growth stages. These stages are identifiable based on the relationship between TVL and Yield. For most protocols, the yield grows and falls over time, moving the protocol back and forth through these stages. However, TVL usually follows the yield to some extent, keeping the protocol in the same stage.

Early Stage

In the first growth stage, a protocol begins to gain initial attention and users. The usage typically grows faster than the amount of TVL it operates with. For example, in DEXes, trading volume increases as more people become aware of the protocol. New liquidity providers are attracted by the high yields the protocol offers its initial providers. This creates attention, which leads to more and more liquidity providers starting to come to the protocol.

New liquidity providers increase interest in the protocol, which leads to more people starting to use it, which also increases its total revenue. This creates a cycle of increasing attention and liquidity. This cycle continues until it reaches the Efficiency Peak.

Middle Stage

At this point, the liquidity attracted by the protocol starts to exceed its trading volume. Consequently, the overall fees generated by the protocol are distributed among a larger group of liquidity providers, reducing the APY for each of them.

The point where the amount of TVL and overall yield that it generates perfectly balance each other can be named Efficiency Peek. This is the point where the protocol is able to generate the highest possible APY for the maximum TVL that it can support.

At this point, the fees that protocol users must pay for usage are very small because the protocol is able to utilize its liquidity as efficiently as possible. However, staying at this point for long is challenging.

If a protocol generates very high APY, it attracts more liquidity providers, increasing TVL and, as a result, decreasing APY. This creates a negative feedback loop that, by idea, must balance the interest of liquidity providers and lead to liquidity outflow. This must move the protocol back to the Efficiency Peak.

Reality, however, is more complex. For many providers, the APY outside of the Efficiency Peak is acceptable. On top of that, investing in any protocol involves fees. In the best case, it is the fees only for transaction execution on the blockchain. But even in that case, providers must wait until their investment covers the costs of deposit and withdrawal transactions to at least break even. In the majority, they wait some extra time to get minimal positive returns.

Additionally, many providers actually invest passively and do not monitor returns actively. They keep investment in protocols based on trust in the solution rather than the relative returns it can provide. They may wait months before withdrawing their funds.

For DEXes, the situation is further complicated by price movements within liquidity pools. When price disproportion moves high enough, many liquidity providers can decide to wait till the moment when the price will return back to avoid making impermanent losses permanent. If the price keeps changing further, this can lock more and more money out of such unlucky providers in the pool.

All of this leads to a snowball effect that drives up TVL and lowers yields over time, moving the protocol into the late stage.

Late Stage

In this stage, you find major protocols like Uniswap, Compound, Aave, and Balancer. They are locked in a state where they have too high TVL and low usage rates to utilize it efficiently.

In other words, they have low demand for high supply. Consequently, investments in these protocols are less profitable compared to those in early-stage protocols that are just launching their services. Such early-stage protocols, on the other hand, usually struggle to attract liquidity, which results in higher APY even on small investments.

Liquidity Provider Cycle

This situation creates an infinite cycle where liquidity providers must actively manage their investments to achieve reasonable returns. They need to constantly search for new protocols offering high APY and shift their liquidity from older protocols that no longer generate sufficient returns.

The efficiency of a liquidity provider’s strategy depends on how quickly and accurately they can find protocols near their Efficiency Peak. The more frequent the liquidity provider can be in this cycle, the higher returns he can get for its investments.

Yield Aggregators

To automate this process, DeFi has introduced yield aggregators.

In comparison, many aggregators operate by collecting fees from a single protocol per token, working more like yield optimizers. However, more mature solutions distribute liquidity across different protocols based on the current yield potential. As a result, they can control larger capital amounts for longer periods while still generating good returns for their users.

Such aggregators can monitor and search for new protocols in which they can move liquidity in a more systematic manner. This workflow is quite similar to investment funds in traditional finances. They basically cover their service of monitoring the market and integrating with new protocols through performance fees on the revenue they generate for their liquidity providers.

This business model appears promising, but in reality, it is very complex to implement it safely and profitably at the same time. I will cover the challenges of this model and possible solutions in future articles.