Decentralized finance (DeFi) has come to flexibilize finance, due to the high degree of interoperability available between applications, blockchains and strategies. Therefore, the investment opportunities are almost unlimited, since everyone in the DeFi space can benefit from customized investment strategies. In this article, we will discuss different return types available in DeFi and explain how the return is generated. - Author: Julio Rubio
Figure 1: DeFi’s investment opportunity universe
DeFi is an ecosystem with unlimited return opportunities, where each individual owns their assets, trades, lends, and borrows at their choice without having to trust a third party. Given the number of possibilities, the lack of a comprehensive and structured overview of existing investment opportunities' risk and performance metrics in DeFi is surprising.
When investing into DeFi return opportunities, three dimensions need to be taken into consideration that comprise an investment opportunity: 1) underlying asset, 2) investment strategy and 3) investment platform (see Figure 1). There are currently around 355 investment platforms according to DeFiLlama2. The total return is dependent on the price performance of the underlying assets and an optional additional return component (see Figure 2).
Figure 2: DeFi’s total return composition
When it comes to the investment strategy, there is where the interoperability of DeFi truly begins. There are four main strategies a DeFi investor might chose:
Each crypto asset, like traditional assets, is susceptible to market movements that affect the market prices. These market fluctuations generate either a negative or positive return on the invested asset. The hodling strategy is the simplest one, since the investor only profits from the price change of the asset itself. You can hold any sort of cryptocurrency including native coins, stable coins and ERC-20 tokens.
On proof-of-stake (PoS) blockchains, the blocks are not validated by miners. Instead, they are validated by validators providing a certain amount of stake of the blockchain's native token and locking it up on the blockchain. In a PoS chain, the transaction fees are distributed to the staking pools or validators. Staking compatible assets in staking pools can generate an additional return source, in this case, the staking fees and rewards for staking.
Figure 3: Staking operation
In DeFi lending and borrowing platforms, users can earn interest on their underlying if they lend it to other users. They can deploy their underlying into smart contracts and lend them directly on a peer to peer basis to other users without having to rely on a third party to enforce the lending contract. To avoid borrowers defaulting to pay back the loan, borrowers need to lock up collateral in order to receive the loan and this collateral is unlocked once the loan is paid back. Borrowers can be individual users but also frequently, other DeFi platforms use these markets to leverage their yield aggregation strategies. The three biggest borrowing/lending platforms in DeFi are: Aaave, InstaDApp and Compound, according to Defipulse1.
This is how a lending/borrowing platform operates:
Figure 4: Lending/borrowing platform operation
By acting as a liquidity provider (LP), providing liquidity to liquidity pools on decentralized exchanges with underlying assets, LPs can collect trading fees and, in some cases, even additional rewards. Funds deployed into liquidity pools can be withdrawn at any time. All decentralized exchanges based on automated market makers (AMMs) instead of an orderbook, offer liquidity pools. The three most popular Decentralized Exchanges (DEXes) are: Curve Finance, Uniswap and Sushiswap, according to Defipulse1. Only these three platforms offer around 53.309 different liquidity pools, according to their own statistics as of the time of writing.4,5,6
This is an example of how providing liquidity to a DEX earns trading fees:
Figure 5: Liquidity pool operation
Multiple decentralized platforms have been built using different protocols and blockchains, increasing the number of investment opportunities. It is difficult to estimate the exact number of investment opportunities available since each platform offers different opportunities and allows different underlyings. There are currently 355 investment platforms according to DefiLlama2. There are broadly two types of investment platforms in DeFi, on the one side the lending and borrowing markets and on the other side there are the DEXes. The additional return process depends very much on the application or platform used because each platform works differently and the return opportunities differ from one platform to another. Accordingly, risks also vary between applications since there are different risks involved in DeFi platforms such as the smart contract risk and the blockchain specific risk.
Underlying asset refers to the selected asset that is going to be allocated to an investment strategy. Underlying assets are susceptible to capital gains (price appreciations) except for stablecoins as they keep price stability usually through asset-backed reserves like fiat money or other cryptocurrencies or sometimes even algorithmically. Sometimes, underlying assets can be a further source of income when locked onto a DeFi investment platform (see 2. Investment platform). According to CoinGecko3, there exist nowadays well over 9,000 cryptocurrencies in circulation but the catalogue of coins available to stake, lend or to provide liquidity with, varies from platform to platform.
One clear advantage of DeFi is that users can fully decide how to set up all three dimensions, underlying, investment strategy and platform, to fit the user's return and risk preferences. Due to the flexible nature of DeFi, cross-protocol allocation is possible, being one of its more attractive features to users. It is also important to note that protocol-specific risks exist. Those risks are difficult to assess quantitatively, but it is not impossible. We will discuss DeFi associated risks in our next article.
About Sharpe Explorer: At Sharpe Explorer, we help our customers leverage the crypto and DeFi revolution to access predictable returns, optimize their portfolio and gain a competitive advantage. Our mission is to provide the best and most trusted user experience for investors in the market. We are going to be the one-stop-shop for the focused and comprehensive assessment of any DeFi asset. Sharpe Explorer is going to open the door to the world of DeFi and will give you direct access to wallets and DeFi protocols.
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Julio Rubio has been in the blockchain and DeFi space for many years. He works for the Blockchain Founders Group as a blockchain consultant and at Sharpe Explorer as a product developer. In parallel, he is in his final year of his Bachelor in Business Studies at the European Business School. You can contact him via mail (email@example.com) or via LinkedIn.