Investment Opportunities in DeFi

Decentralized finance (DeFi) has been established to make finance more flexible and autonomous, due to the high degree of interoperability (“composability”) available between applications and blockchains. Ultimately, this results in a modular way to set-up investment strategies. Therefore, the investment opportunities are almost unlimited, as everyone in the DeFi space can benefit from customizable investment strategies and – if wanted – can participate without having to rely on a central intermediary to execute the strategy.

In this blog article, we will discuss different return types available in DeFi and explain how the return can be generated.   

Figure 1: Perspectives on DeFi investments

DeFi is an ecosystem with nearly unlimited return opportunities, in which each participant owns her assets and corresponding transactions (trades, loans, etc.) autonomously without having to trust another third party. Given the vast number of possibilities, the non-existence of a comprehensive and structured overview of metrics for DeFi investment opportunities is clearly surprising!

When investing into DeFi, (at least) three perspectives that comprise an investment opportunity need to be taken into account (cf. Figure 1):

  1. The underlying asset
  2. The concrete investment strategy, and
  3. The DeFi protocol & Blockchain platform.

There are currently more than 300 investment protocols out there, according to DeFiLlama. 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

1. Investment Strategy

When it comes to the investment strategy, it is there where the interoperability of DeFi through smart contracts truly begins. Four main strategies exist that an investor in DeFi might choose of:

Hodling (in TradFi: “Buy and Hold”)

Each crypto asset, like traditional assets as well, is susceptible to market movements that affect the price. 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, stablecoins or other ERC-20 tokens.

Staking (in TradFi: “Floating-Rate Note”)

On proof-of-stake (PoS) blockchains, the blocks are not validated by miners. Instead, they are validated by validators providing a certain amount at 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 validators (in many cases in form of staking pools). Staking compatible assets can generate an additional source of return, namely, the fees and rewards for staking.

Figure 3: Staking operation

Furthermore, some DeFi protocols like Aave or Curve Finance also incentivize users when they lock up (“stake”) their funds to support the protocol long-term. This makes sense from a protocol perspective and the users can generate an additional income on top.

Lending

On DeFi lending platforms, users can earn interest on their underlying if they lend it to other users. They can deploy their underlying asset 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, typically these loans are over-collateralized, in order to be eligible for the loan and this collateral is unlocked only once the loan is paid back. Borrowers can be individual users but also quite frequently, other DeFi protocols use these markets to leverage their yield aggregation strategies. The biggest DeFi lending protocols on Ethereum are Aaave and Compound, on the Terra blockchain it’s Anchor.

This is how a lending protocol operates:

Figure 4: Lending protocol operation

Liquidity Provision (in TradFi: “Variable-Fee Currency Swap”?)

By providing liquidity to liquidity pools on decentralized exchanges with underlying assets, users can collect trading fees and additional rewards in some cases. Funds deployed into liquidity pools can be withdrawn at any time, but might suffer a potential divergence loss, when doing so. Most decentralized exchanges are based on automated market makers (AMMs) instead of a classical orderbook model. The three most popular Decentralized Exchanges (DEXes) are: Curve Finance, Uniswap and Sushiswap.

This is an example of how providing liquidity to a DEX earns trading fees:

Figure 5: Liquidity pool operation

2. Investment Protocol

Multiple decentralized platforms have been built using different protocols, increasing the number of possible 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 >300 investment protocols according to DefiLlama and there are broadly two types of investment protocol types: The lending markets and the Decentralized Exchanges. The additional return process depends very much on the application or protocol used because each protocol works differently and the return opportunities differ from one to another. Accordingly, risks also vary between applications since – in addition to the investment risks – there are qualitative risks involved such as smart contract risk.

3. Underlying Asset

Underlying asset refers to the selected asset that is going to be allocated to an investment strategy. Underlying assets are susceptible to changes in capital (price appreciations or depreciations) except for possibly stablecoins as they intend to keep price stability usually through asset-backed reserves like fiat money, other cryptocurrencies or sometimes even algorithmically (DAI is the most famous example for the latter). Sometimes, underlying assets can be a further source of income when locked onto a DeFi investment protocol. According to CoinGecko, there exist nowadays >9,000 different cryptocurrencies in circulation, but the catalogue of coins available to stake, lend or to provide liquidity with, varies naturally from protocol to protocol.

Conclusion

One clear advantage of DeFi is that users can fully decide how to set-up all three perspectives of investment opportunities, underlying, investment strategy and protocol, to fit the user’s own return and risk preferences. Due to the flexible nature of DeFi, cross-protocol allocation is possible, being one of its more attractive features. It is also important to note that qualitative, protocol-specific risks exist. Those risks are difficult to assess quantitatively, and there are already certain providers which offer insurance against some of these risks.