How to DeFi - Part 1

When it comes to DeFi, there are a lot of opportunities one can make as– passive income. In addition, many crypto investors are starting to realize that it makes more sense to let your assets make money for you (in DeFi??) rather than letting them stay in centralized exchanges. In today's article, we will briefly understand each of these opportunities, and in the later parts of this series, we'll cover them in depth.

In DeFi terminology, every investment opportunity you come across generally is listed with “APY” rates (eg- TUSD staking on AAVE gives 13% APY). APY is the Annual Percentage Yield - the real rate of return earned on an investment, factoring in compound interest that accrues or grows with the balance.??

But APY can mean different things in different contexts. Let's breakdown a few popular "passive income" strategies and how APYs differ for them:

Lending APY

What it is:?The most uncomplicated strategy to understand. You deposit your assets at a protocol, permission-less (no boundaries) borrowers take that capital in exchange for collateral and interest. The collateral here is generally 125%-150% to ensure the protocol's safety. That's why it's permissionless; anyone with enough ETH can lend ETH and earn interest from borrowers ??(Irrespective of demography).

Benefits:?Interest paid by the borrower of the assets is paid back in the same asset as borrowed ??, so it is excellent to have single-asset exposure (lend USDT, earn interest in USDT).

Your initial deposit (Let's say - 100 USDT) is compounding 24/7, whether the interest rate rises or falls. So even if the lender interest rate falls to a dismal 0.0000001%, you are technically still earning. On the flip side, demand for USDT loans can increase, and you might end up at a comfortable +20% APY.

Risks:?Well one would think that there is always a risk of overlending happening in the protocol, but the liquidation mechanism and incentives, as well as the fact that interest rates(APY) depend on the utilization rate, make it very hard for the protocol to over-lend. For example, say there is 1000 USDT being lent (deposited) on Aave, and 750 USDT being borrowed. Then imagine a lending whale (someone with large deposits into the liquidity pool) pulls out its USDT (i.e., stops lending). Now more USDT is being borrowed than there is being lent. The market would technically be improbable, but the interest rate on the borrowed USDT would skyrocket above 100% APY. This will result in borrowers having to give back the borrowed money.

However, it's unclear how well this mechanism would work in periods of intense market situations. [The discussion is beyond the scope of this newsletter]

Single-coin staking APY

What it is:?Staking is the process of actively participating in transaction validation (similar to mining) on a proof-of-stake (PoS) blockchain. If you're a busy professional who wants to help decentralize the blockchain, you can delegate your assets to those validating the transactions. Anyone with a minimum-required balance of a specific cryptocurrency can validate transactions and earn staking rewards on these blockchains. These rewards are distributed to those who voted (delegated their assets) on them to secure the network.

Benefits:?Most staking opportunities let you vote or even propose changes via governance mechanisms proportional to your stake (similar to being a?shareholder);?besides earning a return.

This method of earning also secures the blockchain!??

Risks:?One needs to be smart while choosing the validator to stake upon. Some validators showcase that they are doing this job for free (0% commission) but manipulate the commission to be 100% just before rewards get distributed to the delegators (the ones who voted for them). This might be much visible since not everyone checks their staking rewards daily.

Liquidity Pool (LP) APY

What it is:?Depositing (usually) two tokens that allow other people to trade those tokens. When you stake (or deposit) USDT and ETH into the pool, you allow others to facilitate trading between this token (i.e., someone can exchange 3300 USDT in return for 1 ETH). Traders pay fees (0.01% - 1%), and all fees are shared proportionally among all liquidity providers. Because you are on the supply side of the market (supplying liquidity), you need to be extremely happy or extremely neutral to hold those two assets in any proportion because as prices of each asset move, the quantities of assets you provided will constantly fluctuate to keep the pool 50/50 in value.

Benefits:?When you deposit your assets into the Liquidity pool, you receive an LP token (Proof that you've deposited some amount into this pool). When you want to access your earned trading fees, you give back (burn) this token and receive your earnings (trading fees for every trade on the liquidity pool). When markets are choppy and trading sideways, LPs are a great strategy because you benefit from all the volatility.??

Risks:?Impermanent loss happens when you provide liquidity to a liquidity pool, and the price of your deposited assets changes compared to when you deposited them. The bigger this change is, the more you are exposed to impermanent loss.

A pool can have a high APR only because the volume in the last day skyrocketed and misled you to invest. So it's better to look at the historical data of this APY.??

Liquidity-Mining APY

What it is:?When you deposit tokens into the liquidity pool, you receive the LP tokens. These tokens can be repurposed for more investment opportunities into other pools called “liquidity mining”.??

Benefits:?if you believe in the protocol, you can deposit your tokens and farm instead of buying it (and then single-stake that token for more rewards). Your LP position will keep earning fees so that you will be double stacking yields.??

Risks:?Although liquidity mining reduces the risk of impermanent loss at some level, it is still a possibility. Also, LP tokens that you've received in return for depositing your asset pair (Let's say USDT-ETH) might undergo loss in another staking pool. So you need to be aware while choosing a pool to earn rewards from LP tokens.

Compared to keeping money in a savings account, choosing DeFi staking is almost a no-brainer. With cross-chain support, these solutions become a compelling proposition for any investor.????

In the next series of “How to DeFi”, we will deep dive into each granule and understand optimized yield (returns) from such opportunities.