The DeFi landscape is very diverse. Sometimes it even feels like a DeFi jungle as described in one of my other articles. That’s why it helps to take a step back and think about your investment profile and appetite for risk before you dive deeper into DeFi. Let’s try to do exactly that!
[If you are totally new to DeFi, you might want to start with part 1 of this series]
I thought a lot about potential categories lately and came up with the following investor profiles:
- The Ambitious HODLer
- The Stablecoin Purist
- The Yield Activist
- The Lazy Aggregator
There are certainly more categories and I would consider myself a mix of them. Yet, it usually helps us humans to think in categories and concrete examples. So let’s see what I actually mean with these fancy names.
[And wouldn’t it be great if someone came up with cool memes for them?
Let’s see what happens…]
The Ambitious HODLer
HODLers are cryptocurrency investors who firmly believe in the long-term development of their favorite tokens like e.g. Bitcoin or Ethereum. But there is more to it. HODLing also means an excellent strategy towards your tax balance. In many countries like here in Germany, profits from cryptocurrency trades are tax-free?—?if(!) you hold your tokens for longer than a year. (Let’s see how long this regulation stays in place…)
So HODLing absolutely makes sense frm that perspective for now.
No matter which investor profile you resemble, I would always recommend to keep track of all your transactions. HODLers have the advantage of a simple book-keeping since they usually trade rather monthly than daily. Newbies to DeFi should think about these benefits.
With DeFi, HODLers can do more than just storing their tokens in thei wallets and watch their tokens appreciate in value. They can deposit their tokens into DeFi smart contracts (usually called “vaults” or “pools”) to let them generate additional passive income. Sure, this includes exhibiting your tokens to different aspects of risk (see some aspects here in the chapter “The risks in DeFi”). But: No risk, no fun. That’s where the “ambitious” part of this investor profile comes into play.
Ambitious HODLers are aware of these benefits, but they are also cautious. They prefer proven DeFi projects with audited smart contracts over the latest and greatest “yield machine”. Like they prefer “proven” tokens like (wrapped) $BTC or $ETH over more risky altcoins. So, what are the options?
To be honest, there are not too many options for Ambitious HODLers in DeFi at the moment. But we’ll see more options appearing quickly?—?I’m certain.
One of the initial DeFi options for Ambitious HODLers is to use MakerDAO and their Oasis vaults to use $ETH or other prominent crypto assets as collateral and borrow $DAI stablecoin and “work with it” in other DeFi platforms. This sounds simple and attractive, but it usually means that you need to very actively track what’s going on with the price of your collateral token (e.g. $ETH) to avoid liquidation. See this video for the basic mechanics:
Another interesting option for Ambitious HODLers is the concept of liquidity providers which appeared in DeFi in summer 2020. The main idea: You provide your tokens as liquidity (“add liquidity”) into one of the trading pools on a Decentralized Exchange (DEX) and get a part of the trading fee as incentive. In return, you usually get back special LP tokens from the DEX which represent your share in that liquidity pool. If you send your LP tokens back to that pool, you get back your original tokens. That’s the basic concept.
Two problems:
- Most prominent DEXes like Uniswap are very attractive for their users because of their very low trading fees (currently 0,3% for Uniswap), so the actual returns for liquidity providers heavily depend on trading volume and their share in the pool.
- In most DEXes you need to invest into liquidity pools with “token pairs”?—?which means usually a 50/50 ratio of two different tokens. Since these tokens develop differently in their price evaluation, DeFi investors suffer from impermanent loss?—?they lose part of the stronger token and win part of the weaker token, because the pools usually rearrange themselves to keep their initial token ratio (e.g. 50/50). The problem is called impermanent loss since your potential loss fluctuates and you won’t materialize that loss until you extract your funds back from the pool. In theory you could wait until the prices of your two tokens have the same ratio as when you did your initial investment. But that might never be the case again. If you want to dive deeper into impermanent loss (and I would urge you to), you can investigate this article.
Other DeFi Protocols like Balancer come up with liquidity pools of different ratios (like 80/20) or liquidity pools with even more than two coins. Projects like Tokensets and their Set Protocol even create index-like structures like their prominent DeFi Pulse Index. These are interesting approaches but usually don’t match the intention of Ambitious HODLers because they get exposed to many different assets.
The usual mitigation strategy for Ambitious HODLers is to invest in pools with assets they expect to develop similarly regarding their price, like e.g. a Uniswap pool with $WBTC and $ETH. This makes sense if you think the prices of Bitcoin and Ethereum will continue to correlate in the future. Yet, it’s still a compromise.
An interesting, but rather fresh option for Ambitious HODLers is Bancor’s recent approach to offer single-sided investments. Bancor doesn’t work in trading pairs like Uniswap and friends, but rather builds all its pools with any token against their own $BNT token (and use their $BNT to convert token x to token y behind the scenes via their “relays”). Bancor gives liquidity providers the option to just invest in their preferred token?—?single-sidedly. And they even provide protection for your assets after an initial grace period. See here the pool for $ETH or here for an overview of their pools. This version 2.1 of Bancor is currently still in public beta, so you should be careful. But I find that approach very interesting.
This video explains Bancor’s relays nicely:
There are other options like Yearn’s ETH vault who again work on top of MakerDAOs vaults, automating away a lot of tedious stuff, but Yearn Vaults are also still in beta and we need to see how Yearn develops after the recent arbitrage hack this week.
The Stablecoin Purist
Stablecoin Purists are very different from ambitious HODLers since they don’t trust the upcoming price developments of cryptocurrencies. They rather seek for a fair yield in regards to their favorite fiat currency?—?usually the $USD.
It might sound surprising, but DeFi has a lot to offer for Stablecoin Purists.
The most prominent projects like Compound and Aave promise their highest yields if you invest in stablecoins instead of typical cryptocurrencies like $ETH. It’s again about depositing your assets as liquidity provider?—?but in this case stablecoins are preferred as collateral and generate the highest yield via peer-to-peer lending. See Aave’s market (focus on Deposit APY) as an example or have a lookt at DeFi rate for comparisons. Be aware, in most cases these yields aren’t guaranteed, they might fluctuate a lot and are just a momentarily snapshot.
Different projects work differently and evolve their concepts Stablecoin Purists quickly. An important trend is that you not only just deposit your stablecoins in these DeFi pools, you now get a token back?—?representing your collateral. Let’s make an example and take Aave: Let’s say you provide liquidity in $DAI to Aave. You’ll get back an equivalent of Aave’s $aDAI?—?an interest bearing version of $DAI. You can now take your $aDAI and either store it?—?or “work” with it on other DeFi platforms. This is where DeFi’s money legos start to shine?—?all these platforms work seamlessly together. The possibilities are endless. In this regard, Compound works very similar to Aave. They have their $cDAI. So, $aDAI and $cDAI also work as LP tokens for stablecoins on Aave and Compound.
You shouldn’t underestimate the success of these interest bearing “wrapper” tokens. At the time of writing Aave’s $aDAI has a market capitalization of 100m$. Compound’s $cDAI is ranked as cryptocurrency #42 on Coingecko with a huge market capitalization of 1.4b$. The original $DAI is ranked #31 with just 1.8b$. So, the “DeFi wrapped” versions currently capture 83% of all existing $DAI on their platform. Impressive.
I mentioned $DAI since it is a “crypto-born” stablecoin, backed by collateral in cryptocurrencies like $ETH and having rather solid decentralized attributes. But there are other prominent players like Tether’s $USDT and Circle’s $USDC who are backed by “real US dollars”. Because of this link to fiat currency, both have centralized elements. Their creators have the option to “freeze” contracts if necessary?—?e.g. in case of a fraud as we saw in last week’s Yearn hack. This sounds like a safety net in these obvious cases, but it might also be misused by governments and it surely isn’t aligned with the values of Cypherpunks who invented Bitcoin. Most Stablecoin Purists don’t care too much, nevertheless using $USDT. They are OK with their governments, their fiat currency and just focus on interesting yield options. Or they simply ignore these aspects.
My point is: While most stablecoins look very similar from the outside, their mechanics are very different. And because different stablecoins make the DeFi world more complex, there are DeFi projects to swap and exchange them?—?giving them even more stability. One of these projects is Curve Finance with their different stablecoin pools. When Stablecoin Purists discover projects like Curve, they might take the next step and become a Yield Activist…
The Yield Activist
In summer 2020, different DeFi projects were searching for ways to drive attention and liquidity to their liquidity pools. New KPIs like TVL (Total Value Locked) became prominent in DeFi to judge the success of a project in attracting capital. Projects like Compound were the first to give additional rewards to liquidity providers?—?and they created these rewards in their own freshly created project tokens. In Compound’s case this is $COMP. Projects like Yearn followed suite with their $YFI token ?—?extending on Compounds ideas. At the time, the only option to get hold of $YFI tokens was to provide liquidity to certain Yearn vaults?—?driving FOMO. Many other DeFi projects joined the party. The concept of yield farming was born.
Most project set up these incentive farms temporarily. It’s usually a three step process:
- You provide liquidity to one of their liquidity pools
(and get back LP tokens).
- You lock your LP tokens into their farm and gradually earn rewards.
- You more or less regularly claim rewards from the farm
(paid in the project’s token).
Yield Activists do exactly that. They follow the most promising projects and the latest and greatest incentive schemes. They actively reshuffle their assets from one liquidity pool to the next one which offers higher yields.
It’s obvious that this phenomenon isn’t too healthy. New project tokens get invented every second day and given out as reward. You might argue: Who determines a reasonable price for these fresh tokens? And why should they be worth anything? Well, there are several reasons why this works (at least for now):
- These tokens are used for governance. Most projects set up a Decentralized Autonomous Organization (DAO) and hand over the governance of their project to their token holders (including governance of future fee structures e.g. on DEXes).
- Most projects distribute a share of their income to their token holders as long-term incentives.
- Some projects increase their profit share for token holders who lock their governance tokens long-term (some of them up to 4 years).
So it’s usually a mix of high-yield short-term incentives with lower mid- to long-term incentives for the community. Only future will tell if these concepts are successful?—?and which aspects are sustainable.
Yield Activists are constantly watching the space for newly announced incentives, lingering in the projects’ Telegram and Discord groups to not miss the next big opportunity. In some cases, you need to claim rewards every week. So, Yield Activists are very active indeed. High gas prices on Ethereum?—?as we see them currently?—?clearly set some limits to these experiments. Even with the promise of high yields, transaction costs easily eat up big parts of the incentives if you invest small amounts. In return, Yield Activists tend to invest bigger sums?—?increasing their risk profile considerably.
Yield farming clearly contradicts some of the early ethos of DeFi. No such thing as “banking the unbanked”. You are clearly out if you are not investing considerable amounts of money. It’s rather a “whale’s game” as I saw already coming in articles I wrote last summer. Yield Activists don’t seem care too much about these problems.
The Lazy Aggregator
Photo by Zhang Kenny on Unsplash
Lazy Aggregators have found an answer to this yield farming craziness. It’s kind of like the return of financial institutions for DeFi. If you don’t want to hunt for the latest and greatest yield farm yourself, why not let someone else take over that part for you, hand over your assets and give them some share of your profit? The big difference to centralized finance is that all operations happen “on-chain” in smart contracts. So, you can track what’s going on with your investment. And?—?in the best case, these aggregators are composable again and give back tokens to you representing your investment. Enabling you to sell them, work with them?—?or god knows what service might be offered tomorrow.
Again, Yearn Finance was the first player to do exactly that in a decentralized manner. If you listen to founder Andre Cronje’s story, he tells how his different services developed along some of the investor profiles described above. Please be careful. Yearn vaults are very young and carry a lot of risk. But I think they are exactly what a Lazy Aggregator is looking for: Self-optimizing high yield without too much day-to-day attention. Implementing investment strategies that encapsulate what a Yield Activist would do manually. Projects like RARI Capital (if you want to trust your assets with teenagers) or Idle Finance go into similar directions.
I guess Lazy Aggregators easily match to most people who currently hold ETF funds in centralized finance. I guess history will repeat itself and most upcoming DeFi investors will fall into this category since you don’t have to dive as deep as the others. But: The field is young and I’m sure bad things (hacks, scams and frauds) will certainly happen and burn the pioneering investors’ fingers. Do your research and have a look at third party opinions.
That’s also why many rather centralized services are now pushing hard to get their piece of the DeFi cake?—?even if their services are built upon custodian services. These services just invest into DeFi without exposing their users to it. Prominent examples are Celsius, BlockFi, Nexo or Swissborg. I’d recommend investors to study their regulations thoroughly?—?especially regarding custody like the one of BlockFi. These will become the true neo-banks innovating on top of cryptocurrencies and DeFi. That’s the way I recommended for retail banks in recent articles. Some of these services even issue their own token (like e.g. $CEL from Celsius or $CHSB from Swissborg)?—?further blurring the lines between DeFi and more centralized options. It will be interesting to see who actually wins the majority of retail and institutional DeFi investors.
Conclusion
I tried a new approach in this article and came up with potential DeFi investor profiles to shed some light upon DeFi and give some orientation. It would be interesting to learn if that approach was useful to you, my dear readers. So, please don’t hesitate to get in touch and give feedback. You are also welcome to follow me on Twitter or get in touch via LinkedIn (and please tell me your reason to connect and how you found me).
Further reading: You can find more articles about Blockchain and DeFi on my blogs on publish0X and Medium.
Disclaimer: This article is not intended to be an investment advice of any sort. Do your own research and search for professional support if you intend to invest in one of the projects mentioned in this article.
