Minimizing DeFi risk through governance
Decentralized finance (DeFi) has created a lot of excitement in 2020, opening a new world of opportunities for users to participate in a trustless (no middlemen) and permissionless financial initiatives to earn interest for their cryptocurrency holdings.
To date, DeFi products hold $9.3 billion of total value locked in DeFi protocol’s smart contracts. What started as an experimental and often confusing segment of the blockchain industry is now the industry’s most popular. This is largely due to the high income earning opportunities DeFi protocols have presented to yield farmers (or users).
Who are yield farmers?
When you deposit money in a bank, you’re effectively providing capital, for which you receive interest in return. Similarly in DeFi protocols, users (Yield farmers) provide liquidity in the protocols. In return, they earn interest, a portion of trading fees, or incentives in the form of DeFi’s protocol own cryptocurrency.
Comparison of crypto yield farming with traditional interest-bearing accounts:
Unlike traditional savings accounts, yield farming reward you with a higher interest rate and your money grows even faster thanks to compound interest — which lets you earn interest on interest. The higher your annual percentage yield (APY), the faster your money grows and you get a better return than you would with a traditional savings account.
The national average APY on savings accounts is just 0.06%, according to the Federal Deposit Insurance Corporation (FDIC). That’s over 50-100 times less than what the crypto yield farming strategies offer.
For instance, let’s look at Compound. A person can put USDC into Compound and earn 2.72% on it. They can put tether (USDT) into it and earn 2.11%. Remember most U.S. bank accounts earn less than 0.06%, which is close enough to nothing.
DeFi gets exponential returns but it has its own caveats
There’s a reason the interest rates are so much juicier: DeFi is a far riskier place to park your money. First, there are no Federal laws protecting these funds. If Compound were ever compromised, users could find themselves unable to withdraw their funds when they wanted. Another example is betting on a stable coin (like USDT) whose transparency about the real-world dollars it’s supposed to hold in a real-world bank is questionable.
Secondly, DeFi products smart contracts that ensure trustless, permissionless exchange of trade are not risk-free. Recently in a podcast with Laura Shin, ETH co-founder Buterin said he was not confident that even audited platforms and protocols could guarantee that they wouldn’t ‘break’ within a set period of time by a set percentage margin.
We’ve already seen big failures in DeFi products. MakerDAO had one so bad this year that people had to give the name – “Black Thursday.” There was also the exploit against flash loan provider bZx. These things do break and when they happen, money gets lost.
Minimizing DeFi risk:
A smart investor can reduce the risk exposures in the pool by spreading its allocation across multiple products (or pools), however, such a strategy gives rise to new challenges.
- Which strategy to choose: Given the rise of DeFi protocols and new strategies getting added each week, it has become difficult to track best performing risk-adjusted alternative strategies.
- Operation cost (Gas fee): Spreading allocation and moving assets in and out to tap on best strategies causes additional gas fees, cutting down their APY returns.
Given the above-described challenge, many new DeFi asset management protocols have risen to the occasion with the primary purpose to provide optimized yields with minimum/adjusted risk. One such project is APY.Finance.
Instead of multiple transactions and incur $100 gas fees just to implement strategies, all users deposit are collected in a pool. As the value in the pool gets accumulated, the APY.Finance platform routes the entire fund in a single transaction to the respective strategy.
Think of it as 100 individuals sending their fund to a DeFi protocol. Each transaction could cost approx. on an average 3$ in gas fees. What if all these transactions are compiled and sent as one. The transaction fee is then shared, saving excess of 99% gas fees. Note: this works for yield farmers who are continuously on a lookout for best strategies, thus always moving their funds from protocol to protocol.
With the problem of gas fee solved, the pools in APY.Finance can hop from one to another strategy and diversify the user’s funds. This reduces the downside risk in the event of a vulnerability. The key here is strategy selection and allocating funds based on the risk score. This is achieved through the platform’s governance token.
Governance tokens have far-reaching effects on the DeFi landscape. The more capital the governance can influence, the more valuable it could be. In simple terms, it determines power over the platform and key decisions. Therefore, it is important to have a wider distribution of governance tokens, thereby, giving the community an increased amount of power.
APY.Finance plans to give the community increasing amounts of power over the governance of the platform by allowing the community to:
- vote on risk scores for strategies.
- determine their level of risk tolerance.
- propose new strategies and
- allow changes to the strategies.
This way the platform also keeps itself up-to-date with the users (community) latest interest. Additionally, it adapts to the strategies proactively as the marketplace evolves, thereby ensuring continued usage.
