What types of risks do DeFi liquidity miners take when investing funds? Arthur Hayes, the founder of BitMEX, proposed a conceptual framework.
Written by: Arthur Hayes, Founder of BitMEX Translation: Lu Jiangfei
After the outbreak of the new crown virus, I became an avid cyclist. I would ride twice a week, 40-60 kilometers each time. Cycling is very popular among young people, but for a “old man” like me, cycling at 5 in the morning is as refreshing as young people dancing. However, cycling is a high-risk thing. Before that, my fastest speed had reached 52 kilometers per hour, which meant that if I missed it, I might hang up.
Of course, in addition to sports, cycling also provides me with some much-needed fresh air, so that I can get enough energy to think. One of my cycling partners happened to be a cryptocurrency “farmer”. During a recent journey, we had a risk management discussion involving decentralized financial “farmers” (also known as liquid miners). ) What types of risks will be taken when investing funds. I have summarized and categorized the conversations between us. I hope this article will enable you to understand why income farming is so popular. At the same time, we have also proposed a conceptual framework to assess the risks taken by “cryptocurrency farmers”. .
DeFi is actually a project ecosystem designed to provide financial services for the digital world, and users do not need to rely on centralized financial service providers such as banks. For example, many DeFi projects allow people to directly borrow money from other people. The operation is very convenient. After these people lend money, they can be used to exchange rewards built into the DeFi network. DeFi has a significant impact on the future development of the lending market, which is mainly reflected in the following two characteristics:
- DeFi does not require credit checks, personal data or bank accounts;
- Everyone can participate, and loan terms are enforced through smart contracts that cannot be tampered with, thereby eliminating the need for trusted intermediaries.
The most typical example of a “centralized intermediary” is a bank. In August 2020, I wrote an article: ” Dreams of a Peasant ” ( Dreams of a Peasant ), which talked about how the DeFi ecosystem can play a role in the digital living environment of human beings. Build prototype banks (proto-banks). As a concept, I completely agree to eventually replace all banking and financial services with open source code. Although the DeFi ecosystem is still far from fully achieving this goal, I bet that it will eventually be achieved in the future.
The ownership of the project is open to everyone and provides useful services to the entire network. Given that many DeFi projects focus on providing lending or asset exchange services, these projects require liquidity lenders and market makers. In order to reward those who lend assets, the project usually mints a native token and distributes these tokens to all lenders (usually distribute tokens according to the distribution schedule), and the distribution ratio is usually the same as that provided by the liquidity provider (LP). Represents proportional to the percentage of the total loan pool. The percentage of holding these tokens also represents the percentage of project ownership. If the utility of the project gets better and better, the corresponding native tokens or governance tokens will increase in value. In some cases, these tokens can even be used to pay for some fees specified by the platform-for example, charged by decentralized exchanges Part of the transaction costs.
In addition, these tokens will also enable token holders to vote on how the agreement operates and is managed. Imagine that at a DeFi bank, token holders can vote on interest rate loan spreads and the types of collateral that can be used for collateral. Imagine a decentralized asset exchange (such as Uniswap, Sushiswap, 1inch, etc.) whose token holders can vote on transaction rates.
Below I give a hypothetical example to illustrate the short cycle of income farming using native tokens on the DeFi protocol. We assume that there is such a simple DeFi protocol that allows borrowers to deposit ETH and lend stability based on fiat currency Tether (USDT):
- The agreement is launched, and users are expected to provide USDT loans secured by ETH;
- The governance token of this protocol is called CORN, and 1,000 CORN tokens will be distributed every day for the next 1,000 days. Of the total amount of CORN tokens distributed on a daily basis, 75% will be allocated to the lender and allocated according to the percentage of funds provided by the lender in the USDT lending pool. The remaining 25% of tokens will be distributed to borrowers, and the distribution ratio is based on the percentage of ETH borrowed every day. One thing is very important: you cannot buy CORN tokens directly from the agreement, but must participate in a loan transaction to earn CORN tokens, but once the CORN tokens are in circulation, you can sell CORN tokens to those on the secondary market Of people buy CORN tokens.
- It can be seen from the above model that whether you loan funds in the agreement or lend funds in the agreement, you can get token rewards, and these tokens can represent the ownership of the agreement. Imagine if you are very poor and cannot have a real bank account. At this time, when you want to receive the new crown virus epidemic relief check provided by the US government and cash it, the bank will charge a 20% handling fee; in addition, Every time you overdraft a little money, the banks that “big ones can’t fail” will charge you high overdraft fees. My mother told me that these banks that charge fees make poor people miserable. At the peak of the new crown virus outbreak, many poor people without masks had to wait in long lines and pay US$200 fees to get the US$1,200 government. Alms. I am disappointed with the US government.
- As a USDT lender, you can connect your browser’s Ethereum web wallet to the CORN Web 3 website (the most commonly used wallet is MetaMask), and after authorizing the connection, you can choose to pledge-for example, allow lending USDT and get the corresponding CORN token. CORN will collect ETH interest from the borrower, then convert it to USDT on a decentralized exchange (such as Uniswap), and then use USDT to pay interest to the lender. All these operations are performed automatically by the program.
- If you are a borrower, you also need to connect your wallet to the CORN platform in your browser. You don’t need to pledge USDT. Instead, you need to pledge ETH as collateral, then lend USDT, and then use ETH to pay continuous interest. In order to repay the loan and recover the ETH collateral, you need to send the USDT that needs to be repaid to the CORN agreement. The CORN agreement will implement a minimum leverage ratio based on the external price of ETH/USDT. As a borrower, if you do not repay the minimum repayment amount as scheduled, the ETH you pledged at this time will be automatically sold on the decentralized exchange (DEX), and the proceeds will be used to repay the amount you owe .
- Regardless of whether you are borrowing or lending, you need to pledge USDT and/or ETH on the CORN agreement, and you will always be counted as a creditor of CORN tokens. CROn tokens represent the ownership of a part of the CORN network, and token holders can vote on many matters, such as changing the CORN agreement and operating terms, and adjusting the proportion of interest fees charged by borrowers. Based on the above characteristics, CORN tokens have a certain value on some trading platforms and can be sold on the secondary market. In order to find the right price, you can build a discounted cash flow model (DCF), which can predict the total lock-up volume (TVL) and estimate how much fee income the CORN agreement can generate. Add the discount factor, and you can get the “fair price” of the CORN token at this time. Here we can actually see why the lock-up amount is an important indicator for evaluating DeFi projects, because the larger the lock-up amount, the larger the size of the future fee pool and the higher the transaction price of the token.
Since the market is very optimistic about the disruption brought by DeFi projects, many DeFi project tokens are being traded at very high “non-zero nominal values”. Therefore, even if the interest rate itself may not be able to attract lenders to enter the market, the availability of DeFi protocol native tokens or governance tokens, and the price of these tokens may increase exponentially, will also induce people to participate in staking.
The main purpose of pledge is to accumulate DeFi platform governance tokens, and then increase value through income farming. If you compare the annualized rate of return (APY) indicator, you will find that the rate of return on investment of encrypted assets can dwarf the centralized traditional financial “free market rate of return”. All this sounds very magical, but it should be noted that there are also great risks in pledge on the DeFi protocol.
It is important to understand the risks of these DeFi agreements. To a large extent, these risks have a lot to do with the degree of code security of the DeFi platform. There are several risk situations that may cause you to lose some or all of your pledged funds.
Although most of the DeFi protocol codes are open source, I believe that not many people have carefully read these codes, and there are only a handful of people who have the ability to find malicious code or bad code knowledge (even I don’t have this ability myself). Because many people do not understand the program code. Even if you want to conduct a lot of code reviews, you must also consider that this work tends to consume a lot of time, while the DeFi lock-up volume and token price have grown at an alarming rate. Perhaps when you complete the audit, you have missed the entry. The best time to play. When you study lines of code on GitHub, the benefits are declining. Why is time so important for DeFi projects? This is mainly because the total amount of tokens allocated by DeFi projects is usually fixed. As the number of creditors and the amount of locked positions continue to increase, the number of tokens received by each creditor will continue to decrease, resulting in a decrease in the annualized rate of return. Therefore, for early adopters of the DeFi protocol, it is common to participate in the contract without any technical due diligence, and it is also very profitable.
Projects with better reputations will entrust audit companies to conduct smart contract security audits. In the encryption industry, well-known audit companies include Quantstamp, Hacken, and Trail of Bits. However, the DeFi market is very profitable, and the number of qualified auditors is not large, which means that if you cannot establish contact with the person in charge of these companies, it is almost impossible to obtain an audit from a reputable company.
Below, I will introduce a few common methods that lead to the loss of principal:
The protocol developers wrote their own backdoor programs and made the protocol contract exhaust all pledged assets. This method is usually called “exit scam”. Basically, the assets pledged by users are difficult to recover.
The protocol developers encode the contract in a “certain way” so that a series of specific operations can lock the contract and prevent users from accessing all the assets in the protocol. Many well-known DeFi projects have tried this method very well.
The code written randomly in the agreement can be manipulated. This situation may be intentional or unintentional, which will eventually cause the economic activities of the agreement to fail to meet expectations, thereby consuming the assets in the contract. There is a common loophole in the mortgage loan platform, namely: lightning attack. There is a great article on the Hacking, Distributed website, which details the many ways that flash loans can be used for arbitrage DeFi agreements.
Backdoor hackers and locked contracts usually cause users to lose all pledged capital, and economic manipulation usually causes most of the pledged capital loss.
Certain agreements may be hacked, resulting in some or all of the loss of funds. As a “farmer” doing income farming, you must model this. Since users cannot directly buy tokens on the primary or secondary market at the beginning, the only way to obtain assets is to pledge, which also puts your funds at risk. It is important to note that you may encounter the risk of hacker attacks when carrying out income farming.
There is also a risk. Since your income is in governance tokens, the token price at the time of final decision determines your return on investment. If the platform encounters an unexpected negative event, the token price will drop sharply. Cause you to “get lost.”
Of course, there are two reasonable strategies to help you effectively manage income farming risks and provide protection for your income returns.
Choose multiple DeFi projects for farming
If you want to be a “good farmer”, you should try to cultivate a variety of crops, and you should also do the same when farming DeFi projects. You need to spread the funds into multiple different projects, so that you can reduce the potential risks of each project. ——The premise of implementing this strategy is that you want to quickly enter popular new projects, but you have no ability to identify which projects may experience negative events. You need to farm multiple DeFi tokens and constantly liquidate the tokens in order to realize profits. Your advantage lies in transaction speed, token breadth and high risk tolerance.
So, how should funds be allocated under actual circumstances? For example, suppose you decide to invest in 10 DeFi projects. At the same time, you think that the probability of a negative event in a DeFi project within a month causing the token price to collapse is 30%, which means you will lose 30% of your funds in a month , Then the average monthly mixed rate of return of the ten projects you invest in should be at least 30%, so as to achieve a balance of payments based on the expected value. Of course, this is just a hypothetical example. The specific figures depend on the actual situation. I believe someone will explore it after reading this article, and real data may be disclosed later.
One more thing to note is that if the DeFi project tokens that you choose income farming are very expensive, but cannot quickly attract enough lock-ups in the short term, then it is recommended that you find another better income farming farm. Generally speaking, DeFi projects that have a large lock-up volume and a growing lock-up volume have a longer survival time and are relatively less likely to be affected by negative events. To put it another way, even if a negative event occurs, the probability of a serious impact on the DeFi project is lower. However, I am just here to provide you with a useful heuristic. It should be noted that even if the market volatility in the past is low, it does not mean that the future will be tepid.
Technical due diligence
If you have the rare ability to quickly read and analyze DeFi code, then there is no doubt that you will gain a very obvious advantage, because you can confidently put your funds on the “safest” DeFi protocol, and then bring you Great return. The stronger the technical ability, the more confident you are to choose projects for profit farming. In addition to income farming, you can also double the return by buying tokens on the secondary market.
However, it is not easy to conduct due diligence on DeFi projects. This is because the current number of security auditors is not large (and their capabilities are limited), while the number of DeFi projects is quite large, so it is basically difficult to conduct in-depth and thorough investigations on all projects. analysis. However, as there are more and more DeFi projects with billions of dollars in locked positions, it is believed that investors are willing to spend more energy, time and expenses to “dig out” the motives of malicious participants before choosing a project to invest.
Generally speaking, the farmers who know the technology best are the easiest to get high returns.
Choose income farming? Or choose to buy in the secondary market?
This can be a very critical decision, depending on multiple factors. In order to obtain relevant governance tokens, you can take risks to pledge encrypted collateral to participate in DeFi projects, or you can buy tokens on the secondary market.
If the quality of a project is not bad, they usually don’t issue too many tokens on the secondary market, because this approach excludes many people who want to participate in income farming, which is not a good thing for the project itself. On the one hand, it will put the pledger’s capital at risk. On the other hand, it will also result in only a small supply of tokens in the secondary market, and it can only be back and forth between a few hands, eventually forming a reflexivity. The reflexive feedback loop, which increases the price of tokens.
If you want to enter the market early, you must learn to farm with profit. In this regard, the two main risks that need to be paid attention to are:
- There must be certain risks in the principal you pledged, and once there is a loss, you may lose your money;
- The distributed tokens have Delta price risk, and the risk of platform credit events is one of the factors. If the project is hacked, the token price will fall along with the locked position. If you don’t sell your tokens in time, the rate of return will continue to decline with various negative events.
For example, suppose we have an income farming farm. Let’s call this farm Lilipad for the time being. There are 100,000 DAIs in it, and LILI tokens can be produced through income farming. You will enter the market as soon as the Lilipad contract is online-Note: For best results, you may need a robot to scan the Ethereum blockchain and monitor when deploying new contracts, especially the amount of lock-up information, because DeFi projects usually Rewards will be given according to the percentage of locked position. If you account for a larger percentage of the amount of lock-up, then the number of incentive tokens may be more; if you account for a smaller percentage of the amount of lock-up, then the number of incentive tokens may be less.
Lilipad’s lock-up volume has expanded from 1 million DAI to 100 million DAI in a week (a 100-fold increase), which means that your lock-up volume percentage has changed from 10% to 0.10% in a week, but the project is released every day There will be no change in the number of tokens, and it will always be 10,000.
If the price of LILI / DAI increases by 100 times with the lock-up amount, it is definitely the result everyone expects, but it should be noted that even if the project becomes more and more successful, your risk profile and annualized rate of return It has not changed.
If the price of LILI rises by less than 100 times, it means that you will take more risks and get less rewards. But for an evil “locust”, the greater the amount of lock-up on the farm, the more food they can eat. Therefore, your risk of principal loss will increase with the increase in the locked position. So, is the risk you face 100 times higher than the locked position? Probably not, but the risk must increase in a non-linear way.
When you carry out income farming, your funds will not increase in value. The value of the DeFi tokens for income farming will really change. From this perspective, if you can directly purchase the tokens, then income farming does not seem to be the most important thing. Excellent choice, if your risk tolerance is 100,000 DAI, then it is best to buy LILI tokens worth 100,000 DAI.
As you can see, it is not in the interest of farmers to liquidate LILI tokens continuously, because farmers’ risk of loss will continue to increase with the increase in the amount of locked positions, but their risk capital remains the same, which means that LILI tokens need to be increased Exposure can “override” the increasing risks. So at this time, farmers are more willing to try their best to limit the supply of LILI tokens in the secondary market, so as to push the price curve upwards-this is what I call the positive reflexive loop (positive reflexive loop).
As the amount of lock-up increases, the price of the token will increase, but it also means that the potential risk of loss will also increase; therefore, if you hold the token and are engaged in profit farming, then the best choice is not to sell the token.
However, if there is no liquidity in the secondary market and it is not conducive to the DeFi project, the rapidly rising token price can attract more people to pay attention to the DeFi project, which will allow the project to obtain more lock-up volume. In order to give more incentives to liquidity providers (LP), many DeFi projects will distribute tokens to those who pledge tokens in the liquidity pool of decentralized exchanges.
The liquidity pool consists of two types of assets. In the above example, those farmers who provide DAI and LILI equally in decentralized exchanges such as Uniswap, Sushiswap and 1inch provide LILI token rewards. Therefore, as long as LILI tokens are available for sale, those who only want to bear the risk of the Delta price will buy LILI tokens, which also provides market quotations for farmers who wish to liquidate the benefits of LILI tokens.
For any farmer participating in the liquidity pool, they calculate impermanent loss. I will not introduce this risk too much in this article, but there is a good blog post on this issue. In a detailed description, impermanence loss is the covariance between two assets. As the price of LILI tokens increases, liquidity pool pledgers will have fewer LILI tokens and more DAI. As the price of LILI tokens drops, liquidity pool pledgers will have more LILI tokens and less DAI. If the sale price of LILI tokens is sufficient to make up for impermanence losses, then this is a good deal for liquidity pool pledgers. Because impermanence loss is a well-known risk, DeFi projects usually provide liquidity providers with very high token rewards.
If you can buy LILI tokens worth 100,000 DAI, that would be the best choice. However, since the initial secondary market supply is zero at T0, the incremental supply will bring higher token prices, so even in the face of small demand, the price will soar. A liquidity exposure of 100,000 DAI may increase the price of LILI tokens by 100% or more. If you think that the amount of locked positions will soar quickly, that’s good, but if the project is dead, it may bring fatal consequences.
In order to better illustrate that traders are in a more advantageous position than farmers, let’s give a simple example:
- Funding = 100,000 DAI
- Time = 0
- LILI / DAI price = N/A
- Time = 1
- Capital = 100,000 DAI
- Tokens = 1,000 LILI
- LILI / DAI price = 1 DAI
When the market goes down
Once a negative event occurs, all locked positions will be cleared, and the LILI / DAI price drops to 0.01 DAI.
- Capital loss = 100,000 DAI
- LILI / DAI loss = 990 DAI
- Total loss = 100,990 DAI
- Trader bought 100,000 LILI tokens for 100,000 DAI
- Capital loss = 0 DAI [No capital investment]
- LILI / DAI loss = 99,000 DAI
It can be seen that under unfavorable circumstances, the trader’s loss is 1,900 DAI less than that of the farmer.
When the market goes up
The lock-up amount increased to 100,000,000 DAI, and the price of LILI/DAI tokens also increased by 100 times, reaching 100 DAI.
- Capital gains = 0 DAI [Capital does not appreciate]
- LILI / DAI income = (100 DAI-1 DAI) * 1,000 Token = 99,000 DAI
- Total revenue = 99,000 DAI
- Capital gains = 0 DAI [They did not pledge anything]
- LILI / DAI income = (100 DAI-1 DAI) * 100,000 Token = 99,000,000 DAI
- Total revenue = 9,900,000 DAI
Especially in the case of an extreme rise in the market, when the initial capital of traders and farmers is 100,000 DAI, the performance of traders’ income is far better than that of farmers. The main assumption in this example is that you can accumulate 100,000 LILI tokens at a reasonable price.
Although some “vegetable” DeFi projects and other meme tokens that allow profitable farming seem dull and boring, there are still some complex risks. For the emerging Internet “farmer class”, it is necessary to weigh and manage related risks. Since I published the last article “The Dream of Farmers”, my opinion has not changed, that is: the quality of most DeFi projects is still unreliable, which will not only make you lose money, but also affect borrowing, loans, asset exchange, and insurance. Wait for multiple businesses. Infrastructure construction driven by Web 3 is the cornerstone of a more inclusive and fair financial system—financial services that support the digital age should be owned by those with the highest participation.
In this new ecosystem, there will still be the problem of centralization of ownership; however, those who dare to take the greatest risk will definitely have the opportunity to get the greatest return. This has nothing to do with their personal background or personal connections, and it has nothing to do with those common in the past. The way of working is in sharp contrast. In a traditional environment, the closer you are to centralized power, the stronger your ability to share the “trophies” of the financial system. What are the consequences? Once there is a problem in the financial system, the risk will pay for the whole society; once there is a huge rent-seeking profit, the profit will be taken away by a few people. If you understand the mystery, you will find yourself in a great game; if you are still a “dumb” who pays taxes stupidly, you probably won’t understand the evil hidden in it.
Source link: cryptohayes.medium.com