DEFI and Me

So, you probably have heard of DEFI, right?  But what really is it?  And why should you care?

DEFI (DEcentralized FInance) isn’t a mythical place where money goes to vanish.  It also isn’t CEFI.

CEFI (CEntral FInance) is what we commonly refer to as the traditional “banking system”, complete with insurance institutions, hedge funds, investment firms, trading desks, and a crap ton of other institution types that I don’t even understand, oh yeah, and banks.

DEFI is more of an open area that treats crypto as a commodity that anyone can benefit from on any side of this newer fiscal system.

Traditional CEFI says if you have a need for a loan, you MUST go to a bank and apply and if you want to be a bank you must apply for a bank charter and be approved.  It also defines the application process and, in my experience, limits lending to those who need money but allows low cost lending to those who don’t.

What’s that entrepreneurial saying?

Borrow money when you don’t need it as that’s the only time a bank will lend to you…

Take this same use-case with DEFI: as a result of the structure and regimented nature of crypto, there are many dApps (Decentralized Applications) that allow for lending, borrowing, and even investments with ease, devoid of an “application process,” and secured by the immutability of the Blockchain technology.  In general, these systems work because the mechanisms behind all the platforms are blockchain-based.

Why does this matter to me?

Well, I have had a history of being denied by banks, not because my credit was bad, but because I didn’t allot myself a large enough salary each month.  I started several companies, always paid my and all of my company’s bills in full and on time each month.  I had/have an above 800 credit score as well.  My “problem” was that I reinvested all profits back into the companies I owned in real time.  Over the years, I only took what I needed to live from these businesses and for that I was penalized when attempting to get a capital infusion for growth.  Even when contracts were executed and in need of up-front financing to collect the downstream recurring payments, the banks I approached all said no because my personal income wasn’t high enough to meet their standards.

As a result, I ended up loaning my own money to my businesses and paying my employees with that money to keep the boat moving.  Apparently this type of C-level leadership is frowned upon by CEFI.  Even the loans I was lucky enough to get had an 8% – 12% APY.  In the end, large debt service monthlies ended up sinking some of my companies into debt-spirals that were hard to avoid.  I wish DEFI had existed at that time; funding to grow new technology would have been far easier for me to ascertain.

Moving into DEFI, even if you have a very little bit of crypto, you can borrow money while using your crypto as collateral. This strategy would allow (in some cases) you to pay less than a traditional bank would charge.  This larger rate is able to be paid since fulfillment of the loan and lockup of the crypto is automated, in the user’s control, and blockchain based.

You could also lend your crypto securely to collect an APY in some cases greater than a traditional savings account or money market in a bank.  You could also take that same crypto and stake it to earn in-kind rewards that are typically also greater in percentage than most consumer CEFI investment products.

How do they do it?

So is it magic?  You may be asking – if this is true, why doesn’t everyone do this?  Well, it’s still a little too geeky for just anyone to dive into.  Though with each day DEFI gets easier and easier to use.  Heck crypto.com is a bridge from DEFI to FIAT and therefore in my mind a critically important DEFI project.

But How?

DEFI being blockchain based allows a finality, speed, attention to detail, trust and ubiquity that a 9-5 m-f bank teller can not.  I could write a novel about the reasons why blockchain software is like this, but it’s really just the nature of the game.  This does not mean that developers can’t make mistakes in the code, or code can’t be misused.

First and foremost I think of code being king.  Code: This essential building block for the blockchain comes in many languages, written by many people, mostly open sourced, and wide open for anyone and everyone to help debug, build upon, and make more secure.  In DEFI the coders / developers write code into smart contracts that facilitate complex transactions in milliseconds.

Smart Contracts and their power

Smart contracts interact with websites as DEFI users click on various action buttons and the proper transaction is signed in the proper wallet.  These contracts aren’t a thousand page legalese contract like what iTunes shoves down our throats, but instead a chunk of code written out that defines the purpose, nature, and rewards given for any project. 

The enacting (or signing) of a smart contract is a two staged process which allows a user to prove they are the person making the request and also the person funding the request.  Users are presented with the smart contract results and the maximum gas fee, once the user accepts the outcome and properly agrees that they will pay for the smart contract execution it’s usually completed in seconds.  Once the contract is completed a result hash is returned that links to the blockchain record of the transaction and whatever action has been completed.

The contracts are smart enough to not execute if the DEFI user doesn’t have proper funding to both pay for the transaction costs and supply the amount of crypto the contract needs to use.  The contracts are linear, follow strict rules, and run in parallel.  

Millions of DEFI users can be interacting with the same smart contract at the same time and nothing will fall out of order because systems were built with such precision.

Traditional areas of DEFI give APY in the 2%-50% range depending on the asset and mechanism deployed, but this wasn’t good enough for me.  I needed to try out these claims for “massive gains” with a “minimal investment” in order for my next round of investments to do their thing.  This is what I focussed on over these past few weeks.  I wanted to understand DEFI inside and out and I found that I was late for a few things, but still early for most.

Disclaimer

The following approach is not advised for anyone to jump into without first doing their own research.  This is not legal, financial, tax, or investment advice – it’s just a statement of some things I have done to test yields in a realistic way.  In many cases the actions I took were not investment related but more a curiosity of what would happen, and in no way do I recommend this to anyone at this time.

What I have done

But let’s back up and identify a few things that I did and let me explain by using some examples for comparison.

Staking

Like everything in DEFI, cutesy names have been developed to represent staking.  Some platforms call this ‘nesting’, others call it ‘cooking’, and a various number of silly sounding things.  This is the gamified nature of DEFI – it’s time to make money management enjoyable eh? LOL.

No matter what it’s called, the act of staking is easy to understand if you imagine having a few traditional savings accounts denoted in separate currencies.  Say you have a savings account with Canadian Dollars in it, another with Euros and finally a US Dollar account.  Each of these accounts will earn “in-kind” rewards called a return / yield / APY.  The CAD account will earn new Canadian Dollars, the EUR account will earn new Euros, and the USD account will earn new US Dollars.  The percentages at the time of writing for traditional savings accounts are below 1%.

Take the concept of a savings account into the blockchain world. This is the core underpinning of staking.  The asset earned doesn’t always have to be the asset staked and in some cases several assets are earned while only one asset staked.

No matter what, to stake in DEFI a user must interact with a staking contract.  The user needs to first initiate the staking action by pushing the proper button on the corresponding website, then they sign the transaction in their DEFI wallet and the staking contract begins accruing rewards.  That’s it, done – set it and forget it.

But what Happens underneath?

The staking contracts do the equivalent of depositing an asset into a contract account and reward the user’s wallet accordingly over time as the APY dictates.  Since all activity takes place on the blockchain, the user can disconnect their wallet and connect back later to check progress.  Nothing will be lost and all tokens remain in the full control of the DEFI wallet user, or anyone who has the private keys to that wallet.

Users have dashboards they go to and measure their gains over time.  I have staked crypto literally hundreds of places with varying results.

The good, the bad and the REALLY ugly…

The first time I got involved with DEFI it was via the Ethereum network as when I started into crypto that was the only DEFI in the game.  As with most seasoned folks in the industry, ETH DEFI was where I started learning about DEFI. However, it got far too crowded and there is now a great push to get out of the ETH DEFI ecosystem.

I won’t go into great detail as it’s not that important, just know that with every transaction done in DEFI there is a gas fee paid.  A transaction tax paid to the miners, stakers, nodes or validators that are running the network.  This gas fee is paid in different quantities based on the rules on the network you transact on.  The ETH gas fees are currently absurd and make sense ONLY to those with enough money that they can throw around hundreds of dollars for just a single trade.

Most of my ETH DEFI bags are actually valued BELOW the cost to move them.  This absurd problem isn’t unique as investments into ETH DEFI early on that haven’t yet matured often sit in limbo because it costs more than the investment is worth to move it.

I have learned a trick, if I wake up around 2am and attempt to transfer the assets out of ETH DEFI the gas fees are much lower as the number of folks on the networks is lower.  But this trick too has started to fail and then I’m stuck up…  Sometimes it works for nice friday or saturday nights on the east coast because it’s all about throughput.  If people are out and about in massive numbers that would assume there would be less people interacting with the ETH defi network….

The problem is that the ETH network can only process so many transactions per second and this creates a bidding war to get your transaction included in each block, hence if lots of folks have lots of transactions, the ones who pay the most get their transactions executed and the others just lose their gas.  So I just gave up and I’ll let things on Ethereum DEFI sit until the next bull cycle or until the gains are great enough to warrant my paying a huge gas fee.  Heck, if I can make a 1 ETH gain in a single transaction it may make sense to pay 0.1 ETH ($387) as a fee for it.

What I did these past weeks was expand outwards and I now stake in the Avalanche, Harmony One, Polygon, Binance Smart Chain, Terra, and of course Ethereum ecosystems.  Not a ton in each position, but enough so if things do well I’ll be happy.  These are all very long term plays, like years versus even months.

I did this because I believe the next wave in income flow will be

into the protocols’ main coins and outwards from there into each ecosystem.

Within each example below, the rewards are different and the purpose of the staked funds vary –  from locking up assets to appreciate price quicker over time, to supplying the market with liquidity in exchange for a percentage of gas fees paid.  Whatever the mechanism, staking involves one asset put into one staking contract on one platform called a dApp or Decentralized Application.

Good example:

So say I go to stake 0.1 BAND in Atomic.  I click stake and I fill in 0.1 – it calculates the USD value.

You also see the network fee in both BAND and USD as well as the yearly earnings predictions based on the 17% yearly yield.  The return looks so small now, but imagine if the BAND token is worth 100 times what it is worth today – that would mean that I appreciated a dollar a day on an initial 75 cent investment and it would cost me .08 cents (or $0.0008 USD) to run the “BAND staking contract” and stake my 0.1 BAND.

Of course I put more BAND into staking but I like reducing to the small because crypto allows you to do that.  Try buying anything in USD for $0.0008 USD even though technically $0.0008 USD = 0.000000246 AMZN stock.  You can transact with this level of granularity on the blockchain but in stock exchanges you can only price down to the penny.

Bad example:

I don’t have a screenshot, but this was just dumb.  It happened to me about a year ago – I was going through a really old wallet and I found a token I had mined in the past – CLO.  I looked it up and there wasn’t anything interesting going on and I saw a staking button.  I pushed it, signed the transaction and haven’t seen that CLO since.  No clue where it went, but my suspicion is it was lost.

You might say this is horrible, why is it lost?  Well, I don’t even know it’s lost – because I never read anything.  Not then, not now, probably not ever because to me I looked at this at it’s value then (0.0001 USD) and if I can’t use it, stake it…  In this case it was foolish for me to act before I read up and understood what I was doing.  Perhaps I’d have been able to learn that there is an online dashboard that shows the staking progress?  Who knows really…  But, I’m not losing sleep over it though.

Liquidity Mining

This is a strategy that brings general DEFI trading traffic into a staking contract.  It does this by requiring the user to perform an extra step and join two assets together into a liquidity pool.  This liquidity pool could have MATIC and USDT as an example or really any other two assets.  The main purpose for liquidity mining is to provide a bucket of assets for general DEFI users to trade against.

You see, if I want MATIC and I have USDT I have to wait for someone who has USDT and wants MATIC and most importantly would agree on a price for this exchange.  This is possible by doing Peer to Peer (P2P) trading, but it’s not likely to be the quickest way to move crypto.  Liquidity miners provide pools of joined assets that help facilitate buy and sell orders at any market price in exchange for a fee that the mining pool distributes to the pool token holders based on percentage asset ownership.

Liquidity Mining has greater risks but FAR greater rewards.

Variable Return Rate

The first risk is the variable return rates.  Almost all Liquidity Mining starts off with HUGE APY’s – some in the billions of percentage APY.  This is because there are no assets in the actual pool or not enough volume but those percentage gains aren’t typically there for long as the pools start to fill up.  That being said, I have seen that they sometimes tend to settle in the 800% to 2200% APY range for auto-compounding pools, and 20%-400% for manually compounded pools. 

The reason for the large APY is because of auto-compounding.  Auto Compounding is the paying of fractional percentage-based rewards more frequently.  Paying rewards as the transactions happen or via a special smart contract auto executed routinely during each day allows for the rewards to be compounded automatically and allows traditional APRs to be compounded several thousand times a day. Therefore some pools have upwards to several thousand percentage point gains over a year.

Asset Depreciation

There are SO MANY Liquidity Providers and some are good while others are crap.  How do we tell the winners this early?  That’s the billion dollar question.  

The assets you are depositing are sometimes coins that are so new there is no history to rationalize even owning the coins.  So, it’s possible to receive a billion percent APY on a coin that is worthless and therefore lose the initial investment.

Impermanent Loss

The most annoying risk in Liquidity Mining is what’s called an “inpermanent loss”.  I can’t even tell you how many things I read about this and I never got it, like really never got it until I started to see it… Once I saw my own pools displaying impermanent loss I got it and I think I know a good way to explain it to you.

Simplifying, say you start a pool with 1 MATIC (worth 1 USD) and 1 USDT (worth 1 USD) ← this means you start the pool with 2 USD worth of value.  Say 1 MATIC appreciates to be worth 2 USDs, you then would assume you’d have 3 USD worth of assets at least, right?  Wrong…  The frequency of the trades using the pool and paying fees as well as the price movement between then and now may leave your balance more like this 0.5 MATIC and 3 USD – it’s a gain for sure, but how the heck did it get off balance?  This is inpermanent loss and is a result of the massive amount of transactions with trading, fee paying ang adding / subtracting assets from the liquidity pool all at once.  In this case, the price appreciation means that more USD would be put into the pool for smaller amounts of MATIC leaving the pool resulting in a non 50/50 balance eventually…

This is the reason my portfolio has very few Liquidity Mining positions because they are so hard for me to monitor.  I’m told that, over time,  it doesn’t matter as much, but it drives me crazy in my monitoring calculations. As such I tend to avoid this type of investment unless the coins are solid and the percentage is good enough to make it worthwhile.

Examples

Good Example:

I joined together some USDT and some EXP in a liquidity pool token (USDT.e-EXP PGLP)

I started with a small amount and added more and now I’ve invested more.  I’m earning about 25 EXP per day.  I haven’t done the technical analysis on EXP, but I think this will be a winner – certainly warrants a small investment considering that the APR is 1,226.7% meaning that each year I’ll make over 10x on my small investment.  Though that assumes this will be around in a year 😉

Bad Example:

OK, this is the worst story of my life and I almost gave up crypto as a result…  My first failed DEFI liquidity mining contract interaction ended up costing me almost $5000 as it used a FULL ETH for gas fees.  At the time 1 ETH was only worth about $300, but 1 ETH was worth almost $5k recently and I would have sold if I had more.

I basically barrelled into something without reading anything and didn’t know to calculate the gas fees, and bamn my ETH was gone…  There are several transactions that need to take place to initiate or withdraw assets from a liquidity pool – these are common on all platforms, but the gas fee calculation on ETH was not in my favor as I went through this process.

Not only did I suffer from gas fatigue, but the impermanent loss was such that I didn’t even make a gain on spot, meaning if I did nothing at all I’d have been better just waiting for the two supplied assets to normally appreciate and sell them today.

Oh well, thus was my expensive learning lesson.

Yield Farming

I see two different definitions for Yield Farming.  One of which is common and the other is a newish way to think about finance.  Let’s start with the common and pick up from liquidity pools.  This is so bizarre to say and you may need to read this a few times, but at no time do these assets leave your crypto wallet and you have COMPLETE control over them during these contracts.

This means that yes technically you can sell liquidity mining positions to other wallet holders, but more importantly you can lock up a liquidity pool into a yield farm for more gains.  This is sometimes called doubling up as you make gains on the liquidity pool at the base but ALSO make gains on the yield farming level.

THIS is where the high APY comes from – it’s because it calculates the gains at all levels.

The only way I can explain this is by going back to the savings account concept except in this case you have a pile of asset 1 and a pile of asset 2.  These piles can be used many ways but the most common is binding them together and providing underlying liquidity for the decentralized exchanges.  That’s called Liquidity Mining.  This need is evident as explained above, but ever since the 1980’s quantitative finance has been on the rise.  Give a quant the ability to use a liquidity pool and they will cook up many more interesting ways to use it to make gains.

Perhaps there are inefficiencies in a market, or an algorithm that wins on every transaction, or perhaps some piece of the underlying protocol can be used to enhance profitability.  Whatever the means the yield farming smart contract is constructed the APR and APY are measured on scale and all over the place from 10% APY up to several billion percent APY.

EVERY RISK ABOVE IS PRESENT AND WORSE IN YIELD FARMING……..

This is no joke, if done incorrectly you can lose a lot of money which is why the rewards are so high.  It’s the only way these folks can entice the needed capital to invest at this risk level.

Yield Farming “the new way” needs to wait until I explain a few other DEFI methods.

Lending

So you wanna be a bank eh?  Who wouldn’t?  Crypto allows anyone who owns crypto to securely lend to anyone else without even knowing who they are.  How is this possible?

Quite simply, the answer is that the code has its own logic that acts as the moderator.  There is a crypto saying “Code is King”, meaning nothing can get around the code of a contract as that is the law of the crypto land.

So let’s say there is a contract that allows you to lend your crypto to a pool (like staking) and make that pool of crypto available for others to borrow against.  This is one type of crypto lending.  Another type includes platforms that allow you to come up with your own lending rates and post your crypto on something similar to that of a job board. Folks who like your terms can take you up on your offer which spells out the duration and payment for the use of your crypto.

Regardless of your approach, the written lending contracts detail exactly what the steps are and how to handle all situations.  In some cases the loans are auto-settled from the blockchain and the interest is automatically calculated, even automatically paid.  The principal is automatically returned to the lender based on whatever rules are set in place and agreed to by both parties.  In other cases, the loans are not time bound and exist into perpetuity so long as the borrowing rates are paid properly.

I never did any lending because, from my experience, the yield is far too low ranging from 2% to 25%.  If you have a LOT of crypto you can participate in larger loans that go for shorter amounts of time and may make annualized gains in excess of 25%, but for me and my small bags, managing my crypto is enough!

Borrowing

This is something that I do as do most folks I know also do.  You traditionally lock up a certain amount of crypto that has a defined value and the platform you borrow from will hold that as collateral in exchange for releasing a portion of another crypto.  Just like in the CEFI world interest is charged based on an agreement with the borrowing entity and certain rules exist to govern the loan.  This I do have a good example of, but no bad one.

Good Example:

I needed a new car kind of suddenly as our second car stopped working.  I researched and found the car I wanted, but knew if I asked a bank I wouldn’t get a loan quickly enough.  So I tapped my crypto.

I pulled a little bit of my BTC into NEXO and applied for a loan against it.  I received USDT deposited in my crypto wallet in exchange for locking up a certain amount of crypto.  So long as I abide by the terms of the loan nothing bad will happen.  Each month interest is automatically added and if ever the worth of the crypto put up for collateral is ever less than the loan plus interest my collateral would be automatically sold to pay for the loan.

I don’t see this as a problem since NEXO is one of my investment hubs with crypto I keep on it.

All in all I was able to move the proper funds to my crypto.com credit card and charge the car, paying in USDT.   The interesting thing was that I was able to do all of this on my phone in a total of 1 hour without talking to anyone or asking permission from any bank to get a loan.

Far less stress and a credit card payment for a car went so smoothly.

I borrowed 12000 USDT as a loan and have paid it off here and there.  I only have 2900 USDT left to pay off!!!

Lending, Borrowing, and Staking oh my

It’s kinda funny because pairing the Borrowing and Staking products of the same platform can sometimes allow you to make a yield.  I don’t know if some Yield Farming contracts do this, but it’s certainly possible to do “yield harvesting” or Yield Farming the new way — just like the professional bankers have been doing for decades but on a much smaller scale.

So, sometimes the borrowing rates are lower than the reward rates.  So in essence, you can lock a crypto, borrow against it, and stake that crypto in place to gain more than you pay.  So over time your yield is the percentage gain between what you pay for your borrowed crypto and what you are paid for folks borrowing the crypto from you.

I currently do this on Celsius whereby I locked a small portion of my BTC and borrowed USDC at a 1% APY rate.  I then left the USDC in the Celsius account and am earning 8.88% APY on the USDC, paid weekly.

This allows me to pocket the delta (7.8%) as my gain on a loan that I otherwise would have paid for.  I don’t do this with a lot of my crypto, but some of it is setup in this closed system because hey, why not!

I intend on looking for a higher yield for this stablecoin and I’ll most probably stake UST in LUNA as that offers a solid 19% APY.  Yes, my savings account gives me 19% APY and the funds are super easy to spend.

The Risks

I participate in Yield Farming, Liquidity mining, staking and other DEFI functions, though it’s sometimes tough for me to tell the difference between them as with each platform their cutsie names aren’t always direct synonyms to any one concept.  For example, what’s a “dungeon” or a “bunker” or even a “jacuzzi”?  I don’t know, but if you put crypto into them, they all give you a return measured in APY…

Everything above highlights the need to do your own research.  This is not now nor will it ever be tax, legal or investment advice, your research is key.  Validate me and what I say just as any other source out there.  Research the underlying assets, their prospects to succeed, the project, the founders, if they founded other successful projects, the network, the protocols used, and most importantly the smart contract code and smart contract platform before you look to do any of the above.

As I’m sure you have heard, there are a lot of things that can go wrong with DEFI if not conceived correctly and/or not executed with proper righteous intentions.

The Rug Pull is the issue of the day on DEFI contracts.  This is a backdoor put into a contract by the developers allowing them to remove all the assets in the contract anytime they want.  This is obviously bad as no one should have access to crypto that isn’t theirs.  Over the past few months many companies have surfaced that check and verify these kinds of contracts. Some also provide their certification of contracts against rug pulls while others provide insurance against rug pulls.

There are other types of attacks that could happen, but in general the rug pull is what scares me the most as that instantly, irrevocably, and universally empties everything from a protocol.  These types of risks are why the APY is so high, the risk to reward ratio needs to make sense to someone or else these pools would go empty.

My Strategy

The risks are the reason that ALL my DEFI bags have started in the $5 – $100 range with MOST sub $20.  I won’t put ANY more crypto into a position until I’m certain the projects are certified and meet my goals in terms of rewards and security.

I took a shotgun approach to DEFI as I explored other networks beyond ETH.  I’m in Avalanche and Polygon mainly now and other networks daily to find potential gains. Although there have been some fantastical sounding APYs, I haven’t seen anything yet that makes enough for me to live on….  Though I believe that’s because my investment is always too low.

I just can’t see putting thousands of dollars into one of these things and have it go to zero – that would be such a disappointment to witness, so I stay small, really small…

I can’t lose my crypto and I need to preserve every last bit, so my plan is to watch these positions and their gains as well as the mechanism to claim the gains.  I’m going to sit for a period of time on each and come back afterwards to collect data on the gains.  This should allow me to realize what projects are trustworthy and what assets are crap.  If an asset itself is crap no matter the percentage they probably won’t deliver.  If it sounds too good to be true, it probably is…

This is why my main goal is to get my savings account up to 100,000 UST because at that point my monthly yield at 19% APY would be almost enough to live on.

My intentions for these DEFI experiments are to simplify and roll in an underperforming asset value into an overperforming position. 

Results will vary

I have not gained any value yet worth celebrating on these investments.  Investments in DEFI tend to be of the “set it and forget it” nature, and I have done my setting.  Now I just need to leave it well enough alone and monitor correctly so I can remove these assets and liquidate at the most optimal times.