This week, we look at how DeFi protocols can attract liquidity. This includes why opportunities exist and some cautionary notes.
DeFi protocols are basically autonomous programs that have been tailored for addressing specific setbacks in the traditional finance sector”. Source: Gwyneth Iredale / 101blockchains.com
Imagine you want to disrupt the incumbent banking model. You have an idea, but you also have a problem: capital for liquidity.
Liquidity begets liquidity, you need to start the flywheel…
In traditional finance the solution would be an investor willing to put up capital, whilst you acquire clients. In DeFi, the problem and solution remain true, but there is no equity to give away and it can be hard to attract capital. Projects can be created by anonymous teams, obfuscating relevant experience and compounding this predicament.
Taking the example of a new borrowing and lending DeFi protocol, this problem becomes obvious – you need a supply of tokens to lend out.
The closest equivalent of equity in DeFi is the protocol’s own token. Designed as ‘governance’ tokens, these are tradable and assume a market value. In our example, the token would be used to incentivise users to supply the protocol with tokens to lend out. Commonly deposited tokens include WETH, WBTC and stable coins.
Depositors will be paid a formulaic interest rate, based on borrowing demand for their supplied token, but with protocol tokens paid on top.
Yield = interest rate + protocol token
Until users start to borrow, the interest rate will be 0. The protocol token is the sole source of yield.
This is attractive to depositors if they believe in the protocol’s ability to grow a user base of borrowers. A more traditional comparison would be acquiring liquidity (or capital) via equity distribution. To build up both sides of the market, borrowers will also be paid a yield. This can eclipse the borrow rate – users are paid to borrow.
The tokens received will be the lion’s share of a user’s yield - here are some questions to consider:
Like any new business, the protocol’s job is to generate interest through narrative (marketing) and a road map (business plan).
The market will determine a value – an increasing value will incentivize more users to borrow and lend. Early-stage valuation is primarily focused on the potential of the protocol.
Road maps allow investors to evaluate the future drivers of price appreciation.
A spread exists between borrowing and lending rates, supplemented by liquidation charges. These sources of income can be passed on to token holders. Protocols may also apply deposit and withdrawal fees.
Eventually, protocols can earn a yield from their own treasury.
In addition to positive sentiment, there are technical aspects of the token economics (“tokenomics”):
Anonymously founded protocols need to be approached with caution.
Smart contracts should be publicly available for evaluation. Trusted 3rd party audits are desirable.
The rise of new EVM-compatible blockchains has produced forks of existing protocols. Whilst official versions raise less of a concern, any forks should be thoroughly assessed:
A high deposit fee forces users to forgo a per cent of the ‘quality’ token deposited, whilst future yields are dependent on a token that could lose significant value over time.
Advertised yields that look too good to be true are often just that. A common theme is a diminishing token valuation.
To understand this better: whilst yields are often displayed in APR/APY terms, they are paid as a fixed number of the protocol’s token over a set period. Any yield is only realised once the emitted tokens are converted to your base token or stable coin.
If the price drops in half so does your yield. If the pool size increases (i.e. more deposits) your yield reduces. Both can be alleviated, at least in the short term, by increasing the number of tokens emitted. However, increased emissions leads to dilution.
The DeFi space is growing at an incredible pace and there are still opportunities to receive yields above those in traditional finance – hopefully this article goes some way to helping you assess future investments.
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