You may not be able to get the DeFi wool, but you may also lose your own sheep

Question: Is it reliable if an investment project has an expected annualized return of 1000%?

"Scammer" and "MLM" were the first reactions of most people in the cryptocurrency circle two months ago.

After all, the ICO era is gone, and investors have been fully educated by the market. The most common phrase used by veteran investors is " Buffett's annualized return is only 20% ."

But in this wave of DeFi liquidity mining craze, four-digit annualized returns can be seen everywhere. Projects such as Compound, YFI, YFII and YAM have triggered a collective carnival, and many old investors who missed out on the opportunity are regretting it.

After the epiphany, the old investors started to invest heavily and become "farmers", digging "corn" and "sweet potatoes". Although they knew it was unsustainable, they still wanted to get a piece of the pie and make some money.

The outcome was not as expected : the farmers who did not grab the first mine and entered the market later were "pleasantly surprised" to find that the income could not even offset the gas cost, and it was even more difficult to escape the endless code loopholes, the sudden failure of the project, and the countdown to the collapse...

In the end, you may not only fail to fleece the sheep, but may also lose your own sheep.

01
DeFi yields tend to stabilize and become a normalized investment

In the past two months, the hottest topic has been DeFi, especially liquidity mining, which has stimulated market participation enthusiasm.

Considering that many old investors still haven’t caught up, let us first explain what liquidity mining is?

Simply put, users provide liquidity for a certain token, and the project party gives governance tokens as profit feedback.

Taking Compound, the originator of liquidity mining, as an example, users deposit/lend DAI, USDC, USDT, ETH and other tokens into it to provide liquidity, and can obtain income from the native governance token COMP.

(1) An annualized return of 20,000% is not a dream

In the early days, as the price of COMP rose from US$18.5 to US$381.89, the annualized rate of return (ARP) for depositing/borrowing USDC and USDT was above 200%.

What does an annualized rate of return of 200% mean? Currently, the highest deposit rate of commercial banks in the United States is 2.10% (American Express Bank), while the global deposit rate is generally below 3%. The DeFi income is more than 100 times that of bank deposits, which is enough to drive people crazy.

Because of this, Compound attracted a large amount of funds in the early stage. The locked-in amount surged to US$1 billion within two weeks, making it the leading product in the lending market, comparable to the old lender MakerDAO.

However, an annualized return of 200% is only the starting point of DeFi. Phenomenal projects such as YFI, YFII, and YAM have taken over from Compound and continue to gallop on the road of high returns.

• On July 18, yearn.finance officially launched the sub-governance token YFI and started liquidity mining. The initial annualized return was as high as 2000%.

• On July 27, YFI, which had been online for two weeks, began to fork the project, giving birth to a new project, YFII, and opened two mining pools for liquidity mining. Among them, the initial annualized rate of return of the second pool was as high as 4000%.

• On August 12, Yam Finance distributed its first YAM token and started liquidity mining, opening eight staking pools. The AMPL/ETH pool had an hourly return of 1.6% after it went online, which is equivalent to an annualized return of 14,049%. The worst performing WETH pool also had an annualized return of more than 2,000%. In less than a day after its launch, the total locked amount of Yam Finance exceeded $200 million.

• On August 13, Yam Finance launched a second pool in addition to the eight mining pools - the YAM/yCRV Uniswap v2 LP pool. The annualized return of the second pool can even reach more than 20,000%. A certain mining user once obtained an annualized return of 500,000%...

The above are just a few of the more well-known DeFi mining projects. In fact, there are many imitations, and the annualized returns are all above four digits.

(2) A sharp drop in returns, a return to rationality

It is obviously illogical to maintain high returns continuously. Most of these projects can only maintain annualized returns of thousands of yuan in 1 to 2 days after they are launched.

On the one hand, with the influx of a large amount of funds, the mining income of users has been diluted (they get fewer coins); on the other hand, the operation path of most miners is "mine-withdraw-sell", and the selling pressure is large, which makes the price of governance tokens in the secondary market unsustainable and drops sharply. Under these two effects, the mining income of users has also dropped sharply.

Taking YFI as an example, the annualized returns of TUSD, USDC and USDT are basically maintained below 6%; the same is true for Compound, with USDC having a maximum annualized return of only 5.7%; dForce has the highest return, which can reach about 30% annualized.

Figure: The income of different currencies on each platform, from yearn.finance

It is worth noting that the above-mentioned DeFi interest rates are basically current interest rates, which are still higher than the current interest rates of centralized financial products.

Taking a certain centralized financial product as an example, the current interest rate for stablecoins such as USDT and TUSD is 3.5%; the 30-day fixed interest rate is 6.5%; and the 90-day fixed interest rate is 7%.

For this reason, even if the DeFi interest rate drops, there are still many investors who use DeFi as an interest-earning tool.

Shenyu posted on Weibo that he participated in Curve liquidity mining, with an investment of up to 43 million US dollars and a net annualized rate of return of 9%.

Image: Shenyu shows CRV mining

In fact, like other projects, Curve's annualized returns are also decreasing. Especially with the decline in CRV prices, the project's returns have also fallen from the early 500%. The current annualized return of the Compound pool can reach up to 20% (dynamically changing).

Figure: Curve mining income table

But in any case, liquidity mining, especially mining with stablecoins as collateral, currently still has higher stable returns than CeFi, showing strong demand, and DeFi is gradually becoming a normalized investment method.

In the long run, the gradual return of returns to the normal financial management range is also a good thing for the entire DeFi.

02
How risky is DeFi mining?

After reading about the DeFi mining income, many friends may be tempted and aspire to become a DeFi "farmer".

Those with sufficient capital may have already planned to invest their money in DeFi projects; those who are short of funds may be thinking of borrowing money from CeFi to arbitrage in DeFi.

However, if you do not consider the following issues before taking action, you may end up losing all your money.

(1) Benefit vs. Cost

Benefits and costs are the primary considerations. Simply put, DeFi mining is not suitable for retail investors.

On the one hand, the current gas fees on the Ethereum chain are extremely high, which directly discourages retail investors with insufficient funds.

Previously, the Gas Price basically remained at 10-20 Gwei, occasionally reaching 20 Gwei; but currently it has basically remained above 200 Gwei, and on August 13 it even broke through the 300 Gwei mark, reaching as high as 309.44 Gwei, setting a new historical high.

This means that when users mine DeFi, the single transfer fee is more than 0.1 ETH (40 USD); during peak periods, they even have to pay 0.3 ETH or even higher fees. Before this DeFi boom, Ethereum Gas basically only required 0.001 ETH (3 USD).

Shenyu posted on Weibo that the highest transaction fee he paid was 2.98 ETH.

If your principal is only a few thousand dollars, it may be completely wiped out in a few transfers.

On the other hand, mining revenue may not be able to cover gas costs.

The fact is that most retail investors cannot get the first mine of the project. Take YAM as an example. When the second pool was first opened, the login page encountered a bug, and most people were blocked from the door. Only a few people who are proficient in code got the first mine.

Moreover, most retail investors learn about project news through the media. Even if you rush in, your funds are not dominant and you can only get a small amount of governance tokens.

If the price of the currency continues to fall, the converted legal currency income may not be able to cover the Gas cost. As shown in the figure below:

To borrow a sentence from a Weibo celebrity: "DeFi is a relatively risky investment behavior. If you don't have more than $50,000 (principal), it is not suitable for you to participate."

(2) DeFi has a high learning threshold

For the vast majority of users, the learning threshold for DeFi liquidity mining is very high, and it takes a lot of time and energy.

Taking Curve mining as an example, the editorial department of Odaily Planet Daily still spent several hours to successfully pledge after referring to the tutorial, and encountered constant problems during the process: from stable currency exchange to transfer to the mining pool for staking, each step seems simple, but in fact there are countless hidden pitfalls.

However, in order to obtain high returns, you must rush to mine first. At this time, there is no tutorial, and users can only explore on their own. The result of self-exploration is that you need to pay a high tuition fee.

Many users reported that they experienced transfer errors and lost tokens during their first liquidity mining.

This situation is uncontrollable and has already spread from person to person. Even experienced projects may make mistakes when dealing with DeFi.

On August 18, TRON's decentralized exchange JustSwap was launched. A decentralized oracle project called Alpha Link made a mistake when adding liquidity and mistakenly locked TRX worth 200,000 USDT in the contract address.

Figure: Alpha Link accidentally locked up

(3) Systemic risk

If investors can exercise their subjective initiative to solve or avoid the first two problems, the final systemic risk is unavoidable and beyond their control.

There are three main systemic risks in DeFi mining: vulnerabilities in the mining project smart contract, failure in economic model design, and vulnerabilities in the mortgage asset smart contract.

Smart contract vulnerabilities in mining projects are the most common problem.

Currently, the vast majority of DeFi projects have not been audited by professional security teams, and their security has been greatly compromised.

On the one hand, the project owner may do evil subjectively and leave a backdoor in the smart contract. After the user pledges the assets, the project owner pretends to be a hacker and attacks the project, directly robbing the user's deposit.

On the other hand, the project owner did not do evil, but due to limited capabilities, the contract code left a bug. In the early morning of August 14, YAM, which had been online for only one day, was found to have a vulnerability. The consequence of this bug was that the actual total amount of YAM exceeded the expected total amount after each rebase (adjustment), and a large number of additional Yam tokens were minted. In the end, the project failed and survived for only 36 hours.

Therefore, users should try to avoid participating in mining projects that have not been audited.

Secondly, failure in the design of the project’s economic model can also lead to a collapse.

A good economic model can motivate network participants. But more importantly, the economic model must be designed to be sustainable. However, the economic models of most DeFi projects currently cannot do this.

Taking liquidity mining as an example, users can earn income by staking, but where does this income come from? If users’ mortgaged assets are lent out to earn interest income, it is undoubtedly sustainable.

However, most projects are just subsidies and cannot generate revenue, which also means that their governance tokens have no value support at all. Therefore, most projects are just one-day trips or passing the parcel, and only a few projects like Compound that have opened up the borrowing/lending network can truly continue.

Furthermore, we must guard against loopholes in the smart contracts of mortgage assets.

In addition to supporting common assets such as USDT, DAI, USDC, many liquidity mining projects also support assets such as AMPL, LEND, MKR, and Comp.

On the one hand, the price of these altcoins fluctuates greatly, and users need to make a comprehensive comparison between benefits and costs to avoid liquidation caused by price drops. On the other hand, the smart contracts of these tokens themselves may also have loopholes.

For example, during the March 12 crash this year, a bug occurred in the MakerDAO price feed system, which eventually led to a liquidation crisis and a sharp drop in MKR prices.

03
Summary: Don’t take over, keep safe

Defipulse data shows that in the past two months, on-chain locked assets have increased from US$1.18 billion to US$6.4 billion, an increase of 450%.

Figure: Value of locked assets on the chain

Behind the data is the real investment of domestic and foreign users.

Every day, a large number of users are using a large amount of funds to stress-test DeFi products in pursuit of returns, but not all products can pass the test. When facing uncertainty, it is always good to be cautious.

If you want to participate in the mining of a DeFi project, you can ask yourself a few questions:

How much money are you prepared to invest?

Are you a big investor?

Do you understand the mining process of this DeFi project?

Are you the lead user of this project?

Has the project been audited? Are the assets safe?

If the answers are all no, then you can basically go to bed.

Of course, you may want to buy some DeFi coins in the secondary market. At this time, think about the story of YAM plummeting 99% in two days and investing 100,000 and turning it into 800. I believe you will be more cautious.

For the majority of leeks, as long as you stay rational enough, the sickle cannot cut you.

Risk Warning : The content of this article is only the author’s personal opinion, does not represent the views or position of Zhikuang University, and does not constitute any investment opinion or recommendation.