(Any views expressed in the below are the personal views of the author and should not form the basis for making investment decisions, nor be construed as a recommendation or advice to engage in investment transactions.)
I became an avid cyclist after the onset of COVID. I try to ride twice a week for 40 – 60km. Given the popularity of cycling with Boomers, you might think it’s a nightclub for uncles on the public bike paths circa 5am—but it’s a high stakes affair. My top speed hit on a sprint so far is 52 km/h; one wrong move and it’s game over.
But aside from exercise, my cycling also gives me some much-needed fresh air to do some of my best thinking. My cycling buddy happens to be a crypto agrarian as well. On a recent ride, we got into a risk management discussion about the types of risk Decentralised Finance (“DeFi”) “farmers” (aka liquidity miners) undertake when putting up their capital. Based on our conversations, I’ve outlined below a quick history on why farming is popular, and a conceptual framework that evaluates the risk undertaken by crypto peasants.
DeFi is an ecosystem of projects that aim to provide financial services to the digital world without the need for centralised financial services providers, such as banks. For example, many DeFi projects allow people to easily borrow directly from other individuals, who lend out their money in exchange for rewards that are built into the network. This has massive implications for the future of lending: no credit check, personal data, or bank account is required. Everyone can participate, and the lending terms are enforced by smart contracts that cannot be tampered with– removing the need for a trustworthy middleman.
An example of a centralized intermediary is a bank. In my August 2020 piece Dreams of a Peasant, I spoke about how the DeFi ecosystem is building proto-banks for humanity’s digital existence. As a concept, I am fully on board with eventually replacing all banking and financial services with open-source code. The ecosystem is nowhere close to fully living up to those ideals, but I am betting that this future will eventually come to fruition.
Ownership of the projects is open to all, and is based on providing a useful service to the network. Given many DeFi projects focus on some sort of borrowing, lending, or asset swapping, these projects need lenders and market makers that provide liquidity. In order to reward people for lending out their assets the projects mint, per a published schedule, a native token and distribute those tokens to all lenders, typically proportionate to the percent of the total lending pool their funds represent. These tokens each represent a percentage of ownership of the project. If the project is useful, these native tokens or governance tokens will have a non-zero value. In some cases, the tokens may even represent the right to receive a proportional percentage of fees enacted by the platform – e.g., receiving a portion of the trading fees charged by a decentralised exchange whose tokens you hold.
Eventually, these tokens will also give tokenholders the ability to vote on how the protocol operates and is governed. Imagine a DeFi bank where the tokenholders get to vote on interest rate loan spreads, and the types of collateral that can be lent against. Or imagine a decentralised asset exchange (e.g., Uniswap, Sushiswap, 1inch, etc.) whose tokenholders vote on trading fee rates.
Below is a hypothetical example of a truncated lifecycle of farming a DeFi protocol’s native token. Let’s assume this is a simple protocol that allows borrowers to deposit Ether (ETH) and borrow a fiat stablecoin Tether (USDT).
- The protocol launches, and would like to offer USDT loans collateralised by ETH.
- The protocol's governance token is called CORN. 1,000 CORN will be distributed every day for the next 1,000 days. 75% of the daily CORN tokens will be distributed to lenders proportional to the percentage of the USDT lending pool they represent. 25% of the daily CORN tokens will be distributed to borrowers based on their percentage of daily ETH borrowed. Something very important to know: you cannot buy CORN directly from the protocol. You must participate to earn CORN. Once there are CORN in circulation, you may purchase CORN in the secondary market from willing sellers.
- Therefore, even when you borrow or lend on the CORN farm, you are rewarded with ownership in the protocol. Imagine if you received shares in your Too Big To Fail bank whenever you paid your overdraft fees, or when you paid 20% in fees to cash your government stimmie check because you are too poor to be a profitable client with a real bank account. My mother recounted that this stimmie cashing situation played out in a blighted section of the inner city. A line formed down the block, during the previous height of COVID, consisting of poor citizens who had no bank account, weren’t wearing masks, and paid $200 of fees to cash a $1,200 government check. Disgraceful.
- As a lender of USDT, you connect your browser’s Ethereum network wallet to the CORN web3 site (a popular wallet is Metamask). You approve the connection, and then elect to stake – i.e., allow CORN to lend out your USDT. CORN will pay you an interest rate in USDT by collecting ETH interest from the borrower, and converting it using a Decentralised Exchange (DEX), such as Uniswap, to convert ETH into USDT at the prevailing exchange rate. All this is done programmatically.
- If you are a borrower, you again connect your wallet to the CORN platform in the browser. Instead of staking USDT, you stake ETH as collateral and then borrow USDT and pay a continuous rate of interest in ETH terms. To repay the loan and receive your ETH collateral back, you send the USDT you owe to the CORN protocol. The CORN protocol will enforce a minimum leverage ratio based on the external price of ETH/USDT. If, as a borrower, you breach the minimum level, the ETH you put up as collateral is programmatically sold on a DEX.
- As long as you are lending or borrowing, meaning you have USDT and/or ETH staked on CORN, you are continuously being credited with CORN tokens. The CORN token represents a fraction of ownership of the CORN network, giving its holders voting power to change the CORN protocol and terms of operation, as well as a percentage of interest fees charged to borrowers. The CORN token has a value determined by the marketplace based on the above traits and can be sold on the secondary market for that price. To find the appropriate price you could construct a discounted cash flow (DCF) model that forecasts total value locked-up (TVL) and uses an assumption on the type of fee income for CORN that will generate. Plug in a discount factor, and boom you have a “fair value” for the CORN token. This is why TVL is the most important statistic for any DeFi project. The more TVL, the larger the assumed future fee pool, the higher the token price trades.
Because the market is currently so bullish on the future disruption DeFi projects will cause, their tokens are trading at very high non-zero nominal values. Therefore, even if the interest rates are not attractive to potential lenders in and of themselves, the opportunity to generate a token that rises exponentially in price still entices users to stake.
The act of staking in order to accumulate platform governance tokens that hopefully appreciate in value is the essence of farming. When you compute the all-in annual percentage yield (APY), the return on your crypto capital dwarfs what you can earn in the centralized “free-market” interest rate markets of traditional finance. That sounds amazing, but there are significant risks undertaken by staking on DeFi protocols.
Skin in the Game
Understanding these risks—which are largely tied to how secure the code of these DeFi platforms is —is critically important, as there are a few ways in which you could be at risk of losing some or all of your staked capital.
While the code for all DeFi protocols is open sourced, most users do not read it. And many (like myself) do not possess the requisite knowledge to discover malicious or poorly-written code because we don’t understand it. Even if you wanted to do extensive code review, the speed at which projects accumulate TVL and appreciate in price punishes those slow to the draw. While you are stumbling through the github, the returns are diminishing. That is chiefly because the number of tokens distributed remains static, so each lender receives fewer tokens as the number of lenders and TVL increases - diminishing the APY. Therefore, ape-ing into contracts without doing any technical due diligence is common and extremely profitable if you are an early mover.
The more reputable projects will commission a smart-contract security review by an audit firm. Quantstamp, Hacken, and Trail of Bits are a few of the industry leaders. However, there is so much interest in this space and so few qualified auditors that obtaining an audit from a reputable firm is almost impossible without a connection to the heads of those firms.
Here are a few of the common ways to suffer principal loss...
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– Arthur Hayes, Co-Founder of 100x Group (@CryptoHayes)