DeFi, Money Legos and Going Bankless
*Disclaimer: this is not financial advice and should not be viewed as recommendations to buy or sell any asset, this is purely educational and the information below is solely my opinion, please do your own research and develop your own conviction*
For the average person, the appeal of crypto is the ability to buy a cheap asset and sell it infinitely higher to create wealth quickly. No matter what anybody says, the average person entered this space for that very reason.
Fortunately for us, we aren’t average people and that’s why we’re here right now, in the trenches, after falling down the rabbit hole and becoming obsessed by this industry and its potential. For those of us who are here for the technology and the revolutionary ideas associated, we’re already familiar with the concept of decentralized finance and have either participated in the games so far, or owned one of the protocols that facilitate this ability to be bankless.
At some point, DeFi and Ethereum will be looked at with the same reverence and regard as the scientists of years past who unlocked some of the secrets of the universe. Although DeFi is still very much in its infancy, it’s an opportunity that society will revel in for years to come as it eventually becomes an everyday part of our life. This might seem like hyperbolic rhetoric from an Ethereum bull, but it’s the inevitable truth about where the world is heading. DeFi enables people to take ownership of their money and engage in unique and creative ways to create value.
In a world where interest rates are artificially manipulated to encourage active investing, rather than saving, people are left looking for opportunities to beat the rate of inflation and create wealth. This is part of the reason we have a stock market that is constantly making new highs and people flocking to any asset that is showing any type of appreciation at all, like NFTs, real estate, Pokemon cards, Funko Pops and even Beanie Babies. One of the easiest ways for people to take advantage of this flaw in society is by understanding DeFi and engaging in some of the most interesting protocols that have been audited.
Aave
Aave is a decentralized lending protocol that allows users to deposit and borrow money into smart contracts to generate yield or take loans. The beauty of DeFi, and Aave by proxy, is the ability to immediately take out a loan without having to go through credit checks and receive permission from a bank or private lender. Instead of going through all of those regulatory hoops and needing to worry about tax records and credit checks, which can take anywhere from days to months depending on the type of loan, users can be approved of a loan in seconds without ever interacting with anyone or filling out any pesky forms. This is made possible through smart contracts, which are typically executed on the Ethereum blockchain, but do exist in smaller supply on other ecosystems.
The main difference between lending in TradFi and DeFi is the aspect of over collateralization. In TradFi, I need to prove I have money based on a track record of proving I can pay bills that are backed by tax documents and good financial behavior from my entire upbringing. If I screwed up as a kid and didn’t pay back my credit card in time, or took out a bad car loan, or simply just had medical bills or student loan debt, I would be priced out of numerous investment opportunities. When it comes to DeFi, the only mechanism preventing you from being approved for a loan is a lack of money. You could be an independent contractor working off the books who never paid taxes, never used a credit card, never signed up for any type of loan before and immediately be approved to borrow money based on the collateral you are willing to deposit. This is great for those who need money for large finances but aren’t, on paper, prime candidates for a loan.
The interesting thing about Aave, and most platforms for that matter is, as you deposit collateral into the system, you are able to lend it to create passive income that could be borrowed against. This creates a flywheel that’s been referred to as yield farming, especially since some protocols offer extra rewards to bring in users and increase adoption. The parts I want to focus on with Aave, however, are its tokenomics, interest bearing tokens, flash loans, growth numbers, and institutional support.
When I first returned to crypto after capitulating at the lows of the last winter we had, I focused primarily on what I understood best, which was just Ethereum. I ignored all alts and eventually pivoted to being just a bitcoin and AMP holder. To a major fault, I owned no ETH and paid zero attention to DeFi, which was the result of me suffering from the PTSD that came from trading shitcoins, making a ton of money and then giving it all back by selling at the lows. From that moment in time I decided to only focus on tokens that provided utility, offered a product actually in use today, and gave token holders a reason for owning that went beyond just governance.
Governance tokens are ok in theory, they offer holders the ability to have a say in the protocol’s progress and in some cases, they can even lend themselves to the mercy of a proxy war from a whale to pass a certain initiative that inadvertently increases the price of an asset. Governance is a needed thing, especially when it limits the power one individual can have an promotes decentralization. But governance is pretty boring beyond just that. There’s very little allure or reason for me to really be that interested in the inner workings of a project that I’m going to only buy the tokens so I can be one vote cast in a sea of millions. I want to own a token for two reasons: it’s going up in value, it provides me with some kind of passive income or value.
When it comes to AAVE, we have a token with a finite supply of 16 million, the ability to participate in governance, and are able to stake our tokens for a lucrative passive APR of 7%. I won’t get into the governance aspect too much, since it doesn’t excite me, but what I do want to discuss is staking. Holders are able to stake their tokens in the Safety Module to generate a passive income of 7%. In the world of TradFi, a 7% dividend is a highly sought after commodity, especially if the underlying asset is appreciating each year alongside the yield that is being generated.
However, holders should know the risks here. You aren’t locking up your tokens just to get a free hand out with zero risk, your tokens are entering a pool that acts as an emergency backstop in case of any black swan event that sends the protocol into massive disarray. Since the tokens locked in the Safety Module act as a safeguard in case of a Shortfall Event, a portion of the staked tokens can be market sold in order to mitigate the deficit that is occurring. This might sound frightening, but unlike the Titan/Iron Finance fiasco that led to a protocol essentially going bankrupt, there is a backstop mechanism in the Safety Module that prevents excessive flow of AAVE into the market to try and level off the waterfall effect that can happen in price. At the moment, the worst case scenario for stakers is a 30% slashing and typical volatility in price. This means that in theory, if I staked 10 tokens, I could lose 3 if we had a Shortfall Event. This isn’t necessarily likely, but shouldn’t be blindly ignored. You should consider and accept this risk when staking.
The one cool thing here is that once you decide to stake your tokens, you receive a tokenized version of AAVE that you can move freely around the network, and this is where we see the potential for some cool things that are often referred to as money legos. We also see money legos at work when we look at aTokens which are interest-bearing tokens that are minted and burned upon deposit and withdrawal into the ecosystem. The value is pegged 1:1 to the asset that is deposited (you deposit ETH, you now have aETH, you want to withdraw your ETH, you now burn your aETH), and can be stored, transferred or traded anywhere while you continue to accrue interest on the deposited asset in your wallet. Basically, what this means is, I can take my ETH, lock it in AAVE, get interest, then take my aETH and throw it in a LP or lock it up somewhere else to gain extra interest. This creates an interesting flywheel that allows you to build and stack as much as you want with your assets as long as you’re ok with the smart contract risks.
In addition to tokenized assets, there are some ways to take NFT’s and have them hold yield-bearing aTokens which creates what Charged Particles refers to as Interest-Bearing NFTs. This is a new idea that’s still in the early stages of development, but the ability to take an NFT and find new creative ways to create value for it could become an interesting moat that increases Aave’s optionality beyond just traditional DeFi.
Aside from just the basics of borrowing/lending, staking and utilizing interest-bearing tokens to create money legos, Aave possesses a unique feature called flash loans that give it an appeal to users over some of the other options.
Flash loans are uncollateralized loans that are borrowed and repaid within one Ehereum transaction with risk mitigated by the ability to reverse the flash loan if the principal, interest and fees are not repaid inside that transaction. In other words, a user wants to borrow money, in order for the smart contract to execute, they have to be able to return the money they borrowed plus the 0.09% fee that Aave charges, if they can’t do that, the entire request is rejected and nothing happens. Flash loans aren’t a typical investment vehicle that we see used by the mainstream public in DeFi, it’s been something that only developers have experimented with thus far since they have to write some code in order to interact with the system. What’s really interesting here, is the use case for flash loans that does exist.
Trying to figure out how you could quickly borrow money, pay it back, alongside a small fee, all within the same transaction is pretty confusing, but the easiest use case here comes in the form of swapping debt and collateral. If you borrowed a stable coin and used your ETH as collateral and we had a massive flash crash occurring, like the ones we’ve seen the past few weeks, you’re very much at risk of being liquidated and losing your collateral. This can be prevented, however, if you’re actively managing your positions and utilize a flash loan to swap assets to prevent liquidation. Currently only developers can utilize flash loans, but if users were in a similar position as the example mentioned above, they could avoid a liquidation, by swapping out their collateral which Aave allows in v2.
In addition to all of this, we have governance proposals for the inclusion of real world asset pools into the Aave protocol which would enable people to use RWA’s as collateral rather than the crypto they are locking up. This would be an interesting and beneficial development that would assist those who could use some liquidity and cash, but aren’t willing to lock up $150 in order to borrow $100. Centrifuge is at the forefront of this governance proposal which could truly redefine DeFi and bring to life the tokenization of everything that many people in crypto have been viewing as inevitable.
RWA’s hasn’t been approved yet by the community, but at the moment, it seems like a possibility with 79% of people in favor of Centrifuge’s proposal.
Beyond just RWA’s, which are a cool feature that will happen eventually, we also see Aave developing a permissioned sandbox for institutions with KYC that allows them to try out DeFi products and understand the market they are slowly entering into. This should lead to a tremendous boost in revenue created for Aave which really excites me.
Everything I have mentioned so far definitely makes me bullish on Aave from a thematic standpoint, but economically speaking, why would I choose to invest in Aave (I currently have a 2% position) over some of the other protocols? It comes down to the data that I came across on Dune Analytics (tremendous alpha there btw) that shows how Aave is becoming a revenue generating machine with consistent user growth.
In the week of June 8th, the Aave protocol generated $21M, $5.6M in interest, $51,000 in flash loan fees, $317,000 in liquidations, $5.6M from v2 distribution and $9M from Polygon distribution with $655,000 collected for the ecosystem with $1.5B in the Safety Module (credit to @A_BertoG on Twitter for this info). The protocol essentially generated $3M a day, which is insane to think about for something that is in a niche market with just over 60,000 users. And to put it all into perspective, Compound.Finance has over 300,000 users currently.
Despite the drop off in users between COMP and AAVE, Aave is still somehow managing to steal market share from them. While Compound started off as the dominant force in DeFi, their market share has decreased. When we compare Maker, Compound and Aave, Aave currently has 10-15% more market share than the other two, this kind of growth, coupled with the ability to stake my tokens (despite the risks), is why I decided to start into Aave instead of the other two projects.
With Aave having over $9B in Total Value Locked, despite 99% of the planet not even knowing what DeFi is, and adoption coming strictly from developers and hardcore crypto fanatics that are living in the rabbit hole, there is a tremendous opportunity for growth here that really excites me if Aave can continue generating the revenues it has and continues to grow its user base to eventually Compound’s level. There is a tremendous opportunity in DeFi, and it’s something people should become familiar with before the institutions start taking hold.
Compound
When it comes to DeFi, it would be criminal to not discuss Compound.Finance, its impact on the world of yield farming and the recent developments that are shaping its future and potentially the future of DeFi.
Compound was the first protocol to make it big and go mainstream. A lot of the yield farming techniques we’re familiar with today originated in the Compound ecosystem, as well as the idea of incentivizing users to borrow and lend by rewarding them with COMP tokens in addition to the yield they generated passively on their assets. Because of this, Compound kickstarted the DeFi revolution and became one of the leading protocols with the most users around. This has now been changing to favor Aave a little more from a growth perspective, but one of the reasons we want to focus on Compound today is because of where COMP is going in the near future.
Currently DeFi protocols exist only within the ecosystem they are subscribed to. I can only borrow erc20 assets or use them as collateral when engaging with a DeFi protocol on the Ethereum blockchain. If I wanted to use an asset that doesn’t exist on ETH’s blockchain, I would have to settle for the wrapped or Ren version of the token, but I can’t lock up that native asset anywhere other than the chain it inherently exists on. However, Compound has decided to make it possible to make DeFi a cross-chain event.
With the introduction of the Compound Chain, which is still under development, Compound plans to create a cross-chain interest rate market by allowing users to borrow native assets from one chain using collateral from a completely different one. This kind of interoperability has been a thematic that we love following and think very highly of as the world of crypto continues to grow and reach the point of real mainstream adoption.
Compound is making this all possible by using Substrate to create its blockchain, which will continue to be governed by COMP and be fully upgradeable without the need to fork or have any periods of downtime. All users will need to do is vote on upgrades and nature will take care of business for them.
At the moment, this upgrade is being referred to as Gateway which will act slightly different than what users see currently in the Compound UI. Users in Gateway will receive interest on their loans through the introduction of CASH which is the reward token for the Gateway platform. The one cool thing here is the entire ecosystem revolves around crypto, rather than fiat. If you decide to borrow one ETH, you will only ever owe one ETH, which is different from your debt being denominated in fiat as it is typically done today.
Gateway truly is a cross-chain platform that will enable users to transfer any asset to any wallet regardless of the walled gardens that have existed typically. This is very similar to what Thorchain is working on but primarily focused on the world of interest markets rather than the world of decentralized exchanges.
Compound is also increasing their optionality by offering a new product called Compound Treasury, which allows non-crypto native businesses and financial institutions to access the benefits of the Compound protocol. Users on this side of business will have the ability to utilize the USDC markets on Compound without having to worry about private key management or any of the other issues and concerns that surround DeFi. Users will be able to wire USD into their treasury accounts and receive a guaranteed fixed rate of 4% interest per year. This has the potential to act as a bridge between TradFi and DeFi and allow people to have access to markets that are far more yielding and rewarding than anything currently available in the banking world.
For this reason I am intrigued by Compound’s long term outlook and could become interested in being a token holder at some point (currently no position). If they can execute on the idea of cross-chain interest markets, introduce a new token, CASH, that rewards users and validators, and find a way to engage non-crypto businesses and institutions through the introduction of their Treasury program, this could become a protocol that becomes highly sought after. COMP currently is around a $1B market cap at this current moment ($255), in theory, $1B or less is a pretty buyable point considering that at the peak of the DeFi bull market COMP had reached nearly $893 per coin. With 5 million coins in circulation and a highly sought after ecosystem that is expanding its offerings, this could be one worth watching in the near future with decent risk/reward at this point, if we avoid a bear market and long crypto winter.
Alchemix
I’m going to pivot a little here with Alchemix. Where I focused mostly on the protocols as investment vehicles with Aave and Compound, with Alchemix I’m going to focus more on the DeFi aspect instead. To make it clear, and for the sake of transparency, I have not used ALCX’s platform, and currently do not have any plans to utilize it, but the protocol is a pretty interesting piece of technology to me and I think it’s worth talking about if you are currently unfamiliar.
Alchemix refers to itself as a future yield tokenization protocol. That might sound complicated, but the idea behind this process is pretty simple. Users deposit DAI, it’s used to mint alDAI which is a synthetic stablecoin that tokenizes your future yield that is earned by having your collateral locked up and lent out in Yearn.Finance vaults, which generates the interest that is used to pay down your debt and eventually unlock your collateral.
So, to put that into simpler terms, I deposit $1000 in DAI, Alchemix mints $500 worth of alDAI that I can convert back to DAI or trade on Curve.Finance or Sushiswap. This $500 worth of alDAI never has to be repaid with my collateral never being liquidated because of the interest my collateral is earning in Yearn.Finance vaults. Rather than me taking my money and depositing into Yearn vaults today and slowly earning enough interest to one day have $500, Alchemix will give me the $500 outright because they are using the money I deposited to passively generate yield.
Because the DAI is locked up in a smart contract that is set to earn interest over time, I never have to worry about paying back my loan or being liquidated since that all gets done automatically by the interest eating away at the collateral I deposited. This is a pretty cool way to passively yield farm and unlock the future value of an asset that I plan on holding long term, especially since I could either mint the alDAI back to DAI or trade it for another asset I want to own long term on Curve or Sushiswap.
In addition, users can take their synthetic assets and stake them in the Transmuter which can be used to have those synths eventually be converted into their base asset over time.
This does come with some risks of course. Recently Alchemix introduced the ability to engage in this process with ETH instead of DAI, and the resulting issue was users being able to withdraw their ETH AND the alETH essentially making free money. This was a flaw in the smart contract and has since been addressed and is currently being worked on. Surprisingly a decent amount of users have returned the alETH they wrongfully received and are being rewarded with ALCX tokens as a sign of good faith.
This wasn’t necessarily an issue that hurt users, but it does remind you that yield farming and DeFi does leave itself vulnerable to risks with smart contracts, and it’s imperative to only use money you can afford to lose and only engage with protocols that are frequently audited. Alchemix is currently working with CertiK to audit its code and make sure there aren’t any new issues that pop up.
Another concern that users should consider is the timeline of their yield. It should be noted that since Alchemix is using Yearn’s yield aggregator to farm for and deliver future value, it is possible that repayment timelines could be different than one expected. Users, however, have the ability to unlock their money whenever they desire by simply paying back their debt.
From a tokenomics standpoint, it should be noted that ALCX is a low float coin with just under 482,000 coins in circulation and a max supply of 2,393,000. This is definitely enticing from a supply and demand standpoint, but users should know that this lack of supply could lend the coin to be very volatile and high in beta. This creates great opportunities for traders, however, and could be something that draws people to the project. In addition, ALCX is a staking token with users able to receive an APR if they lock their coins in the ALCX pool, and eventually, stakers will be able to participate in fee sharing which could be a very rewarding experience down the road if Alchemix continues to grow its offerings and see an increase in user growth. Currently the project has $889M in TVL which is pretty impressive considering the token’s market cap is only $172M.
While I currently don’t have any plans for using Alcehmix, it’s worth noting that users could take advantage of pulling their future yield forward as a way to lever up and increase their position size in DAI, or ETH when it’s unlocked again. The fact that the debt doesn’t necessarily have to be repaid if your timeline is long enough, and the fact that liquidations aren’t in the cards, barring any black swan risks, makes this an innovative and inventive protocol that builds off of the money legos thematic that has drawn so many people into DeFi.
This is a project that I can see myself using down the road when the ETH vaults open up again, as well as potentially owning as a bet on the ecosystem growing as they increase their offerings and begin their fee sharing protocol.
Yearn.Finance
Since we’re on the topic of Yearn, we might as well discuss the protocol that Andre Cronje came up with. Yearn functions as a lending aggregator that automatically switches capital between lending platforms to find the best yield possible. In addition to its work as an aggregator that yield farms autonomously for users, Yearn introduced its vaults which function as a way for users to participate in yield-bearing token pools.
In a lot of ways, Yearn vaults are very similar to working with a hedge fund. Users deposit their money into the vaults, and the vaults automate the yield generation and rebalancing process, converting their money from one farm to another the same way a hedge fund manager would take your investment and trade it from asset to asset.
Yearn has also increased their optionality through the use of delegated vaults. Users have been granted the ability to deposit any asset as collateral to borrow a stablecoin which is then deposited into a stablecoin vault to generate yield. Those earnings are then used to buy back the collateral which creates a flywheel of farming. As Coingecko puts it, a user can deposit ETH, that ETH is sent to Maker Dao as collateral to draw DAI where the DAI gets deposited into the stable vault to earn interest which is then used to buy back the ETH that was deposited.
The really cool thing about Yearn’s vaults is the fact that users can truly deposit any asset that’s available on Uniswap and begin participating in yield farming. The yVaults will accept the asset (as long as it can be swapped with less than 1% slippage) and convert it to whatever asset is needed for that particular vault and get to work for the user. When withdrawing, however, users will have to zap back to one of the following assets: ETH, WETH, DAI, USDT, USDC, WBTC.
Like a hedge fund, Yearn also takes a fee from the vaults. In v1 Yearn takes a 0.5% withdrawal fee and 5% performance fee. In v2, the numbers increase to a 20% performance fee, 2% management fee and no withdrawal fee. This has allowed Yearn to begin building up a balance sheet and deliver quarterly earnings reports to holders which outline their fundamentals. Something that is truly revolutionary for crypto and a bridge of TradFi into DeFi.
From a tokenomics standpoint, Yearn functions primarily as a governance token with a fixed supply of 36,666 which often leads itself vulnerable to massive price fluctuations that surpass bitcoin on a regular basis dollar wise.
In essence, if one wanted to find a way to create money legos without having to know the ins and outs of DeFi and how to farm, Yearn would be the product to use throughout this process. If we had to pick which protocol best resembles a hedge fund, or even acts as a replacement for one, Yearn would also take that title. There are a lot of layers to Yearn, but this is one worth diving into and playing around with as the rabbit hole here is essentially never ending.
I’ve never used Yearn, and honestly, it does seem a little confusing upon first look, but the protocol and its optionality is becoming a mainstay in DeFi and something projects are working with and mimicking.
Anchor Protocol
In my previous article I mentioned how much I liked the Terra ecosystem, touching briefly on Anchor as one of their big draws. Anchor Protocol functions as a high yield savings account for crypto enabling people the ability to go bankless and earn 20% APY on their money This is typically facilitated by the protocol relying on people’s over collateralization to create yield that is kicked back to savers.
The idea here is pretty simple, I lock up my UST to earn interest that is derived from you locking up your coins to yield farm. One of the benefits here is the ability for the protocol to create yield by utilizing staking tokens that are deposited into the ecosystem as collateral. When you deposit twice as much as you borrow, and you are able to have those coins generate yield through staking, your rewards are amplified and it allows people to passively create wealth through the savings feature. This sounds amazing and has major potential, but of course, it has its risks and drawbacks, primarily forced liquidations which can in theory lead to UST losing its peg and in black swan cases create another Titan/Iron Finance event (although UST/LUNA has more of a backstop mechanism that is aimed at avoiding this catastrophe but of course, risks always exist). In addition, we could see a drawdown in reserve funds that either leads to a decrease in interest rates, which could lead to a bank run, or we could see the reserve pool run out completely. This is not something to take lightly and think is impossible, it’s a very real risk, especially when considering that ANC has seen its reserve pools decreasing of late.
I mention this risk not as FUD or to slander the project or Terra ecosystem, I think very highly of everyone involved. I’m rooting for Anchor and may eventually deposit a small portion of money that I am comfortable losing in the near future. But it’s important for people to understand what is at stake with yield farming, money legos and trying to be bankless. The one reason why I am continuing to even talk about Anchor here today is because of how I think they will get around this issue of a decreasing reserve pool.
At the moment, if I want to borrow aUST from Anchor, I need to bond LUNA, and that bLUNA is where our 20% APY is derived from since it’s a PoS token. This has worked for the most part, but at the moment we are seeing the reserve slowly burn money to keep the project afloat. One of the things that’s been talked about and is in development, and this is where I maintain my interest in the project, is the ability to bond other staking tokens, such as ETH, SOL and DOT. Users will be incentivized to borrow aUST using those coins as collateral and the staking rewards generated will help refill the project’s reserves.
Founder Do Kwon has also tweeted that he was working on a solution to this issue with reserves dwindling and it is possible that he finds a creative way to operate a backstopping mechanism to prevent the pool from depleting, or a new innovative way to encourage users to deposit collateral into the ecosystem and borrow aUST.
The major drawback for adoption has been the need to only provide bLUNA as collateral, which really closes the door to the majority of DeFi when considering that Ethereum is the leader in borrowing and lending by a very wide margin. If Anchor could open its doors to more forms of collateral, preferably coins from other, more popular ecosystems, as well as find new ways for users to utilize aUST to create yield elsewhere, this could become a very valuable project to be involved in.
Right now, the majority of aUST that is borrowed is being utilized for yield farming mAssets on Mirror, which is one of the ways the Terra ecosystem incentivizes borrowing, and by proxy creates the 20% APY that Anchor relies on to attract new users. In order to continue growing the Anchor platform and increasing its reserves, the Terra team will need to also find new reasons to encourage users to borrow aUST. If they could develop some other projects that allow users to yield farm, or take advantage of borrowing, it would help increase attention and lead to an influx of new users. Cross chain bridges and derivatives like options and perpetual swaps could be some of the ways to elicit more loans and create more value for the ecosystem and help maintain that 20% APY that acts as Anchor’s moat.
There are some concerns and question marks with Anchor Protocol. ANC is not something that should be looked at as a clear cut home run and easy, guaranteed way to make money, but the project does offer some tremendous opportunities and potential for people to become bankless and be in complete control of their own wealth. If the Terra team can continue innovating and developing their ecosystem, which they have shown that they are capable of doing thus far, this could become one of those projects that becomes a staple of DeFi and potentially even be looked at as a blue chip down the road. We are a very long way from that journey currently, more optionality needs to develop around the entire Terra ecosystem, but if we can see an increase in collateral options coupled with an increase in reasons to borrow aUST and use it elsewhere, we could see a very undervalued platform emerge and create a ton of alpha for savers, traders, investors and users.
I currently am not invested in ANC but at a market cap under $1B I am intrigued and could consider starting a small position at some point. The main factor, however, will be how Do Kwon addresses its dwindling reserves.