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The strategy of holding DeFi governance tokens is generally inferior to active strategies such as ETH spot positions and stablecoin mining.
Original title: “Is DeFi’s profitability better than ETH investment? 》
Author: Decentralized Financial Community
Analysts at Glassnode evaluated the risk-adjusted returns of active and passive DeFi strategies and the situation of spot buying and holding of ETH.
With the explosive growth of DeFi, countless new projects, tools, and new ways of creating new financial products have emerged. Innovation brings growth challenges and risks, and DeFi tools, as the name suggests, usually require more attention and active participation. This is completely different from the “set and forget it” method that many cryptocurrency investors are accustomed to.
In this article, when we discuss the profitability difference between holding spot ETH, a basket of DeFi governance tokens, and active DeFi mining, we will share some unique considerations about actively participating in the DeFi market. We will share ideas and tools:
Manage profitability, risk and market exposure;
Measure the difference in profitability between passive and active strategies;
Measure the cost of participating in active strategies.
Management of profitability, risk and market exposure
Just because the cryptocurrency field is an experimental high-risk market does not mean that risk management can be forgotten. On the contrary, investors can understand their own risks based on established benchmarks and comparable strategies.
An understanding of the metrics used in traditional finance often contributes to a clear understanding of the risk/return profile. Below, we study a set of indicators commonly used by traders to measure risk and return on investment, and show the performance of these indicators on DeFi and ETH.
We will compare the performance of four investment strategies in six months:
Buy and hold ETH;
Buy and hold DeFi Pulse Index (DPI), which is a basket of blue chip DeFi tokens;
Liquidity mining in the popular DeFi of Sushiswap (SUSHI-WETH);
Stablecoin mining on Yearn Finance.
Before starting to compare strategies, let us describe each strategy in more detail. Each strategy represents a simulated position of USD 10,000 between January 1 and June 14, 2021.
Buy and hold ETH
This strategy is often used as a benchmark by DeFi market participants. We will compare the profitability of each of the other strategies in this report with it.
Buy and hold DeFi Pulse Index (DPI)
DPI is a DeFi governance token weighted by market capitalization. This is a passive index that reflects the overall profitability of DeFi tokens. The DeFi token basket is one of many available DeFi market indexes. DPI is rebalanced on the first day of each month.
Mining with governance tokens on Sushiswap
There are many different return pools on Sushiswap. We will use the SUSHI/WETH pool, which is Sushiswap’s third largest pool (approximately USD 400 million in locked capital). This mining pool is in 2020 (early 2021) because it has higher rewards compared to other pools on Sushiswap. At the beginning of the year, the reward in units of SUSHI was hundreds of%, and by June 2021, the annual reward was about 20%.
Liquidity providers can use liquidity mortgage options, and in addition to getting rewards in SUSHI, they can also get commissions from the pool. Traders can keep the SUSHI they received as part of the strategy, or they can claim and sell them immediately. As part of the analysis, we will calculate revenue based on the immediate sale of tokens.
Mining with stablecoins on Year Finance
Placing stablecoins on Year provides depositors with profitability. The strategy provider creates strategies for investors that can generate income. In return, the platform charges a 2% management fee and 20% profit commission.
Traders are willing to pay these commissions for the added value created by Year’s strategists. Despite the general downturn in the market, Yearn’s frozen funds surged to a record high.
The profitability of this strategy is simply estimated by the annual profitability as a percentage of the storage yvDAI, which includes the profit earned by the contributors.
Let us compare the indicators of all four strategies since the beginning of the year and propose a set of main indicators to measure the effectiveness of the strategy.
Alpha coefficient estimation
When investors refer to alpha, they usually refer to the excess return of the strategy compared to some specific benchmark. This is not a risk-adjusted alpha.
First, let us calculate the returns of buying and holding ETH and buying and holding DeFi governance tokens (based on DeFi Pulse Index, DPI). A simple comparison of yields shows that from the beginning of the year to mid-June, DeFi governance tokens performed significantly better than ETH in most cases.
The worst ratio of DPI and ETH position profitability was observed between March and mid-June: DPI was -18%, while ETH was +30%. Since the beginning of 2021, DPI has increased by 2.8 times and ETH has increased by 3.6 times. During the study period, the ratio of DPI alpha to ETH was negative.
The overall profitability of passive participation in the DeFi market in 2021 is significantly lower than simply buying and holding ETH. Now let’s compare the profitability of buying and holding ETH and stablecoins on Year Finance.
Since the beginning of this year, the growth of ETH has reached a historic scale. Therefore, it is not surprising that the profit of a stablecoin mining strategy is lower than buying and holding ETH. For the whole year, the average annual return (APY) of the yvDAI repository on Year Finance is about 15%. It looks like a straight line on the chart, which is due to the fact that the strategy was lower than spot ETH during the study period.
At the same time, it should be noted that in different periods, the rate of return of the stable currency strategy exceeds the rate of return of spot ETH. For example, since the beginning of May, the profitability of ETH spot positions has been negative, while the profitability of stablecoins fluctuates by about 8-12% every year. This is obviously equivalent to holding cash only, but by depositing cash in Year, traders can get a basically risk-free return.
Therefore, in some periods, the yvDAI strategy has the best alpha coefficient compared with ETH’s spot head village. Some traders permanently lock part of their investment portfolio in yvDAI or other Yearn stable pools to generate income, while retaining stablecoins for profitable downside purchases or participation in popular high-yield pools.
Finally, let us compare the profitability of the grafted high-yield pool SUSHI-WETH on Sushiswap with the spot position on ETH. This analysis is somewhat complicated because the choices and behaviors of the automatic market maker (AMM) are presented to the user.
In this simulation, we ignore SUSHI-WETH’s haircut, assume that the rewards received are sold immediately, and ignore the 6-month lock-up period. We ran a simple simulation in Croco Finance and found that the size of our fund pool was initially equal to US$10,000. After paying commissions and taking into account the impermanence loss, it was approximately US$32,000 by the end of the study period.
On the basis of 32,000 USD, we also paid an extra for Sushiswap. Taking into account all commissions, volatility losses and SUSHI liquidity incentives, we get the final portfolio value for this period. For SUSHI-WETH liquidity providers during the six-month period, the six-month period is calculated in the form of remuneration in SUSHI with an average of 140% per year.
Profitability is modeled according to the worst possible scenario, there is no compound interest, the lowest annual interest rate, the unsuccessful time to open a position on the underlying asset, etc.
As shown above, during the study period, the simple strategy of buying and holding DeFi governance tokens was significantly less profitable in ETH spot positions. Compared with buying and holding ETH, active participation in the SUSHI-WETH pool performs better.
In DeFi mining, many major risk opportunities are the same. In most time frames, these stable strategies outperformed ETH, as did cash strategies. Obviously, total return is not the only important indicator. Next, we will study volatility and risk adjustment indicators.
Volatility reflects the change in returns over time. The standard deviation is most commonly used to measure this value, which is calculated as the square root of the variance of historical returns. A higher standard deviation means higher volatility.
Under other conditions unchanged, traders want to see more moderate fluctuations. When traders create additional returns without increasing the volatility of the benchmark value, the risk-adjusted alpha value can be obtained.
Crypto assets are known for their volatility. But encryption strategies are not necessarily capricious. Let’s take a look at the volatility of these four strategies. It is worth noting that although the overall return rate of Yearn Finance’s strategy is very low, its volatility is negligible. Traders interested in obtaining stable returns and low volatility may find yvDAI storage very attractive.
Similarly, the SUSHI-WETH strategy, while returning SUSHI, absorbs some DeFi volatility through exposure to ETH. Regardless of the volatility of SUSHI-WETH hedging, it will suffer volatility losses. The volatility below only reflects the volatility of the underlying asset. In fact, part of the volatility is absorbed by the commission.
In the DeFi market, risk is not only reflected in price fluctuations, but also in, for example, the use of smart contracts.
Traders also like to analyze the duration and magnitude of the decline. The loss period and loss chart are useful for this analysis. Let’s take the difference between ETH and DPI as an example.
The upper chart shows the duration of the decline, and the lower chart shows their magnitude. Two main conclusions can be drawn from this:
In the DPI group, the decline time was significantly longer than that in the ETH group;
The average drop in DPI is slightly higher than that of ETH;
The maximum drop in ETH is about -49%, and the maximum drop in DPI is about -52%.
The Sharpe Ratio is a popular indicator that aims to measure the extent to which the return on an asset compensates for the risk taken by investors. Traditional finance always considers risk-adjusted returns because they always consider saving capital.
The Sharpe ratio is calculated as the rate of return minus the risk-free rate of return divided by the standard deviation of the rate of return. This calculation takes into account both the upward and downward fluctuations.
In this case, the interest rate of the 10-year US Treasury bond is used as the risk-free interest rate. Pay attention to the result value of the stablecoin strategy yvDAI. Since we are using the 10-year bond interest rate (1.5%) in this case, the Sharpe ratio in this strategy is very high. The reason is that the volatility of positions is negligible, and the growth of assets is completely related to risk-free interest rates.
Risk-free strategies with this profitability are extremely rare. The Sharpe ratio of SUSHI-WETH is also subsidized by the excess profits generated by SUSHI rewards and commissions; any downward fluctuations will be slightly suppressed, and upward fluctuations will be additionally accelerated. The Sharpe ratio of 1 is generally considered to be a good one. Anything above 2 is good or excellent.
Pure pricing risk/reward ratios like Sharpe or Calmar do not take into account the unique risks of DeFi’s unique smart contract vulnerabilities or protocol failures in any case. Traders need to consider the risk of funds leaking from the pool due to exploits.
By understanding and applying these indicators, we can understand how the strategy works under different market conditions. For example, during a market downturn, high-risk strategies lose money, while the “stable” graft pool continues to make a profit. Some traders prefer to keep part of their portfolios in stablecoins at any time and under any market trend in order to generate income in the pool while retaining the decline in capital for potential purchases.
Past profitability is by no means an indicator of future profitability, just as the absence of loopholes in the past cannot guarantee the security of future smart contracts.
Active strategic spending
There are several main types of costs associated with participating in active strategies. They are not in the above analysis. Some become irrelevant in large enough quantities, while others remain important. We will consider:
The more sensitive the cost of natural gas, the lower the location, which is an important factor to consider when adopting DeFi. With a certain level of capital and participation, it becomes more profitable for investors to buy and hold beta assets.
In DeFi, any operation related to the underlying asset will be related to the cost of natural gas in some way:
Transmission of base tokens;
Deposit tokens in the pool;
The total gas consumption of these key actions is> 400 Gwei-more than US$50 as of mid-June 2021. Gas prices are 90% cheaper than at the peak of the bull market rebound. During peak periods, they rarely fall below the $75-120 range. That is to say, the cost of these key actions often exceeds 1,500Gwei; at such a gas price, this can easily mean transactions, pooling, and collections of more than $200. Stake and get rewards.
When managing multiple graft positions within a month, the user’s deposit and withdrawal costs can easily reach hundreds of dollars. For many DeFi market participants, the gas cost of depositing/withdrawing tokens from the pool is usually the largest expenditure. In addition, the volatility of gas prices must also be considered. Historically, gas prices have reached a much higher level and have remained unchanged for a long time.
We have already talked about the problem of impermanence loss. Due to volatility losses, asset pools may suffer significant losses. The basic pool is a 50/50 governance token pair against another token.
Governance tokens have great volatility. This intermittent loss stems from the operation of automatic market makers (AMM). Arbitrageurs work hard to ensure that these 50/50 fund pools are balanced and priced appropriately to profit from exchange rate arbitrage.
This exchange rate arbitrage will cause intermittent losses due to price differences after deposits. The greater the difference, the greater the volatility loss. In the DeFi market, almost all traders with high-risk mining will face huge volatility losses. The challenge is to ensure that liquid mining rewards and transaction commissions make up for these losses and generate revenue.
In the following simulation, UNI’s 1.15 times profit and ETH’s 0.83 times profit resulted in a loss of 1.31% of the position due to volatility losses. Our model shows the number of days it takes to recover this money in the commission. Another way to recover capital is to restore the price to its original value.
Many platforms charge fees for using the agreement in the form of transaction fees. These are the profit mechanism for protocol vaults and token holders. For example, the standard commission for DEX is ~0.30%.
Slippage is the difference between the trader’s expectations and the resulting price of the transaction. The expected transaction size is US$1,000, and the position value is US$990, a decrease of 1%.
For large traders, the impact of bids on prices is particularly important. Due to the lack of liquidity of automatic market makers and order logs, traders use aggregators and special algorithms to minimize the impact of orders on prices.
For small traders, this loss may be small—only a few basis points in a low-liquid environment. Larger orders may have a much more severe impact on the exchange rate, creating attractive arbitrage opportunities in the case of lower liquidity.
Other expenses in the ecosystem include withdrawal fees, profit and withdrawal fees. These are basic fees, and the funds are transferred to strategy developers, vaults, and sometimes to token holders. Yearn uses a basic 2/20 structure: 2% management fee and 20% profit commission.
Of all our strategies, buying and holding ETH is obviously the cheapest. The only additional expense incurred here is transaction fees.
Buying and holding DPI means that the cost is very low; this is the benefit of using an index like DPI. The additional fee includes 0.95% of the streaming media fee, which can be regarded as a management fee.
In Sushiswap, mining means the gas cost associated with exchanging assets to obtain assets, storing assets in pools, and holding liquidity. In a year’s time, SUSHI-WETH did not suffer significant volatility losses, but gained 6% of the profit at the beginning of the year and additional SUSHI liquidity rewards.
From the beginning of 2021 to mid-June, the DeFi performance of the passive buy and hold strategy was very low. In most time frames, the strategy of buying and holding governance tokens is generally not as profitable as ETH spot positions. However, many active strategies have shown better performance, and the active rotation of stablecoin mining during periods of high and downward volatility also exceeds the income of buying and holding ETH.