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Once the token distribution plan is completed, the revenue of the revenue aggregator will be exhausted. Although the new protocol can flourish with the newly started token distribution plan, it seems unlikely that this source of revenue will be sustainable. The revenue sharing tokens seem to be the most durable, especially if DeFi can maintain its recent growth rate.
Original title: “Imperial College of Technology publishes DeFi research paper “SoK: Yield Aggregators in DeFi””
Written by: Captain Hiro
This article summarizes the paper “SoK: Yield Aggregators in DeFi”, which is the result of a joint research conducted by the Blockchain Data Center (UCL CBT) of University College London (UCL CBT) and Imperial College London.
Since the outbreak of decentralized finance (DeFi) in the summer of 2020, Yield Farming has been a very popular activity for cryptocurrency holders.
As of May 2021, the asset management agreement in DeFi has locked in more than $3 billion, and as of this writing, the locked amount has reached nearly $2 billion.
Although there are many (scam) projects that promise users huge benefits in a short period of time, revenue aggregation projects such as Idle Finance, Pickle Finance, Harvest Finance, and Year Finance are trying to establish a sustainable source of revenue for the DeFi community. This makes me wonder:
Where does the income come from?
How much revenue does the aggregator use to build Lego with money?
What is the general mechanism behind all these aggregators (if any)?
What are the benefits and risks of putting your money into a revenue aggregator?
I co-authored a paper on Yield Aggregators in DeFi with Jiahua Xu, the Blockchain Technology Center of University College London and Toshiko Matsui of Imperial College London. This paper answers all the questions raised above. . We propose a generalized revenue aggregator framework. Now let’s dive into the most profitable part of DeFi, which is Yield Farming.
As you read in my previous article on Automated Market Makers (AMM), since the summer of 2020, DeFi has achieved explosive growth. Yield Farming is one of the most concerned applications in DeFi. This concept was first introduced by Synthetix, but with the release and distribution of Compound’s governance token COMP, this concept has received wider attention.
Since then, the participants of Compound have received newly minted COMP tokens as rewards through lending activities, a process that later became known as “liquid mining”.
To this day, this process is still being replicated by other projects, and it encourages developers to find a way to combine rewards from different protocols. Yield Farming was born under this background. In this context, the aggregation protocol built on DeFi’s existing projects is trying to provide a one-stop solution for people who want to carry out Yield Farming.
Where does the income come from?
There is no free lunch in the world, so where do these revenue aggregators come from? It seems to have three main sources.
As the demand for encrypted asset loans grows, lending rates will rise, leading to higher returns for lenders. Especially in a bull market, despite the high interest rates, speculators are still willing to borrow money because they anticipate the appreciation of assets that use leverage to do more. The annualized return of Aave and Compound’s stablecoins reached 10% in April 2021, when the market sentiment was very optimistic.
Liquidity mining project
Early participants often receive governance tokens that represent ownership of the agreement. This incentivizes people to invest money into the agreement, because reward tokens usually have additional governance functions. This function is often considered valuable because the token holders will have a say in the future strategic direction of the project. In essence, early users are rewarded for helping the project grow and taking on the risks that may occur in the early stages of smart contracts. Sushiswap and Finance Finance are examples of this.
Some tokens authorize users to receive part of the income obtained through the agreement. An example is Liquidity Provider (LP) tokens in automated market makers (you can read more about it here). The more people who trade, the higher the return for the liquidity provider. Another revenue share token is xSUSHI. Holders of Sushi tokens will receive xSUSHI in return, which will allow them to receive 0.05% of the Sushiswap protocol transaction income. Vesper Finance’s governance token VSP can be included in the vVSP pool, which captures approximately 95% of the fees incurred by Vesper.
The mechanism behind the revenue aggregation strategy
Now that we know where the revenue of the aggregator comes from, how do users get the revenue through the revenue aggregator? Let us take a hypothetical yield aggregator “SimpleYield” as an example to explain the following chart.
Mechanism of revenue aggregator
In phase 0, funds are placed in smart contracts. Although newer protocols allow for the emergence of multi-asset pools, usually a pool contains only one asset.
Users deposit assets in a pool, and in return, they receive tokens that represent their share of value in the pool. For example: deposit # ETH into the SimpleYiel dETH pool, and receive the returned #syETH tokens, which represents x% of the total locked value of the pool.
In stage 1, the funds in the pool are used as collateral to borrow another asset through loan platforms such as Compound, Aave or Maker. This stage is not always necessary and can be skipped. The main purpose of this step is to allow the use of another asset (rather than the original collective asset) to execute the Yield Farming strategy. For example: the ETH recharged by users in the SimpleYield ETH pool can be put into Maker, thereby borrowing the stable coin DAI.
Phase 2 includes revenue generation strategies, and different protocols can have very different levels of complexity. The figure below shows that the input at this stage is either an asset that does not attempt to gain (red coins) or an asset that generates gains (green coins). Over time, green coins generate revenue and continue to grow. For example: SimpleYield ETH pool uses ETH to borrow DAI, and now this DAI is used in Compound, where the aggregator earns revenue through cDAI tokens and COMP tokens as part of the Compound liquidity mining plan.
The execution process of a single strategy. SC stands for smart contract
In the final phase, Phase 3, the proceeds from Phase 2 will sell the assets of the original pool on the open market and flow back to Phase 0, where they will be redeployed in Phase 1 and Phase 2. The pool increases the value of existing shares without issuing new shares. For example: COMP tokens generated in Phase 2 are sold at Uniswap for ETH, and then flowed back to Phase 0. The #syETH tokens originally generated by users now have more value because the value of the pool has grown without generating new syETH tokens.
Now that we have understood how the revenue aggregator usually works, the main point of the agreement is in the second stage, which is the stage where revenue is actually generated. Let’s look at some examples of Yield Farming strategies. Note that the examples described here are relatively simple, and these strategies may be much more complicated in reality.
The evolution of the value of the pool is simulated in a controlled market environment. This article gives the simulation results.
The example used in the previous section is a simple loan strategy. As part of a liquid mining project, funds are deposited into a loanable funds (PLF) agreement to earn interest and governance tokens.
This strategy aims to maximize the number of governance tokens obtained by liquid mining plans through circular borrowing. The aggregator can deposit DAI into loanable funds, use this deposit to borrow more DAI, and provide the DAI to loanable funds again. This cycle can be repeated many times, but the results of a simulation based on supply and interest rates show that this strategy can become very dangerous when borrowing too many cycles.
Use automatic market maker LP tokens for liquidity mining
Automated Market Making (AMM) LP tokens have benefits because transaction fees are kept in the pool of automated market makers. When the automatic market maker is still running the liquidity mining program, the user will be rewarded with governance tokens in addition to the income from transaction fees. This strategy is also considered to be relatively risky, because when the price of the underlying asset begins to change, gratuitous losses may eat up a large amount of returns.
Compare proven revenue aggregators
Summary of major existing and early production revenue aggregators-May 1st data
Idle Finance is one of the first yield aggregation agreements, which was launched in August 2019. Idle currently only uses simple lending strategies to allocate funds on loanable funds (Compound, Aave, Fulcrum, dYdX and Maker). The agreement has two strategies, “best return” and “risk adjustment”. The first is to seek the best interest rate through the above-mentioned platform, and the risk adjustment strategy considers risk factors to further optimize the risk return score.
Pickle was launched in September 2020, and the agreement provides revenue through two products: Pickle Jars (pJars) and Pickle Farms. Jar is a Yield Farming robot, which can get rewards from users’ funds, while Farm is a pool of liquid mining. Users can obtain PICKLE governance tokens through staking of different types of assets. pJars uses the “automatic market maker LP token liquidity mining” strategy. Farmers recharge Curve LP tokens or Uniswap/Sushiswap LP tokens, which are used to generate governance tokens through liquid mining projects.
Harvest was launched in August 2020, and the agreement provides compound interest through its FARM liquidity mining project. The agreement has two main strategies: a single asset strategy (including a “simple borrowing and lending” strategy) and an LP token strategy (including the “using AMM LP token to mine liquidity” strategy). 30% of the income generated is used to buy back FARM on the open market and flow to FARM holders instead of the original pool.
In July 2020, the world’s largest revenue aggregator was finally launched. Yearn offers a variety of products, and this article considers Earn and Vaults. The Earn pool uses a “simple borrowing” strategy to deposit assets into the loanable funding agreement at the highest interest rate. Vaults allow for more complex strategies.
The total value is locked, the data comes from https://defillama.com/home
Benefits and risks of revenue aggregators
Farmers do not need to actively develop their own strategies, but they can use workflows invented by other users to change their investment strategies from active to passive.
Since cross-protocol transactions are carried out through smart contracts, the transfer of funds is done automatically, so users do not need to manually transfer funds between agreements.
Since the funds are concentrated in the contract, the number of interactions is reduced and the interaction cost is reduced, so that the gas cost is diluted.
When the Yield Farming strategy uses assets as collateral to borrow other assets, even when they only provide assets to the loanable funding agreement, the borrowing risk will always exist. In the case of high utilization (high borrowing/funding ratio), when many lenders raise the line at the same time, some of them may have to wait for some borrowers to repay their outstanding loans. This is the so-called “liquidity risk.” When borrowing funds, when the value of the collateral is lower than the predetermined liquidation threshold, there is a “liquidation risk”.
Since the Yield Farming strategy is usually based on a series of Lego bricks, there is a combination risk. Technical and economic weaknesses provide attractive opportunities for malicious hackers.
The return of a strategy is usually determined by many factors. For some strategies, this results in unstable annual returns. Fluctuations in annual yields caused by unpaid losses, low trading activity by automated market makers, or changes in the price of governance tokens are unattractive to many potential investors.
to sum up
In the past year, a large number of revenue aggregator agreements have emerged. Although the overall framework behind them is similar, they all have their own styles. Idle Finance launched the first version of its product in 2019, which deposits funds in PLF and provides the best interest rate at a given time.
Inspired by the Compound liquidity mining project, Year Finance expanded this model in July 2020, inventing a more complex strategy called Vault at the same time as their Earn product release. With the emergence of more forms of liquid mining projects, Harvest Finance and Pickle Finance exclusively used LP tokens for Yield Farming late last summer.
Yield aggregators were and still are an attractive way to collect yields with DeFi. But how long can this benefit last? As we have seen, there are three main sources of income. Although the research on the sustainability of earnings is worthy of a separate paper, we can think that the event from the distribution of local tokens is relatively short.
Once the token distribution plan is completed, this benefit will be exhausted. Although the new protocol can flourish with the newly started token distribution plan, it seems unlikely that this source of revenue will be sustainable. In this regard, borrowing demand may be more sustainable, but it is highly dependent on market sentiment, especially for non-stable currencies. The revenue sharing tokens seem to be the most durable, especially if DeFi can maintain its recent growth rate.