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The growing volume and variety of DeFi projects provide very good interest-earning assets for crypto financial institutions that are extremely sensitive to income and extremely flexible in operation.
Written by: Damen, founder and CEO of 1Token and BitLink; Phil, Business Director of 1Token and BitLink
DeFi comes from Decentralized Finance in English and “Decentralized Finance” in Chinese. In a broad sense, DeFi refers to blockchain-based finance. It does not rely on traditional financial institutions, such as brokers, exchanges, or banks, but instead conducts financial activities based on smart contracts on the blockchain. The narrow understanding of DeFi is liquid mining in the decentralized market (also known as DeFi yield farming, or DeFi mining), as a method of earning more digital currency through the digital currency held by The “smart contract” of the blockchain provides the locked-in digital currency as liquidity to the market for lending and trading to others, and at the same time as a return for providing liquidity. The depositor (ie Liquidity Provider, abbreviated as LP) You will get benefits such as interest or handling fees.
Liquidity mining itself is not a new thing. In the earlier centralized trading platforms such as FCoin, there was order book liquidity mining, and certain token rewards were given to users who placed orders in the market to incentivize the provision of liquidity . The recent large-scale outbreak of DeFi began with Compound’s lending liquidity incentive project in 2020-both the lender of deposits and the borrower of borrowers can receive COMP token rewards.
The value of token rewards exceeds the loan-to-lending gap in the initial stage. Users can deposit and borrow a large amount of tokens at the same time to obtain token rewards. This attracts a large number of professional users to participate. This is the early DeFi yield farming / DeFi mining. Since then, other DeFi projects have also put forward innovative plans to improve the liquidity of their ecosystem, such as the well-known YFI, Uniswap, Sushiswap, and Pancakeswap and MDEX that have emerged on other chains.
As mentioned in the previous article ” Understanding the Market Structure and Asset Types of Cryptocurrency Institutions “, funds hope to invest in good assets to achieve appreciation; assets require more money to complete the goals they want to accomplish . DeFi mining has now become one of the mainstream assets in the currency circle. Because it generally provides a higher yield, many loan projects and liquid mining projects one after another, will provide annual mining incentives of more than 1000% at the beginning, and after the maturity period It is also generally 10%-50% annualized, far exceeding traditional assets. The project has developed from the Ethereum protogenesis chain and Ethereum L2 to the BSC and HECO chains; the agreement includes the loan direction COMP and AAVE, the aggregation direction Year, and the transaction direction includes Uniswap, Sushiswap, MDEX, etc.
At present, the total lock-up value (TVL) of the top 10 DeFi smart contracts has exceeded US$50 billion and is growing. These projects provide very good interest-bearing assets for financial institutions in the currency circle that are extremely sensitive to income and extremely flexible in operation .
Basic classification of DeFi mining
Common DeFi mining on the market is mainly divided into single currency loan mining, dual currency AMM mining, “single currency” leveraged mining and machine gun pool mining . Other types include synthetic assets Synthetix, MCDEX on perpetual contracts and The following is an introduction to the four main types of order book transaction liquidity mining and so on that are expected to appear in the future.
Loan mining (single currency mining)
Loan mining is similar to depositing money in a bank to obtain current/periodical interest, and is considered risk-free mining . Risk-free here means that apart from the technical risk of the mining smart contract itself (the contract is hacked), there are no other risks , because contract technical risks inevitably exist in all DeFi protocols.
The interest-generating model of loan deposit mining comes from borrowing, the fund provider charges interest, and the lender pays the interest. The income of LP comes from the loan interest .
Obviously, the advantage of loan mining is that the risk is relatively low, but it also has the disadvantage of lower yield. Therefore, some platforms additionally reward platform coins as LP incentives, such as compound and other lending agreements.
At the same time, users can carry out the “domestic” operation of repeatedly obtaining loan-to-mining revenue . Generally speaking, loan mining is to deposit coins into the corresponding contract, and then continue to obtain income, and some loan agreements will mint tokens on their own to represent the digital currency deposited by the user in the system. For example, by depositing DAI in Compound, you can get cDAI (ie Compound DAI); by depositing Ethereum in Compound, you can get cETH. Continuing with the “mock doll” operation, you can deposit cDAI into another agreement that will mint a third token to represent cDAI that represents DAI, and so on.
This type of operation is particularly common in lending agreements (Curve, Compound and AAVE). The original intention is to continue to exchange for liquidity in the locked part. At the same time, because deposits and loans have farming incentives, advanced players use multiple deposits and loans cleverly. Get multiple interest rates.
Dual currency AMM mining
Liquidity mining based on the automated market maker (AMM) model. The method of mining is to deposit two different digital currency funds into the liquidity pool of a decentralized exchange (DEX) to become a liquidity provider . This fund pool provides fund/liquidity support for the trading platform. Other trading users can use this fund pool to exchange/transaction tokens and pay handling fees. LPs can get handling fee remuneration and/or platform currency rewards according to their share.
This is the basis of the operation of the automated market maker (AMM). There are several different market maker functions (such as Uniswap V2, Uniswap V3, Balancer V2, Curve V2, etc.), so this article will not go into details.
The concept of impermanent loss (Impermanent loss) should be mentioned here, which is that when the token price deviates from the initial price during liquid mining on AMM, the two currencies of AMM’s LP assets change separately (generally, the number of two currencies increases by one. Minus), if you use the hybrid standard to calculate the current assets and initial investment (that is, compare the total assets of AMM LP and the original two coins of pure hodl), you will find that the current assets cannot be fully exchanged back to the initial investment, and the difference is Impermanence loss; the greater the price deviation, the greater the impermanence loss, and if the price returns to the initial price, the current asset and the initial investment are exactly the same, and the impermanence loss will no longer exist.
Of course, considering that AMM has mining income (handling fees, etc.), the final DeFi mining profit is the surplus after mining income minus impermanent losses . Generally, the currency pair that is expected to lose less impermanence is the mining pool between USD stable currency pairs, such as Uniswap’s USDC-DAI mining pool, because their theoretical value is 1USD. The empirical (not constitute investment advice) impermanent loss, stable currency-stable currency <mainstream currency-mainstream currency (with a certain correlation coefficient) <mainstream currency-stable currency <non-mainstream currency-stable currency / mainstream currency (even anti-correlated Currency) .
For example, Uniswap V3. Now that a large number of players enter Uniswap V3, they can provide liquidity within a certain price range. Due to the concentration of funds, Farming’s income expectations are higher, and it is currently a hot spot for DeFi mining.
Leverage mining (“single currency” mining)
The reason why the single currency is quoted here is because the operating method of leveraged mining is to deposit a single currency into the leveraged mining agreement A, but the agreement borrows more assets through the external lending agreement B to mine the single currency of the agreement C or Dual-currency mining pools to gain income. This is essentially similar to the leveraged trading logic of centralized exchanges , that is, the agreement borrows more assets for mining or investment through pledge A currency.
For example, go to another preferred loan agreement B in the market to lend another currency, match the amount of the two currencies and deposit them into AMM transaction agreement C. The income comes from the interest subsidy on loan agreement B and the AMM handling fee of agreement C Income, in order to achieve higher income.
Theoretical rate of return = (agreement C fee income-loan agreement B interest expense + loan B interest subsidy) / initial unlevered principal .
The advantage of leveraged mining lies in its convenience, one-stop service and the benefits are multiplied . The disadvantage is that users need to bear multiple risks . One is contract risk: once any of the above A/B/C contracts have problems, leveraged mining will be affected. Second, leveraged mining also has the risk of liquidation due to the excessively high debt ratio in the loan agreement B. Third, if agreement C is AMM liquidity mining, its impermanent loss will be further amplified by the leverage effect. Therefore, investors must understand the clearing rules of each agreement before investing funds, avoid losses due to large fluctuations in assets, and can properly hedge against impermanent losses. In short, leveraged mining management costs are high, and it is a comprehensive benefit for large funds. It’s not as good as it seems.
For example: Booster, Alpaca, etc.
Aggregator/Machine Gun Pool (“single coin” mining)
The most classic is Yearn Finance (nicknamed Uncle Fu) launched in 2020. As an aggregator of DeFi interest-bearing services, it can search for various agreements in the market and obtain assets with the best interest rates (not necessarily a simple Agreement, which may be a series of operation combinations), even if the interest rate of these assets changes, the smart contract will automatically update the current highest interest rate. Other aggregator projects include subsequent Coinwind aggregators that appear on other chains.
Behind the high returns, there are naturally higher risks than “deposit banks”. The main risk of this type of project is the risk of the DeFi project contract itself being attacked/stolen, including the aggregator protocol itself and the protocol being aggregated.
The risks and corresponding strategies of DeFi mining
All agreements have technical agreement risks. For related risks, you can search for keywords such as “DeFi stolen/attacked” in the media. Based on past experience, agreements with a long running time and a large amount of locked positions usually have lower technical risks.
In addition to the agreement risk, the DeFi risks that everyone mainly talked about are liquidation liquidation and impermanent loss risks. The following table sorts out the risk sources of different mining agreements:
Liquidation risk of liquidation : Different agreements have different liquidation risks, which generally appear in pledge lending or leverage agreements. For example, Compound defines the Collateral Factor as 75%, that is, if the pledge rate is lower than 1.33 (that is, the LTV is higher than 75%), then Compound will put the collateral on the auction shelf and transfer the creditor’s rights. The liquidation risk of another type of loan agreement, AAVE, varies with different currencies.
It should be noted that the liquidation of the DeFi agreement may incur a handling fee of up to 10% of the liquidation value. Therefore, users should take the initiative to prevent risks, keep a margin of pledge rate as much as possible, and monitor the pledge rate in each loan agreement in real time to reinsure in time to avoid liquidation .
Impermanence loss : Impermanence loss is the public enemy of DeFi AMM farming, which was briefly introduced in the previous article. Let’s first make a quantitative analysis and compare Uniswap V2 (the classic constant constant formula) and the most popular Uniswap V3, which has higher impermanence loss under the assumption that the fee income is not considered. Uniswap V3 means that by keeping the price range within a small interval, concentrated liquidity generates greater returns, and at the same time brings a higher risk of impermanence .
Suppose that 10 ETH and 20k USDC are deposited when the current ETH price is $2000. When the ETH price drops to $1000 or rises to $3000, assuming a mixed standard calculation is based on the net value of the initial assets of 10 ETH and 20k USDC:
As can be seen from the above example, the impermanence level of the dual-currency AMM mining pool that provides liquidity in a certain price range will be multiplied compared to the infinite range. Therefore, it is necessary to use centralized exchanges for hedging at the same time, and Monitor overall profit and loss and exposure .
Regarding the risk control of impermanent losses, the mainstream method currently on the market is to hedge Delta by using a centralized exchange (such as Binance) perpetual/future/spot . The principle of the hedging strategy is to set the risk control parameters such as exposure, or the threshold of the currency price, and automatically run the hedging strategy on the centralized exchange according to the position in the DEX. The hedging strategy is generally divided into three steps:
1. Forecast the future market trend (in the next mining cycle, in which range will the currency price fluctuate, and what may be the highest and lowest points);
2. Based on the backtest of the expected market trend, set the parameters of the automatic hedging strategy;
3. Design corresponding measures when market trends exceed expectations;
There are quantitative teams on the market that provide impermanent risk hedging services. They usually charge a fixed annualized interest or share the net mining income. For example, they provide quantitative hedging services (whether options or futures perpetual spot hedging) in exchange for AUM annualized 10- 25% of the cost is used as a benefit.
How does the institutional investor of DeFi mining operate?
Institutional investors have the following characteristics:
The amount of funds is large, and the sources are diverse , and may be divided into different risk preferences or funding needs with flexibility in time periods;
Raise funds in batches when raising funds, and may only raise funds in a single currency (such as a U-based fund or a single-currency-based fund), and balance positions are required when entering dual-currency mining;
There are various investments on the asset side , and various mining sites are invested according to the attributes of the funds, single currency/dual currency, current/regular, large currency/small currency, U standard/currency standard, etc., and different types of assets are required:
* Bookkeeping, have an overall view of the asset side
* Risk control to ensure that the overall risk is controllable
* Clearing and settlement, accounts receivable and payable and profit distribution
The overall risk appetite is conservative , I hope to bear almost no contract risk, and to bear controllable and impermanent losses, and do not want to bear any liquidation losses, so it will:
* Mining in mature mining pools, such as Compound, Sushiswap, to minimize contract technical risks
* Hedging impermanent losses and reducing exposure
* Excess pledge and real-time monitoring to avoid liquidation
For example, the first-phase DeFi mining fund team raised 5 million USDT (assuming 1 ETH=2500 USDT at that time), and the goal is to enter Sushiswap’s ETH-USDT mining pool for liquidity mining. The funds are divided into the following share:
Mortgage loans can also be used here. Because of the premium of futures, USDT is generally used to exchange currency for futures hedging. If you use currency to exchange USDT, it is more recommended to use mortgage lending. If you only raise ETH, you can go to MakerDao or a centralized mortgage lending platform to exchange DAI, and then use ETH+DAI to mine Uniswap.
1. Monitor net worth, exposure, and leverage
2. Hedging impermanence losses after exposure reaches a certain threshold
3. After the leverage reaches a certain threshold, it will cover or reduce the position
4. Farming’s realized income and unrealized income are included in the net value of the fund’s basic assets and presented to investors
Tools used for DeFi mining
There are already DeFi aggregator tools in the market, which provide mining suggestions through open market data, or read the wallet in the blockchain address, and list a few common websites:
DeFiPulse, APY999 , summarize the market interest rate level, and guide asset allocation;
Debank, DeFiBox , summarize the basic analysis of the market, and provide address-based DeFi asset reading;
Messari , a comprehensive website, including research and on-chain data aggregation;
The above-mentioned website is a very useful public tool, but it is not enough for institutional investors. While 1Token provides a more comprehensive solution for institutions, the institutional functions of DeFi mining on the asset side can be summarized as the following 3 points:
1. Comprehensive bookkeeping and flexible clearing and settlement from the capital end to the asset end
Funding side <br>The share of funds entered by different investors in different periods;
Graded funds (priority / inferior);
Record and calculation of various cost items;
Real-time profit and loss analysis and time-sharing clearing and settlement income.
On the asset side <br>just need to bind the DeFi address (public key) to monitor the asset status and impermanent losses on DeFi in real time, as well as the hedging positions and assets of the centralized exchange;
Combine DeFi and centralized exchange assets, even external allocations or mortgage loans, to calculate profit and loss based on the initial capital investment, and finally calculate the revenue share based on complex clearing and settlement terms.
2. Risk control of various assets, especially DeFi assets
* The risk of liquidation in futures-spot hedging accounts;
* The pledge rate risk and warning of a single coin mining pool;
* AMM mining causes impermanent losses and currency exposure due to currency price fluctuations;
* Consider the exposure after hedge against impermanence;
* Real-time and expected profit and loss, net worth at the time of exit, based on real-time currency prices and positions;
3. Transaction execution / smart algorithm hedging tool
* On the trigger risk control threshold, an alarm is issued for the manager to manually hedge, or set the hedging conditions/threshold to intelligently hedge on the contract or spot of the centralized exchange (parameters can be adjusted, automatic/semi-automatic operation). For example, the Delta exposure threshold of the currency, after reaching the threshold, hedge all the Delta exposure, or hedge a part, or delay x minutes/hour (to avoid unnecessary repeated hedging in the “pin” market);
* 1Token also provides back-testing services based on historical data. According to the expectations of future market trends, back-testing of different parameters is carried out to ensure that customers can select the most appropriate parameters under various market conditions;
In short, 1Token from the capital end to the asset end, covering the front-middle-back office , provides comprehensive services for financial institutions that use DeFi mining as the asset end, so that investors can see the investment share and unrealized profit and loss in real time, and the manager has a clear view of all asset portfolios. Understand the conditions and risks, and fully control the loss of impermanence and liquidation of liquidation.
1Token provides one-stop system solutions for various encrypted financial institutions
The 1Token CAM system provides front-, middle- and back-office software system support for medium and large financial institutions in the global currency circle. At present, the leading financial institutions in the domestic field, such as the FOF/MOM fund of Bixin, the FOF/MOM fund of Matrixport, the asset management business of FBGOne, the quantitative trading fund of BitLink, the multi-strategy fund of the United States and Europe, the FOF/MOM or the main Brokers PB are all clients of the 1Token CAM system.
The CAM system has three coverages:
Covers various institutions, including currency circle buyers, sellers and custodian banks . Specific business lines such as wealth management/asset management, DeFi miners, FOF/MOM, PB, structured product sellers, lending platforms, mining pools, institutional miners, manual/quantitative funds, OTC liquidity providers, etc.;
Cover all major modules , including trading, clearing, risk control, quotation, transfer/wallet, authority module, etc.;
Covers various types of assets in the currency circle , including funds, (structured) derivatives, lending/allocation, Defi mining, computing power/mining machines, etc., as well as traditional securities and derivatives assets.
In terms of breadth:
The 1Token team has experience in the development of systems such as lending, capital allocation, and derivatives in the traditional market, and has experience in systems such as quantitative funds, institutional brokerages, and institutional miners in the currency circle. Scivantage (acquired by refinitiv), the company where the 1Token core team previously worked, is a well-known financial system provider in the traditional American market. Its services include Bank of America, Deutsche Bank, vanguard, Scottrade and other well-known seller institutions serving traditional markets. Through the accumulation of nearly 10 years, the 1Token system module covers the front, middle and back-end modules of various assets, and can quickly support the customization of needs.
From the perspective of depth: +1Token’s self-use brokerage system and quantitative fund system (multiple sets of different DeFi quantitative strategies) have carried an average daily trading volume of 1 billion RMB+ for 3 consecutive years, with a peak value of 5 billion RMB+, which fully illustrates the system’s Robustness.
Considering that 1Token CAM’s customers are basically medium and large financial institutions and are very concerned about data security, the system supports localized deployment, protects the privacy of data, and uses a separate module to store sensitive information such as api keys.