What should I consider when choosing a DeFi loan agreement? Analysis from annualized interest rate, handling fee and security
Too long to ignore: Many liquid mining projects now rely on DeFi loan agreements. The DeFi lending agreement is regarded as a relatively safe and mature way of using cryptographic assets to create income. As people’s interest in the DeFi protocol grows, we think it’s time to write an article detailing the DeFi lending protocol to help people choose the lending protocol that suits them. This introductory guide compares popular lending platforms on Ethereum in terms of annualized interest rates, handling fees, and security, and explains some important considerations about handling fees.
The DeFi lending agreement allows anyone to lend money without going through KYC, and unlike a centralized exchange, it is impossible for the custodian to take money away.
Although there is a certain degree of risk in investment, many DeFi loan agreements have been in operation for some time and no major accidents have occurred. Facts have proved that these lending agreements are already highly resistant to attacks, have survived severe market turbulence, and can still stand up, and they can also provide an annualized rate of return of about 5%.
Where does the income come from?
Before the more popular lending platforms and in-depth discussion of the important considerations of choosing a lending platform, we must first know where the lending income comes from. As far as the loan agreement is concerned, the loan proceeds come from the borrower.
Each loan agreement provides cryptographic asset loan services and requires the lender to pay interest when repayment. Interest will be paid to savers. Generally, there are more savers (ie, liquidity providers) than lenders, so the loan interest rate is higher.
How to choose a DeFi lending platform
There is no standard answer to this question about how to choose a DeFi loan agreement. Popular protocols such as AAVE, Compound, and dYdX adopt roughly the same model, with the main differences being risks, benefits, and personalized needs. From this perspective, some important considerations can be made.
Annualized rate of return comparison
When discussing loan agreements, people’s first topic is likely to be expected returns. In other words, people want to know how much annualized rate of return the DeFi agreement provides to savers.
The annualized rate of return determines the interest income that savers can expect to receive in one year under other conditions unchanged. The problem is that the annualized rate of return provided by the DeFi agreement fluctuates greatly. Generally speaking, the annualized rate of return is determined by the ratio between deposited funds and loaned funds (that is, the utilization rate of the borrowing pool). If the utilization rate of funds in the borrowing pool is high, the deposit interest rate will rise, which will encourage lenders to inject more liquidity into the borrowing pool, but it will also discourage many lenders.
The ratio between lenders and savers may change daily or even frequently between blocks. For example, in just a few days, the annualized rate of return of BAT tokens on the BAT protocol increased from 0% to 27% due to the introduction of COMP governance tokens by Compound, and then fell to 0%.
The annualized rate of return varies between different agreements and even between different assets, even for highly correlated assets such as stable currencies (DAI/USDC/USDT are all stable currencies anchored to the US dollar).
A better way is to track the annualized rate of return in real time. The Compound website provides historical data graphs of all assets supported by the platform. Of course, historical data cannot allow us to predict the future, but it can provide us with a good reference. (You can also check the historical annualized rate of return of different agreements and assets on defirate.com and loanscan.io.)
Transaction costs and gas fees
As we know, every transaction on Ethereum requires a fee to be paid to miners to ensure the security of the network. The dollar cost of each transaction mainly depends on the following three factors:
Gas consumption: represents the complexity of calculation. The more complex the smart contract, the more gas is required to complete each transaction.
Gas price: The greater the user’s demand for transactions, the higher the gas price. The space of each block is limited, so users must pay a higher gas price to allow their transactions to be packaged into the block.
ETH price: Gas is paid in ETH. If the price of ETH increases, transaction costs will increase.
GasAmountGasPriceEthPrice=transaction_fee
The price of gas and ETH has nothing to do with the DeFi lending agreement. Both depend on the user’s demand for ETH and transactions on the Ethereum blockchain.
The amount of gas consumed to use the platform will vary according to different protocols, different tokens, and even deposit and withdrawal transactions.
Given the gas consumption, multiply the gas consumption by the gas price and the ETH price to calculate the transaction price. In order to compare the AAVE, Compound and dYdX protocols fairly, we calculated the average amount of gas consumed by a single deposit transaction (lending) and a single withdrawal transaction (withdrawal) of each protocol based on the transaction history of Ethereum.
Among them, whether it is a deposit transaction or a withdrawal transaction, the transaction cost of each asset on the dYdX protocol is the lowest. Compound’s ETH deposit transaction fee is the lowest, and the withdrawal transaction cost of all assets on AAVE is much higher than other transactions.
The price displayed by the wallet usually slightly overestimates the actual amount of gas consumed for a successful transaction. In order to estimate more accurately, we looked at the historical data of the transaction gas caps of several popular tokens on these three protocols. The specific results can be viewed in our data board on Dune Analytics (account opening required). Some key conclusions are as follows:
The handling fee for DAI deposit transactions is the highest on Compound and the lowest on dYdX.
In most use cases, the cost of using the AAVE protocol is higher than other lending protocols. dYdX is the most consistent protocol, and the amount of gas consumed for the deposit and withdrawal of tokens is almost the same. Compound has the lowest cost in ETH deposit transactions, and the cost of USDT deposit and withdrawal transactions is lower than AAVE (dYdY does not provide USDT lending pool).
Calculation
Before deciding whether to participate in lending, you must first calculate an account. You need to make the right choice based on the current annualized rate of return of each agreement, current market price, lock-up time and minimum pledge amount requirements.
For example, we want to deposit USDC on dYdX, because the miner fee for a single transaction is the lowest and the current annualized rate of return is the highest. Assume that the annualized rate of return is stable at 5%, the price of ETH is stable at $400, and the price of gas reaches 50 GWei due to network congestion. First, we calculate the gas fee for deposit and withdrawal transactions.
According to the table data, the total amount of gas required to deposit and withdraw USDC on dYdX is:
188,784+210,934=~400,000 Gas
Given that the price of ETH is 400 USD, multiply the total amount of gas by 50GWei (50*10^-9 ETH) to get:
5010^-9 ETH/GAS400,000 GAS*400$/ETH=$8
Considering the handling fee, we should lend at least X*0.05>$8, which is US$160, in order to guarantee the return after one year. Of course, these parameters may change. Gas prices are highly volatile, and ETH prices and annualized returns also change every day. The advantage is that the gas fee is almost independent of the amount of funds deposited. Regardless of whether it is a deposit of $100 or $100,000, the fees charged by the Ethereum network are the same.
safety
Security is an important factor when choosing a protocol. Running on the blockchain does not mean that these DeFi protocols are absolutely secure. In the final analysis, all these contracts that drive the operation of the agreement are just software, and any software may have loopholes that can lead to the loss of user funds or the complete collapse of the agreement.
A recent example is the bZx Fulcrum platform, where a contract bug caused users to lose 350,000 US dollars. When an incident occurs, the agreement can only be completely suspended, and withdrawals and deposits are not allowed. (Insert a sentence: The CEO of Compound at the time criticized the bZx platform for copying Compound’s code without understanding.)
Like all financial services, as users, it is necessary to know whether these lending platforms have accumulated positive reviews and are reliable. AAVE, Compound and dYdX have all undergone code audits by well-known security companies. Several platforms have also received more than one audit. Although auditing is not a security guarantee, because the code may still be flawed, if it has not been audited, then there is a question mark whether the protocol is reliable at all.
Another important security factor to consider is whether a single entity is in control of these contracts, who holds the control key, and whether there is a refund service if funds are lost. Sometimes these factors are difficult to fully understand, but users should not give up due diligence. This is especially true for large savings users.
Recently, Gauntlet and Defipulse jointly launched a safety index, first analyzing Compound and AAVE. The safety index is based on internal simulations performed by Garuntlet, which simulates a variety of market conditions and network conditions. The purpose of the safety index is to determine the possibility of each agreement (after encountering even severe challenges such as “Black Thursday”) that can remain solvency. This index is not a constant number, nor does it take all risk points into consideration, but it is also a usable tool when making investments.
Not all platforms support the same multiple types of tokens. In our test, dYdX is the best performer in terms of fees, but it only supports USDC, DAI and ETH. The types of tokens supported by AAVE and Compound are larger and comprehensive. For example, UNI tokens can now be borrowed on Compound, but if you want to borrow KNC, you can only use AAVE.
On ZenGo, we have recently added a variety of well-known DeFi tokens to our list of supported assets, including the aforementioned AAVE, UNI (users can also buy and trade), and KNC tokens. ZenGo Savings also integrates the Compound protocol, so all the assets supported by Compound can be used in Savings, which is very simple and safe, and you can also earn COMP tokens.
Finally, if this guide does not include Year, it would be incomplete. Yearn is a set of protocols developed by senior smart contract developer Andre Cronje, which has brought many surprises to everyone. Yearn’s YFI token was recently added to ZenGo’s list of supported assets.
When the agreement was first born, it appeared as a yield aggregator for lending agreements. It was intended to help users maximize the annualized return on savings on different DeFi lending platforms. It does not rely on manual switching of the savings platform, but puts all the funds in a pool (one pool for each token), and then invests all the funds in the platform that can generate the highest rate of return.
Every time a user interacts with Year, regardless of whether the TA is depositing or withdrawing money, the Year contract will check the annualized rate of return on each platform’s savings (at the time of writing, the platforms covered by Year are dYdX, Compound and AAVE). If the platform that generates the highest rate of return is different from the platform where the funds in the pool are currently located, all funds will be withdrawn and transferred to a more profitable platform.
The current Year’s structure has changed compared to when it was first born, but the principle is the same: put all funds in a pool, and let the contract determine where the money should be placed to generate revenue.
In the future, Year’s coverage may be wider, but it needs to be reminded that for every additional contract, there is an additional layer of complexity and risk. Moreover, because Year is an aggregator, the transaction fee for interacting with it also depends on the underlying protocol used and the complexity of the added contract itself.
Loan agreement is a good way to use cryptocurrency assets to obtain stable income without taking a lot of risk. However, everyone must do their own due diligence to protect their assets and get the most benefit from the investment. So, be sure to keep the following habits:
Understand the historical value of the annualized rate of return paid by the agreement. Although this value cannot be stable, it is still an important indicator.
Think clearly about how much money and how long to invest. Although you can withdraw funds at any time, the fees for withdrawals can be very high.
Understand the security of the agreement and the reputation of the operator.
In the past few months, the handling fee rate has remained high, and it seems that the usage of the network will only increase with the release of more agreements, so it is more cost-effective to invest a larger amount at once.
