How should crypto financial institutions make steady profits amid the DeFi wave?

Original title: "How should crypto financial institutions make steady money in the tide of DeFi?"

Original author: Damen, founder and CEO of 1Token and Bitpnk; Phil, business director of 1Token and Bitpnk

DeFi comes from Decentrapzed Finance in English, and "decentralized finance" in Chinese. DeFi in a broad sense refers to blockchain-based finance, which does not rely on traditional financial institutions such as brokerages, exchanges or banks, but conducts financial activities based on smart contracts on the blockchain.

The narrow understanding of DeFi is liquidity mining (also known as DeFi yield farming, or DeFi mining) in the decentralized market. As a way to earn more digital currencies through the digital currencies held, it provides liquidity to the market through blockchain-based "smart contracts" to lock digital currencies to achieve lending and trading to others. At the same time, as a return for providing liquidity, the depositor (i.e., liquidity provider pquidity Provider, abbreviated as LP) will receive interest or fees and other income.

Liquidity mining itself is not a new thing. In the early centralized trading platforms such as FCoin, there was order book liquidity mining, giving certain token rewards to users who placed orders on 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 the deposit and the borrower of the borrowed currency can get COMP token rewards.

The value of token rewards exceeded the lending difference in the early stage. Users could deposit and borrow a large amount of coins at the same time to obtain token rewards, which attracted a large number of professional users to participate. This was the early DeFi yield farming / DeFi mining. Since then, other subsequent DeFi projects have also proposed innovative plans to improve the liquidity of their ecosystems, such as the well-known YFI, Uniswap, Sushiswap, and Pancakeswap and MDEX that later emerged on other chains.

As mentioned in the previous article "Understanding the Market Structure and Asset Types of Cryptocurrency Institutions in One Article", funds hope to invest in good assets to achieve value-added; assets need more money to achieve the goals they want to achieve. DeFi mining has become one of the mainstream assets in the cryptocurrency circle. Due to its generally high yield, many lending projects and liquidity mining projects have emerged one after another. In the early stage, they will provide mining incentives of more than 1000% annualized, and after maturity, they are generally 10%-50% annualized, far exceeding traditional assets. Projects have developed from Ethereum native chain and Ethereum L2 to BSC and HECO chain; the protocols include COMP and AAVE in the lending direction, Yearn in the aggregation direction, and Uniswap, Sushiswap, MDEX, etc. in the trading direction.

Currently, the total locked value (TVL) of the top 10 DeFi smart contracts has exceeded 50 billion US dollars and is growing. These projects provide very good interest-bearing assets for financial institutions in the cryptocurrency circle that are extremely sensitive to returns and have extremely flexible operating methods.

Basic classification of DeFi mining

Common DeFi mining on the market is mainly divided into single-currency lending 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 order book trading liquidity mining that is expected to appear in the future. The following is an introduction to the 4 main types.

Lending mining (single-currency mining)

Lending mining is similar to depositing money in a bank to obtain current/regular interest, and is considered to be risk-free mining. Risk-free here means that there are no other risks except the technical risks of the mining smart contract itself (the contract is hacked), because the technical risks of the contract are inevitably present in all DeFi protocols.

The interest-bearing model of lending and deposit mining comes from lending, the fund provider collects interest, the lender pays interest, and the LP's income comes from the interest of lending.

Obviously, the advantage of lending mining is that the risk is relatively low, but there is also a corresponding disadvantage of low yield. Therefore, some platforms additionally reward platform coins as LP incentives, such as Compound and other lending protocols.

At the same time, users can perform "nesting doll-style" operations to repeatedly obtain lending and mining income. Generally speaking, lending mining is to deposit coins into the corresponding contract and then continue to obtain income, while some lending protocols will mint tokens by themselves to represent the digital currency deposited by users in the system. For example, if you deposit DAI into Compound, you can get cDAI (i.e. Compound DAI); if you deposit Ethereum into Compound, you can get cETH. Continuing the "nesting doll" operation, you can deposit cDAI into another protocol, which will mint a third token to represent cDAI used to represent DAI, and so on.

This type of operation is particularly common in lending protocols (Curve, Compound, and AAVE). The original intention is to continue to exchange liquidity for the locked part. At the same time, since both deposits and loans have farming incentives, advanced players can cleverly use multiple deposits and loans to obtain multiple interests.

Dual Currency AMM Mining

Liquidity mining based on the automated market maker (AMM) model, the mining method is to deposit two different digital currency funds into the liquidity pool of the decentralized exchange (DEX) to become a liquidity provider. The fund pool provides funds/liquidity support for the trading platform. Other trading users can use the fund pool to exchange/trade tokens and pay handling fees. LP can obtain handling fee compensation and/or platform currency rewards according to their share.

This is the basis for the operation of automated market makers (AMMs). There are several different market maker functions (such as Uniswap V2, Uniswap V3, Balancer V2, Curve V2, etc.), which will not be discussed in detail in this article.

Here we have to mention the concept of impermanent loss, which is the change of the two currencies of the LP assets of the AMM (generally, the number of the two currencies increases and decreases) due to the deviation of the token price from the initial price during liquidity mining on the AMM. If the current assets and initial investment are calculated using a mixed standard (that is, the total LP assets of the AMM are compared with the two initial currencies of the simple hodl), it will be found that the current assets cannot be fully redeemed for the initial investment. This difference is the impermanent loss; the greater the price deviation, the greater the impermanent loss, and if the price returns to the initial price, the current assets and the initial investment are exactly the same, and the impermanent 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 deducting impermanent loss from mining income.
Generally, the currency pairs with smaller expected impermanent loss are the mining pools between USD stablecoin pairs, such as Uniswap's USDC-DAI mining pool, because their theoretical value is 1USD. Empirically (not constituting investment advice), impermanent loss, stablecoin-stablecoin < mainstream coin-mainstream coin (with a certain correlation coefficient) < mainstream coin-stablecoin < non-mainstream coin-stablecoin/mainstream coin (even anti-correlated coins).

For example, Uniswap V3, now a large number of players have entered Uniswap V3, which can provide liquidity within a certain price range. Due to the concentration of funds, the expected return on Farming is higher, which is currently a hot spot for DeFi mining.

Leveraged Mining ("Single Currency" Mining)

The reason why the single currency is quoted here is that the operation method of leveraged mining is to deposit a single currency into leveraged mining protocol A, but the protocol borrows more assets through external lending protocol B to mine the single currency or dual currency mining pool of protocol C to obtain income. This is essentially similar to the leveraged trading logic of centralized exchanges, that is, the protocol borrows more assets for mining or investment by pledging coin A.

For example, borrow another currency on other preferred lending protocols B in the market, match the amount of 2 currencies and deposit them into AMM trading protocol C together, and the income comes from the interest subsidy on lending protocol B and the AMM fee income of protocol C, so as to achieve higher income.

Theoretical rate of return = (Protocol C handling fee income - Lending Protocol B interest expenditure + Lending B interest subsidy) / initial unleveraged principal.

The advantage of leveraged mining is that it is convenient, one-stop service and the income is multiplied. The disadvantage is that users need to bear multiple risks. The first is contract risk: once any of the above A/B/C contracts has problems, leveraged mining will be affected. Second, leveraged mining also has the risk of being liquidated due to excessive debt ratio in lending protocol B. Third, if protocol C is AMM liquidity mining, its impermanent loss will be further amplified by the leverage effect. Therefore, investors must understand the liquidation rules of each protocol before investing funds to avoid losses caused by large fluctuations in assets, and be able to properly hedge after impermanent losses occur. In short, the management cost of leveraged mining is high, and the comprehensive benefits for large funds are not as good as they seem.

For example: Booster, Alpaca, etc.

Aggregator/Machine Gun Pool ("Single Currency" Mining)

The most classic one is Yearn Finance (nicknamed Uncle) launched in 2020. As an aggregator of DeFi interest-bearing services, it can search various protocols on the market for users and obtain assets with the best current interest rates (not necessarily a simple protocol, but a series of operation combinations). Even if the interest rates of these assets change, the smart contract will automatically update the current highest interest rate. Other aggregator projects include the Coinwind aggregator that will appear on other chains later.

Behind high returns, there are naturally higher risks than "bank deposits". 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 aggregated protocol.

Risks and corresponding strategies of DeFi mining

All protocols have technical protocol risks. You can search for keywords such as "DeFi stolen/attacked" in the media to view the relevant risks. Based on past experience, protocols with long running time and large lock-up volume usually have lower technical risks.

In addition to protocol risks, the DeFi risks that everyone talks about are mainly liquidation and impermanent loss risks. The following table summarizes the risk sources of different mining protocols:

Liquidation risk:
Different protocols have different liquidation risks, which generally appear in pledged lending or leveraged protocols. For example, Compound defines the Collateral Factor as 75%, that is, if the pledge rate is lower than 1.33 (that is, LTV is higher than 75%), then Compound will put the collateral on the auction shelf and transfer the debt. The risk of liquidation of another lending protocol, AAVE, varies depending on the currency.

It should be noted that liquidation of DeFi protocols may incur a handling fee of up to 10% of the liquidation value. Therefore, users should take the initiative to prevent risks, keep as much collateral margin as possible, and monitor the collateral ratio in each lending agreement in real time and make up for the margin in time to avoid liquidation.

Impermanent loss:
Impermanent loss is the public enemy of DeFi AMM farming, which has been briefly introduced in the previous article. Let's do a quantitative analysis first, assuming that the handling fee income is not considered, to compare which Uniswap V2 (classic constant formula) and the currently most popular Uniswap V3 have higher impermanent losses. Uniswap V3 refers to the concentration of liquidity to generate greater returns by keeping the price range in a smaller interval, while bringing a higher risk of impermanent loss.

Assuming 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 hybrid basis, the net value of the initial assets based on 10 ETH and 20k USDC is:

From the above example, it can be seen that the level of impermanent loss of the dual-currency AMM mining pool providing liquidity in a certain price range will be multiplied compared to the infinite range, so it is bound to use centralized exchanges for hedging at the same time, and it is necessary to monitor the overall profit and loss and exposure.

For the risk control of impermanent loss, the mainstream method on the market is to hedge Delta by using perpetual/futures/spot on centralized exchanges (such as Binance). The principle of hedging strategy is to set risk control parameters such as exposure, or thresholds for currency price fluctuations, and automatically run hedging strategies on centralized exchanges based on positions in DEX. Hedging strategies are generally divided into three steps:

Predict future market trends (in the next mining cycle, the currency price will fluctuate roughly in which range, and what the highest and lowest points may be);

Set the parameters of the automatic hedging strategy based on the backtest of the expected market trend;

Design corresponding measures when the market trend exceeds expectations;

There are quantitative teams on the market that provide services for hedging impermanent risks. They usually charge a fixed annualized interest or share the net mining income, such as providing quantitative hedging services (whether options or futures perpetual spot hedging) in exchange for an annualized cost of 10-25% of AUM as income.

How institutional investors operate DeFi mining

Institutional investors have the following characteristics:

They have large amounts of funds from various sources, and may have different risk preferences or time period flexibility.

They raise funds in batches, and may only raise funds of a single currency (such as a U-based fund for the first phase, or a single-currency-based fund), and need to balance their positions when entering dual-currency mining.

They have diverse investments on the asset side, and according to the attributes of the funds, they invest in various mining venues, such as single-currency/dual-currency, current/fixed deposits, large-currency/small-currency, U-based/currency-based, etc., and they need to do the following for different types of assets:
* Bookkeeping, with a holistic view of the asset side
* Risk control, to ensure that overall risks are controllable
* Clearing and settlement, accounts receivable and payable, and profit distribution

The overall risk preference is conservative. It is hoped that there will be almost no contract risk and controllable impermanent loss, and no hope of incurring any liquidation loss. Therefore, the following will be adopted: * Mining in mature mining pools, such as Compound and Sushiswap, to minimize contract technical risks * Hedge against impermanent loss and reduce exposure * Over-collateralize and monitor in real time to avoid liquidation

For example, the first phase of the DeFi mining fund team raised 5 million USDT (assuming that 1 ETH=2500 USDT at that time), and aimed to enter the ETH-USDT mining pool of Sushiswap for liquidity mining. The funds were divided into the following parts:

* Mortgage lending can also be done here. Because of the futures premium, USDT is generally used to exchange coins and futures are used for hedging

If you exchange coins for USDT, it is recommended to use mortgage lending. If you only raise ETH, you can go to MakerDao. Or exchange DAI on a centralized mortgage lending platform, and then use ETH+DAI to mine on Uniswap.

Daily needs:
1. Monitor net value, exposure, and leverage
2. Hedge against impermanent loss after exposure reaches a certain threshold
3. Cover or reduce positions after leverage reaches a certain threshold
4. Farming realized and unrealized gains are included in the net value according to the fund's assets and presented to investors

* Schematic diagram of complex DeFi mining capital structure

Tools used for DeFi mining

There are already DeFi aggregator tools on the market that provide mining suggestions through public market data, or read wallets in blockchain addresses. Here are a few common websites:

DeFiPpse, APY999, summarize market interest rate levels and guide asset allocation;
*

Debank, DeFiBox

, summarize basic market analysis and provide address-based DeFi asset reading;
*

Messari

*, a comprehensive website including research and on-chain data aggregation;

The above websites are useful public tools, but they are not enough for institutional investors. 1Token provides a more comprehensive solution for institutions. The institutional functions for DeFi mining on the asset side can be summarized into the following 3 points:

1. Comprehensive accounting and flexible clearing and settlement from the capital side to the asset side

Capital side

The share of funds entered by different investors at different times;
Tiered funds (priority/inferior);
Record and calculate various cost items;
Real-time profit and loss analysis and clearing and settlement of income when sharing.

Asset side

You only need to bind the DeFi address (public key) to monitor the asset status and impermanent loss on DeFi in real time, and the hedging positions and assets of centralized exchanges;
Combine DeFi and centralized exchange assets, even external capital allocation or mortgage lending, calculate profits and losses based on initial capital investment, and finally calculate the income sharing based on complex clearing and settlement terms.

2. Risk control of various assets, especially DeFi assets
* Liquidation risk of futures-spot hedging accounts;
* Pledge rate risk and alarm of single-coin mining pools;
* AMM mining leads to impermanent loss and exposure of different currencies due to coin price fluctuations;
* Exposure after hedging with impermanent loss;
* Profit and loss, net value at real-time and expected exit, based on real-time coin price and positions;

3. Transaction execution/intelligent algorithm hedging tools
* When the risk control threshold is triggered, an alarm is issued for the manager to manually hedge, or hedging conditions/thresholds are set for intelligent hedging on contracts or spots on centralized exchanges (parameters are adjustable, automatic/semi-automatic operation). For example, the Delta exposure threshold of a currency. When the threshold is reached, hedge all Delta exposures, or hedge part of them, or delay for x minutes/hours (to avoid unnecessary repeated hedging in "pin-in" market conditions);
* 1Token also provides backtesting services based on historical data. According to the expectations of future market trends, backtesting of different parameters is carried out to ensure that customers can be advised to select the most appropriate parameters under various market conditions;

In short, 1Token covers the front, middle and back ends from the capital end to the asset end, and fully serves 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 understanding of the status and risks of all assets, and can fully control the impermanent loss and liquidation loss.

1Token provides one-stop system solutions for various crypto financial institutions

1Token CAM system provides front, middle and back end 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 Bixin's FOF/MOM fund, Matrixport's FOF/MOM fund, FBGOne's asset management business, Bitpnk's quantitative trading fund, multi-strategy funds, FOF/MOM or prime brokers PB in the United States and Europe, are all customers of the 1Token CAM system.

CAM system has three coverages:

Covering all kinds of institutions, including buyers, sellers and custodian banks in the currency circle. Specific business lines include 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.;
Covering major modules, including trading, clearing, risk control, quotation, transfer/wallet, permission module, etc.;
Covering all major asset classes in the currency circle, including funds, (structured) derivatives, lending/capitalization, Defi mining, computing power/mining machines, etc., as well as traditional securities and derivative assets.

In terms of breadth:
The 1Token team has experience in developing systems such as lending, capital allocation, and derivatives in the traditional market, and has experience in systems such as quantitative funds, institutional securities firms, and institutional miners in the currency circle.
The company where the 1Token core team previously worked, Scivantage (which has been acquired by Refinitiv), is a well-known financial system provider in the traditional US market, serving well-known sell-side institutions in the traditional market, including Bank of America, Deutsche Bank, Vanguard, Scottrade, etc. Through nearly 10 years of accumulation, 1Token system modules cover all modules of the front, middle and back ends of various assets, and can quickly support customized needs.

In 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 RMB1 billion+ for three consecutive years, with a peak of RMB5 billion+, which fully demonstrates the robustness of the system.

Considering that 1Token CAM’s customers are basically medium-sized and large financial institutions that are very concerned about data security, the system supports localized deployment to protect data privacy, and uses separate modules to store sensitive information such as API keys.

References
https://defippse.com/
https://debank.com/
https://decentyields.com/impermanent-loss-calcpator
https://defi-lab.xyz/uniswapv3simpator
https://docs.aave.com/faq/pquidations
https://compound.finance/markets/USDC
https://app.uniswap.org/#/pool
https://v1.yearn.finance/earn
https://1token.trade/

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