Under the DeFi tide, how should crypto financial institutions steadily dig money?
The growing volume and variety of DeFi projects provide very good interest-earning assets for encrypted 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 (also known as DeFi yield farming, or DeFi mining) in the decentralized market. Blockchain’s “smart contract” lock-up digital currency is provided to the market as liquidity 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. Earlier centralized trading platforms such as FCoin have had order book liquidity mining. Users who place orders in the market are given certain token rewards 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 borrowed coins can receive COMP token rewards.
The value of token rewards exceeds the loan-to-lending gap in the early 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. Due to its generally higher yields, many loan projects and liquid mining projects have emerged one after another. Initially, they will provide annual mining incentives of more than 1000%. After the mature 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 has 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, etc., which 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/fixed 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-to-deposit coin mining comes from borrowing. The fund provider collects interest, and the lender pays the interest. The income of LP comes from the interest of the loan.
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 that repeatedly obtains loan and 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, 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 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) is mentioned here, which is that when the token price deviates from the initial price when liquidity 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, to 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 (does 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 expectation is higher. 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 operation 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 is that it is convenient, one-stop service is completed and the income is 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 impermanence 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 be able to 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 beautiful 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 various agreements on the market for users and obtain assets with the best interest rates currently (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 risks, the DeFi risks that everyone mainly talked about are liquidation and impermanent loss risks. The following table sorts out the risk sources of different mining agreements:
Liquidation risk: Different agreements have different liquidation risks, which generally appear in pledged 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 loan agreement, AAVE mechanism, is differentiated according to 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, leave as much margin as possible in the pledge rate, and monitor the pledge rate in each lending agreement in real time to reinsure in a timely manner to avoid liquidation.
Impermanence loss: Impermanence loss is the public enemy of DeFi AMM farming, which was briefly introduced in the previous article. Let us first make a quantitative analysis and compare Uniswap V2 (the classic constant constant formula) and the current 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 impermanent loss.
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 loss, 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 hedging strategy is to set risk control parameters such as exposure, or the threshold of currency price rise and fall, and automatically run hedging strategies on centralized exchanges according to the positions in the DEX. The hedging strategy is generally divided into three steps:
1. Forecast the future market trend (in the next mining cycle, the currency price will fluctuate roughly in which range, and what the highest and lowest points may be);
2. Backtest based on the expected trend of the market, set Determine the parameters of the automatic hedging strategy;
3. Design corresponding measures when the market trend exceeds 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, 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;
The asset side has a variety of inputs, depending on the nature of the funds to invest in various different mining sites, 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, receivables and payables, and profit distribution
The overall risk appetite is conservative, I hope to bear almost no contract risk, and bear controllable and impermanent losses, and do not want to bear any liquidation losses, so I will:
* Go to mature mining pools for mining, such as Compound, Sushiswap, and 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 futures premiums, 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 for DAI, and then use ETH+DAI to mine Uniswap.
1. Monitoring net worth, exposure, and leverage
2. Hedging impermanent losses after exposure reaches a certain threshold
3. Covering or
reducing positions after leverage reaches a certain threshold 4. Farming realized and unrealized gains are calculated based on the fund’s basic assets Enter the net worth and present it 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, aggregate market interest rates 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
The capital end
of the fund share of different investors in different periods;
tiered funds (priority / inferior);
various cost item records and calculations;
real-time profit and loss analysis and share time clearing and settlement income.
The asset side
only needs 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, and even external Capital allocation or mortgage lending, combined with the initial capital investment to calculate the profit and loss, and finally calculate the revenue share based on the complex clearing and settlement terms.
2. Risk control of various assets, especially for DeFi assets
* The risk of liquidation of futures-spot hedging accounts;
* The pledge rate risk and warning of a single currency mining pool;
* AMM mining causes impermanent losses and currency splits due to currency price fluctuations the exposure;
* considered in conjunction exposure after hedging loss of impermanence;
* Real-time profit and loss and the expected exit time, fund, based on real-time currency prices, positions;
3. Transaction execution / smart algorithm hedging tool
* On the triggering risk control threshold, an alarm is issued for the manager to manually hedge, or set the hedging conditions/threshold to smart hedge on the contract or spot of the centralized exchange (parameters can be adjusted and automated / Semi-automated operation). For example, the Delta exposure threshold of a currency, after reaching the threshold, hedge all of the Delta exposure, or hedge a part, or delay x minutes/hour (to avoid unnecessary repeated hedging in the “pin” market);
* 1Token At the same time, it provides back-testing services based on historical data. According to the expectations of future market trends, back-testing of different parameters is performed to ensure that customers can select the most appropriate parameters under various market conditions;
In short, 1Token covers the front-middle-back office from the capital end to the asset end, and 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 situation 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 funds of the United States and Europe, FOF/MOM or the main Brokers PB are all clients of the 1Token CAM system.
The CAM system has three coverage:
covering 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.;
covering all major modules, including Transaction, clearing, risk control, quotation, transfer/wallet, authority module, etc.;
covering all major 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:
1Token team has experience in the development of systems such as lending, capital allocation, and derivatives in the traditional market, and 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 the customers of 1Token CAM are basically medium and large financial institutions, they are very concerned about data security, so the system supports localized deployment, protects the privacy of data, and uses a separate module to store sensitive information such as api key.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/under-the-defi-tide-how-should-crypto-financial-institutions-steadily-dig-money/
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