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diff --git a/src/_posts/2021-06-07-adventures-in-defi.md b/src/_posts/2021-06-07-adventures-in-defi.md new file mode 100644 index 0000000..f5a5879 --- /dev/null +++ b/src/_posts/2021-06-07-adventures-in-defi.md @@ -0,0 +1,271 @@ +--- +title: >- + Adventures In DeFi +description: >- + There and Back Again, a Yield Farmer's Tale. +--- + +It's difficult to be remotely interested in crypto and avoid the world of +decentralized finance (DeFi). Somewhere between the explosion of new projects, +implausible APY percents, complex tokens schemes, new phrases like "yield +farming" and "impermanent loss", rug pulls, hacks, and astronomical ethereum +fees, you simply _must_ have heard of it, even in passing. + +In late November of 2020 I decided to jump in and see what would happen. I read +everything I could find, got as educated as I could, did some (but probably not +enough) math, and got to work. Almost immediately afterwards a giant bull +market hit, fees on ethereum shot up to the moon, and my little yield farming +DeFi ship was effectively out to sea. + +For the past 200 days I haven't been able to tweak or withdraw any of the DeFi +positions I made, for fear of incurring so many ethereum fees that any gains I +made would be essentially wiped out. But the bull market is finally at a rest, +fees are down, and I'm interested in what the results of my involuntary +long-term experiment were. Before getting to the results though, let's start at +the beginning. I'm going to walk you through all the steps I took, as well as my +decision making process (as flawed as it surely was) and risk assessments. + +## Step 1: The Base Positions + +My first step was to set aside some ETH and BTC for this experiment. I was (and +remain) confident that these assets would acrue in value, and so wanted to hold +onto them for a long period of time. But while holding onto those assets, why +not make a little interest on them by putting them to use? That's where DeFi +comes in. + +I started with 2.04 ETH and 0.04 BTC. The ETH existed as normal ETH on the +ethereum blockchain, while the 0.04 BTC I had to first convert to [renBTC][ren]. + +renBTC is an ethereum token whose value is pinned to the value of BTC. This is +accomplished via a decentralized locking mechanism, wherein real BTC is +transferred to a decentralized network of ren nodes, and they lock it such that +no individual node has access to the wallet holding the BTC. At the same time +that the BTC is locked, the nodes print and transfer a corresponding amount of +renBTC to a wallet specified in the BTC transaction. It's a very interesting +project, though the exact locking mechanism used was closed-source at the time I +used it, which concerned me somewhat. + +[ren]: https://renproject.io/ + +### Step 1.5: Collateralization + +In Step 2 I deposit my assets into liquidity pools. For my renBTC this was no +problem, but for my ETH it wasn't so simple. I'll explain what a liquidity pool +is in the next section, but for now all that needs to be known is that there are +no worthwhile liquidity pools between ETH and anything ostensibly pinned to ETH +(e.g. WETH). So I needed to first convert my ETH into an asset for which there +are worthwhile liquidity pools, while also not losing my ETH position. + +Enter [MakerDAO][makerdao]. MakerDAO runs a decentralized collateralization app, +wheren a user deposits assets into a contract and is granted an amount of DAI +tokens relative to the value of the deposited assets. The value of DAI tokens +are carefully managed via the variable fee structure of the MakerDAO app, such +that 1 DAI is, generally, equal to 1 USD. If the value of the collateralized +assets drops below a certain threshold the position is liquidated, meaning the +user keeps the DAI and MakerDAO keeps the assets. It's not dissimilar to taking +a loan out, using one's house as collateral, except that the collateral is ETH +and not a house. + +MakerDAO allows you to choose, within some bounds, how much DAI you withdraw on +your deposited collateral. The more DAI you withdraw, the higher your +liquidation threshold, and if your assets fall in value and hit that threshold +you lose them, so a higher threshold entails more risk. In this way the user has +some say over how risky of a position they want to take out. + +In my case I took out a total of 500 DAI on my 2.04 ETH. Even at the time this +was somewhat conservative, but now that the price of ETH has 5x'd it's almost +comical. In any case, I now had 500 DAI to work with, and could move on to the +next step. + +[makerdao]: https://makerdao.com/ + +## Step 2: Liquidity Pools + +My assets were ready to get put to work, and the work they got put to was in +liquidity pools (LPs). The function of an LP is to facilitate the exchange of +one asset for another between users. They play the same role as a centralized +exchange like Kraken or Binance, but are able to operate on decentralized chains +by using a different exchange mechanism. + +I won't go into the details of how LPs work here, as it's not super pertinent. +There's great explainers, like [this one][lp], that are easy to find. Suffice it +to say that each LP operates on a set of assets that it allows users to convert +between, and LP providers can deposit one or more of those assets into the pool +in order to earn fees on each conversion. + +When you deposit an asset into an LP you receive back a corresponding amount of +tokens representing your position in that LP. Each LP has its own token, and +each token represents a share of of the pool that the provider owns. The value +of each token goes up over time as fees are collected, and so acts as the +mechanism by which the provider ultimately collects their yield. + +In addition to the yield one gets from users making conversions via the LP, LP +providers are often also further incentivized by being granted governance tokens +in the LPs they provide for, which they can then turn around and sell directly +or hold onto as an investment. These are usually granted via a staking +mechanism, where the LP provider stakes (or "locks") their LP tokens into the +platform, and is able to withdraw the incentive token based on how long and how +much they've staked. + +Some LP projects, such as [Sushi][sushi], have gone further and completely +gamified the whole experience, and are the cause of the multi thousand percent +APYs that DeFi has become somewhat famous for. These projects are flashy, but I +couldn't find myself placing any trust in them. + +There is a risk in being an LP provider, and it's called ["impermanent +loss"][il]. This is another area where it's not worth going into super detail, +so I'll just say that impermanent loss occurs when the relative value of the +assets in the pool diverges significantly. For example, if you are a provider in +a BTC/USDC pool, and the value of BTC relative to USD either tanks or +skyrockets, you will have ended up losing money. + +I wanted to avoid impermanent loss, and so focused on pools where the assets +have little chance of diverging. These would be pools where the assets are +ostensibly pinned in value, for example a pool between DAI and USDC, or between +renBTC and WBTC. These are called stable pools. By choosing such pools my only +risk was in one of the pooled assets suddenly losing all of its value due to a +flaw in its mechanism, for example if MakerDAO's smart contract were to be +hacked. Unfortunately, stable pools don't have as great yields as their volatile +counterparts, but given that this was all gravy on top of the appreciation of +the underlying ETH and BTC I didn't mind this as much. + +I chose the [Curve][curve] project as my LP project of choice. Curve focuses +mainly on stable pools, and provides decent yield percents in that area while +also being a relatively trusted and actively developed project. + +I made the following deposits into Curve: + +* 200 DAI into the [Y Pool][ypool], receiving back 188 LP tokens. +* 300 DAI into the [USDN Pool][usdnpool], receiving back 299 LP tokens. +* 0.04 renBTC into the [tBTC Pool][tbtcpool], receiving back 0.039 LP tokens. + +[lp]: https://finematics.com/liquidity-pools-explained/ +[il]: https://finematics.com/impermanent-loss-explained/ +[sushi]: https://www.sushi.com/ +[curve]: https://curve.fi +[ypool]: https://curve.fi/iearn +[usdnpool]: https://curve.fi/usdn +[tbtcpool]: https://curve.fi/tbtc + +## Step 3: Yield Farming + +At this point I could have taken the next step of staking my LP tokens into the +Curve platform, and periodically going in and reaping the incentive tokens that +doing so would earn me. I could then sell these tokens and re-invest the profits +back into the LP, and then stake the resulting LP tokens back into Curve, +resulting in a higher yield the next time I reap the incentives, ad neaseaum +forever. + +This is a fine strategy, but it has two major drawbacks: + +* I don't have the time, nor the patience, to implement it. +* ETH transaction fees would make it completely impractical. + +Luckily, yield farming platforms exist. Rather than staking your LP tokens +yourself, you instead deposit them into a yield farming platform. The platform +aggregates everyone's LP tokens, stakes them, and automatically collects and +re-invests incentives in large batches. By using a yield farming platform, +small, humble yield farmers like myself can pool our resources together to take +advantage of scale we wouldn't normally have. + +Of course, yield farming adds yet another gamification layer to the whole +system, and complicates everything. You'll see what I mean in a moment. + +The yield farming platform I chose was [Harvest][harvest]. Overall +Harvest had the best advertised APYs (though those can obviously change on a +dime), a large number of farmed pools that gets updated regularly, as well as a +simple interface that I could sort of understand. The project is a _bit_ of a +mess, and there's probably better options now, but it was what I had at the +time. + +For each of the 3 kinds of LP tokens I had collected in Step 2 I deposited them +into the corresponding farming pool on Harvest. As with the LPs, for each +farming pool you deposit into you receive back a corresponding amount of farming +pool tokens which you can then stake back into Harvest. Based on how much you +stake into Harvest you can collect a certain amount of FARM tokens periodically, +which you can then sell, yada yada yada. It's farming all the way down. I didn't +bother much with this. + +[harvest]: https://harvest.finance + +## Step 4: Wait + +At this point the market picked up, ethereum transactions shot up from 20 to 200 +gwei, and I was no longer able to play with my DeFi money without incurring huge +losses. So I mostly forgot about it, and only now am coming back to it to see +the damage. + +## Step 5: Reap What I've Sown + +It's 200 days later, fees are down again, and enough time has passed that I +could plausibly evaluate my strategy, I've gone through the trouble of undoing +all my positions in order to arrive back at my base assets, ETC and BTC. While +it's tempting to just keep the DeFi ship floating on, I think I need to redo it +in a way that I won't be paralyzed during the next market turn, and I'd like to +evaluate other chains besides ethereum. + +First, I've unrolled my Harvest positions, collecting the original LP tokens +back plus whatever yield the farming was able to generate. The results of that +step are: + +* 194 Y Pool tokens (originally 188). +* 336 USDN Pool tokens (originally 299). +* 0.0405 tBTC Pool tokens (originally 0.039). + +Second, I've burned those LP tokens to collect back the original assets from the +LPs, resulting in: + +* 215.83 DAI from the Y Pool (originally 200). +* 346.45 DAI from the USDN Pool (originally 300). +* 0.0405 renBTC from the tBTC Pool (originally 0.04). + +For a total DAI of 562.28. + +Finally, I've re-deposited the DAI back into MakerDAO to reclaim my original +ETH. I had originally withdrawn 500 DAI, but due to interest I now owed 511 +DAI. So after reclaiming my full 2.04 ETH I have ~51 DAI leftover. + +## Insane Profits + +Calculating actual APY for the BTC investment is straightforward: it came out to +about 4.20% APY. Not too bad, considering the position is fairly immune to price +movements. + +Calculating for ETH is a bit trickier, since in the end I ended up with the same +ETH as I started with (2.04) plus 51 DAI. If I were to purchase ETH with that +DAI now, it would get me ~0.02 further ETH. Not a whole heck of a lot. And that +doesn't even account for ethereum fees! I made 22 ethereum transactions +throughout this whole process, resulting in ~0.098 ETH spent on transaction +fees. + +So in the end, I lost 0.078 ETH, but gained 0.0005 BTC. If I were to +convert the BTC gain to ETH now it would give me a net total profit of: + +**-0.071 ETH** + +A net loss, how fun! + +## Conclusions + +There were a lot of takeaways from this experiment: + +* ETH fees will get ya, even in the good times. I would need to be working with + at least an order of magnitude higher base position in order for this to work + out in my favor. + +* I should have put all my DAI in the Curve USDN pool, and not bothered with the + Y pool. It had almost double the percent return in the end. + +* Borrowing DAI on my ETH was fun, but it really cuts down on how much of my ETH + value I'm able to take advantage of. My BTC was able to be fully invested, + whereas at most half of my ETH value was. + +* If I have a large USD position I want to sit on, the USDN pool on its own is + not the worst place to park it. The APY on it was about 30%! + +I _will_ be trying this again, albeit with a bigger budget and more knowledge. I +want to check out other chains besides ethereum, so as to avoid the fees, as +well as other yield mechanisms besides LPs, and other yield farming platforms +besides Harvest. + +Until then! |