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Yield farming in Decentralized Finance (DeFi) has long been a high-risk endeavor with high rewards. However, steep risks may also dampen investor confidence, and prevent new entrants from entering the space. DeFi players should consider putting into place effective measures to address this in preparation for the next wave of DeFi growth.
It was 2020 when DeFi Summer officially took off. Thanks to the likes of Compound, MakerDAO and Uniswap helping to catapult the market, DeFi has become a significant crypto segment attracting attention from the incumbent financial market. While more engineers upgrade and strengthen the current architecture of products and protocols, we’re also witnessing greater participation by mainstream institutions.
Recent examples include the world’s largest asset manager, BlackRock adding crypto services, accounting firm KPMG Canada adding crypto to its balance sheet, and Ontario Teachers Pension Plan investing in crypto investing company FTX. Tesla, not a stranger to Bitcoin, announced that it held nearly $2 billion worth of Bitcoin at the end of 2021, reaffirming its continued belief in Bitcoin’s potential. From what we have seen, it’s likely that financial institutions will continue investing in digital assets throughout 2022. But while more are investing and holding crypto, are they ready to adopt DeFi?
Various solutions have emerged as early responses to the high risk in yield farming. Products like Binance Custody, a Centralized Finance (CeFi) platform delivers a platform that aims to conform to regulatory requirements and could serve as a rite of passage for institutional types entering a high-risk DeFi environment. Institutions ready to dip their toes in DeFi can turn to Aave’s Arc, a permissioned DeFi protocol that is compliant with AML regulations and KYC and KYB verifications. This is however just the tip of the iceberg – a lot more still needs to be done. For the industry to be fully embraced by the mainstream, we need to take steps to ensure the correct entry points are available for yield farming.
Address High-Risk Exposures in Yield Farming to Welcome More Institutions
Yield farming is an attractive investment strategy because it gives users a high return on investment without minimum or high capital requirements. Through smart contracts, capital is placed into a liquidity pool and in return, liquidity providers receive a native reward. However, yield farming is far from accommodative for the uninitiated. It is not common for platforms to cater to different investing profiles, indicate risk levels or provide guidelines on where investors should allocate their capital.
While yield farming may be considered akin to investing in a number of different companies, it brings the possibility of earning more at a quicker pace than possible with traditional companies. So how can we as an industry help to lower the risk, which, in turn, will attract more individuals and institutions to DeFi?
Yield farming: Protocols to Introduce New Revenue Models to Mitigate Risks
The total value locked (TVL) in DeFi protocols sits at just under $200 billion compared to the US stock market’s total market cap at $53 trillion, according to DeFi Llama, indicating that DeFi is very much in its infancy. Its potential to grow into its own financial framework in comparison is significant.
New value in DeFi essentially involves printing “future money” through token emissions, which means the release of new tokens. The more these tokens are acquired by the market, the higher their value increases. This is similar to an equity model whereby if people believe in a company or in this case, a protocol, and what it stands for, more value will be generated. Many protocols today still rely solely on native token emissions, but there are protocols attempting to make DeFi less risky. This is achieved by adopting different revenue models for more stable and consistent returns.
Some of these protocols include Ankr and Tranchess which generate revenue by performing a validator service for the BNB Chain (formerly Binance Smart Chain), on top of executing yield farming strategies. By introducing alternative sources of returns and revenue models, users would be less likely to jump to other protocols due to having confidence from higher value for their investments on the protocol from its focus on growing revenue. This also better shields them from the volatility of DeFi and broader financial market impact.
Both DeFi and TradFi Need to Converge to Remain Relevant
With more financial institutions adopting crypto in some form, we are beginning to see the gradual acceptance of crypto in the mainstream. Yet much of Traditional Finance (TradFi) still operates in a status quo in terms of its offerings to customers. Some have made strides to adopt fintech solutions which provide a more seamless banking experience to a greater number of customers.
However, there is much left to be accomplished. Beyond giving customers better user experiences and exposure to crypto assets, institutions should give users exposure to high yield opportunities through DeFi. As an example, users are able to deposit the UST Stablecoin on Anchor Protocol for 19% Annual Percentage Yield (APY), as opposed to a traditional savings bank account which gives interest rates of under 1%. Introducing the most compelling products would give institutions a competitive advantage and prevent TradFi from becoming like telephone companies of the finance world, unable to provide differentiated and competitive offerings.
On the flip side, the DeFi industry needs to put in concerted efforts to create a new business model mixed with stable and sustainable returns.
Yield farming: Looking Forward
DeFi is here to stay. While new financial investors enter the market, those who have already dipped their toes will continue venturing deeper into new protocols, chains, layer-2 solutions, and tech upgrades.
For this trajectory to be sustainable, DeFi protocols need to de-risk their offerings, strengthen underlying technology and maximize security through audits and other measures (e.g. multi-sig wallet for their treasuries), while TradFi embraces greater but manageable risk as a part of their portfolios. As TradFi and DeFi converge, together they will bring a mix of expertise and experience that pushes progress forward, while being informed by ever-evolving regulations. All of these will assert to the mainstream that DeFi is a viable and valuable option to earn sustainable returns.
About the author
Danny Chong is the co-founder of Tranchess, a decentralized yield-enhancing asset tracker that provides stable and varied high-yield returns for users of different risk capacities. With over 16 years of experience in investment banks, Danny has previously held leading roles in trading, sales and management at prominent French banks including BNP Paribas and Société Générale for the APAC region.
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