Decentralized finance (DeFi) has been in the news a lot lately, but not always for the right reasons.
DeFi projects have the ability to offer people eye-popping yields in excess of 10% per year.
But these projects can be opaque and risky. They often lure investors into scams or poorly constructed protocols.
“Remember that old expression: If it seems too good to be true, it probably is,” said Michael Rosmer, co-founder and CEO of DeFiYield.
DeFiYield offers a product in two parts – one is a security layer for smart contracts to help investors avoid getting scammed or hacked, the other is a cross-chain asset management platform that Rosmer describes as a kind of “Robinhood for crypto.”
“The perspective that I take, as an investor, is that I want to understand what’s going on with the things I put my money into and where the returns are coming from,” Rosmer said.
Even if the projects are credible, they can offer returns that are unsustainable. The super-high yields offered by some of these DeFi projects only exist because they are new and represent just a handful of participants enjoying elevated early returns.
“In DeFi, in some cases, it’s just unsustainable, it’s not going to work out,” Rosmer said. “What’s totally fair is that these yields are not going to last. The super-high yields are short-term yields and things normalize as more participants become involved.”
Let’s look at how DeFi works and why these yields are unsustainable before addressing what red flags to look out for.
Two flavors of yield-generating DeFi
How do decentralized finance projects work?
Imagine trading on a traditional finance exchange. Typically, buyers bidding on securities don’t perfectly match up with sellers asking prices. There are market makers who act in the middle to facilitate trades to make it easier on everyone else.
In decentralized finance, there are automated market makers. Algorithms take on the middleman responsibilities for crypto trading.
In order to generate yield in DeFi, users have a couple of options.
One option is lending. Depositing tokens on a DeFi platform so that they can be loaned out to borrowers is a way for DeFi users to generate yield. Depositors collect regular interest payments from borrowers.
Another option is liquidity pools, which don’t bear direct resemblance to traditional finance.
The way liquidity pools work is that participants deposit two different tokens – say ether (ETH) and tether (USDT) – into a pool. The pool of deposited tokens can then facilitate liquidity for others who want to buy or sell each of the tokens. The people depositing the tokens earn a reward every time a transaction takes place.
“If there are a lot of people trading and not a lot of money deposited into the liquidity pool, the money is being reused time after time and the rewards earned can add up to quite a bit when they’re compounded,” said Rosmer. “Early on, people will get a great return.”
Read more: The Era of Easy DeFi Yields Is Over
Liquidity pools are especially important to new DeFi projects that are trying to create enough liquidity so others can easily trade their tokens.
In these cases, projects will create incentives for early participants in their liquidity pools, literally paying them liquidity tokens that help artificially juice their returns from participating in the project. However, as more people participate over time, the incentives will be withdrawn.
“You’re really bribing people to give some liquidity to allow users to come and swap tokens, and how well it will work in the long term is an interesting conversation,” Rosmer said. “Maybe the incentives will have to change.”
The general trend in DeFi is that returns tend to decline over time as more participants become involved in projects. The more people there are providing liquidity, the greater the distribution of incentives becomes. In other words, decentralized finance projects trend towards more efficiency as they mature.
As investors, we want to exercise appropriate precaution before putting our money into a liquidity vault.
One precaution we want to take is to make sure we know who is launching the protocols where we are getting involved.
Among the first liquidity vaults we may look at are projects like Convex, Balancer and Vancor. They are the blue chips of DeFi. These are big protocols with a lot of participants and the returns aren’t great.
However, when looking elsewhere for higher returns, we have to be careful.
“What happens in DeFi is that anyone can launch a protocol and do so very quickly,” Rosmer said. “Oftentimes they do not show who they are or discuss the project in an open ecosystem, but they do offer great incentives or the potential for large returns.”
This can create opportunities for bad actors to conduct scams. In particular, bad actors can write code into DeFi projects that allows them to siphon off money from the liquidity vault.
One good example of these bad actors is “infinite minting.” This is where a new liquidity token is created with a smart contract that gives them the ability to create an unlimited number of that token. This allows them to go into the project’s vault and trade that liquidity token for all of the ether or USDT in the vault. As the value of the liquidity token goes to zero, the founder of the smart contract absconds with the assets of value.
“There are all kinds of opportunities for people to go and essentially rob unsuspecting investors who don’t know how to read code,” Rosmer said. “People are lured in by the attractive gains and don’t understand what they are getting themselves into.”