Dabbling in DeFi as Bitcoin got Boring

  • Rangebound trading in Bitcoin has seen cryptocurrency traders shift into decentralized finance or DeFi to generate yield 
  • DeFi is not without risks and high or low yields are not indicative of relative risk, investors need to recognize that their pledged cryptocurrency to generate yield is still exposed to high levels of risk 
With Bitcoin saddled within a (relatively) tight trading band, traders betting on volatility for returns have had to look elsewhere and increasingly been drawn to the high stakes game of decentralized finance or DeFi.
 
With annual interest rates from anywhere as high as 12% for stablecoins (cryptocurrencies tied to fiat currencies like the dollar), investors are being lured by the potential for outsized returns in what appears on the surface to be a relatively risk-free way to generate above market yields.
 
“Yield farming,” involves staking or depositing cryptocurrencies, including dollar-based stablecoins in “liquidity pools” that often pay out yields in the DeFi platform’s native token.
 
Many of these DeFi liquidity pools can offer as high as four to five-digit annual interest rates to draw in depositors before the yields inevitably come crashing down.
 
But the complex yield-generating strategies may make many of these DeFi yield-generating strategies unsuited to retail investors, even as more of them enter the market to look for opportunities outside of Bitcoin and even Ether.
 
For some retail investors, the relatively lower returns compared to the rest of the cryptocurrency space, like 12% annual yields, are high enough to entice them in, but low enough that they appear safer.
 
But without a proper understanding of the mechanics of how these yields are generated or paid out, the function of the smart contract into which the deposits are made, or the safety and security of their operation, many investors could expose themselves to what’s been called a “rug pull” where seemingly legitimate-looking DeFi websites are setup to deprive investors of their cryptocurrencies.
 
And because much of those yields are tied to shaky DeFi token issuances that are often the subject of pump-and-dump schemes, the actual realizable yields after catering for swaps back to fiat currencies may be much more muted. 
 
But low yield doesn’t mean low risk either, and just because a liquidity pool promises what appears to be reasonable returns, doesn’t mean that it’s free from poorly designed smart contracts or dubious DeFi tokens susceptible to volatility.
 
To be sure, DeFi strategies are not new and have been around for years, but have gained in popularity recently because of rangebound markets, which can leave intraday traders vulnerable to the dreaded death by a thousand pinpricks as stops keep getting hit all day long.
 
Rangebound markets are risky because all it takes is intraday volatility outside of tightly positioned stops to make everyday a losing day, which is why some professional traders have decided to just sit out and earn interest instead of trying to play the market.
 
And while it may be tempting to allocate some funds into Gemini Earn, the 7.4%-yielding program of regulated cryptocurrency exchange Gemini, which has some US$2 billion in assets, swapping cryptocurrency back to fiat currency entails fees which could whittle away some of those returns especially when investors consider that even junk bonds yield as high as 6.4%. 
 
Yet for those investors who know what they’re doing, they could do worse than DeFi.
 
Whereas in the past, traders waiting for opportunities could do little outside of holding their reserves in non-yielding stablecoins, they now have an opportunity to generate not insubstantial returns on their deposits.
 
And for those who are accustomed to the risks in cryptocurrencies, the arrival of liquidity pools has been somewhat of a godsend. 
 
 

Novum Digital Asset Alpha is a digital asset quantitative trading firm.

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