The DeFi Learning Curve: Investing on the Ethereum Mainnet
Can crypto-coins really be called currencies? Fundamentally, a currency is any form of money that can be used as a medium of exchange. Today, crypto coins, like an ETH or BTC, are primarily used for investment purposes rather than a medium for payments and exchange of goods. The transition of crypto coins from an asset class to a currency is a gradual one. But in this process, decentralized finance, or DeFi, acts as a catalyst.
I spent the last 3 weeks trying to understand what DeFi is and how it works. After trying out applications on 4 different chains, making a ton of mistakes, losing a lot of money, and eventually recovering it, I’ve gained some critical insights about each stage of the DeFi learning curve, which I’ve shared in this article.
Setting the context
Before describing the experience, it’s important to understand what DeFi is. Traditional finance has a lot of use cases today, e.g. lending, foreign exchanges, derivatives, etc. Similarly, there are three pillars and use cases in DeFi:
- Staking: This is the process of committing and locking in your cryptocurrencies in order to have a stake in the verification process of a blockchain. For any proof-of-stake (PoS) blockchain, say Ethereum, the probability of an individual to get designated for verifying transactions on a blockchain is proportional to the amount of Ethereum (s)he has staked. For verifying transactions on the blockchain, the individual is rewarded with a transaction/gas fee charged on each transaction which translates to an annual percentage rate (APR) ranging from 4 to 10% depending on the blockchain network.
- Liquidity Mining: Just like traditional finance has the FX exchange, decentralized finance has decentralized exchanges (DEX, not to be confused with centralized exchanges like WazirX, CoinDCX, etc.), where users can swap cryptocurrencies in one denominator (say ETH) to another (say DAI). For a decentralized exchange to function, there has to be ample liquidity between 2 denominators (ETH and DAI in this case), so that when demand for ETH-to-DAI swapping is high but the supply of DAI is low, the liquidity pool for the ETH-DAI pair can help compensate DAI to match the demand. Liquidity mining involves supplying token pairs (say ETH/DAI in this case) into their liquidity pool for a DEX. In return, the liquidity providers (LP) are rewarded with an equivalent amount of LP tokens and other governance tokens. Additionally, they earn fees from trades that happen in their pool. Uniswap and Sushiswap are 2 such decentralized exchanges that require liquidity.
- Yield farming: This is the process of locking in crypto assets in protocols for earning passive income. In traditional finance, banks enable users to take loans. DeFi is trying to replace banks by allowing P2P borrowing and lending using protocols such as Maker, Compound, and Aave. Using these protocols, a user can borrow stablecoins (say a USDC) or any other coin of their choice by keeping their crypto assets as collateral (say ETH). Individuals owning USDC tokens can lend them at specified interest rates. Stablecoins serve as a great parking mechanism for investors who want to keep a check on asset volatility. Typical annual yields (APY) earned by lenders vary from 0–10%, depending on token circulation, price, liquidity, etc. All 3 protocols — Maker, Aave, and Dao — have the same offering. However, they have slight differences in their value proposition. Loan-to-value (amount of loan sanctioned to the value of collateral) is highest for Aave and lowest for Maker. This makes Maker a more secure and stable protocol over others. On the contrary, Aave is more borrower-friendly, allowing non-collateralized loans in some cases.
The Learning Curve
For a first-time investor, using any Web3 application may be overwhelming. A new interface, high gas fee, infinite number of protocols, etc. add to the troubles of a new investor. There are several blockchain networks to choose from depending on the gas and transaction fee, variety of DeFi protocols, and safety around transactions.
Although I’ve tried DeFi applications across 4 networks, I’ll keep the discussion limited to DeFi applications on the Ethereum blockchain, since it is the most popular network and leads the TVL of all other networks by a large margin. Typically, a first-time Indian investor would start investing with a small principal amount, say USD250 (~INR 20K).
As an example, I’ll demonstrate the outcome of investing USD 250 in yield farming of USDC, a stablecoin pegged to the value of USD.
Learning DeFi requires a user to cross 4 key learning barriers: A) Using a non-custodial wallet; B) Transferring tokens from Ethereum Mainnet to Polygon Testnet; C) Swapping tokens from one denominator to another; D) Finding and investing in the right yield farming algorithm
Step1: Using a non-custodial wallet
Metamask is the most popular non-custodial wallet for ERC20 tokens. The easy part is installing Metamask on your chrome browser or android phone and storing your 12-word seed in a safe place. The hard part is purchasing or transferring tokens to Metamask.
Although there are several fiat-to-crypto on-ramp solutions available today, like MoonPay or Transak, there are high chances that you’re trying this out in India, where a lot of credit/debit cards are not wired with any of these solutions. When I had tried 3 of my credit/debit cards none of them worked.
The other way to get money into your Metamask or Coinbase wallet is by transferring it from a custodial wallet, like WazirX or Binance.
WazirX charges a fixed fee of 0.01 ETH (approximately USD 25) to withdraw ETH into a non-custodial wallet. So if a first-time investor has a budget of $250 for investment, (s)he would have to pay $25 dollars as a fee to withdraw ETH to their Metamask wallet, essentially crediting $225 worth of Ether (0.09 ETH) in it.
On the other hand, Binance offers a peer-to-peer method to purchase any token, where sellers can transfer tokens to the buyer’s Binance wallet. In return, the buyer must transfer INR to a seller’s Google Pay wallet. In this process, the seller usually sells his tokens for a 9–10% inflated price. Additionally, to transfer tokens from a buyer’s Binance wallet to Metamask, one has to pay a network fee worth approximately $15–20. In this entire process, if an investor starts off with $250, (s)he would end up getting $220-$230 in his/her Metamask wallet.
Step 2: Bridging tokens from Ethereum mainnet to Polygon testnet
Once tokens are credited in Metamask, they are now accessible for DeFi. However, any transactions that you make on the Ethereum mainnet would come at a hefty price. A usual $100-$150 dollars per transaction is charged as gas and network fee. To lower the gas and transaction fee, it’s important to shift tokens from Ethereum’s mainnet to Polygon’s testnet, where the transaction/gas fee is in cents or tens of rupees.
Unfortunately, there’s still one transaction that still cannot be bypassed on the mainnet — the transaction involved in transferring tokens from Ethereum mainnet to Polygon testnet. If you had $225 worth of tokens (0.09 ETH) in your Metamask in the Ethereum testnet, a network fee of $100 (0.04 ETH) would be charged, essentially bridging just $125 worth of tokens (0.05 WETH) to Polygon’s testnet (50% down from the initial amount?!).
Step 3: Swapping tokens from one denominator to another
Now that one’s tokens are on the Polygon testnet, it’s time to bring them in useful form. Yield farming on Ethereum won’t really give good APYs. Hence, it’s important to swap WETH (wrapped ETH on Polygon) with other tokens. This can be done using swapping protocols like Uniswap or Sushiswap. In this example, you could swap $125 worth of WETH with USDC, with a negligible gas fee since the transaction is done on Polygon.
Why USDC? The reason is that USDC is a stablecoin. Stablecoins are cryptocurrencies pegged to the value of a fiat currency. They are less volatile, making it an easier tender to perform any financial transactions with.
As an end result, you should have approximately 125 USDC in your Metamask wallet on the Polygon testnet.
Step 4: Investing in a DeFi protocol
We’re at the last step. Fortunately, there’s no expenditure involved in this phase. Unfortunately, this is where you have to use the majority of your brains. There are plenty of different protocols out there which make use of USDC. Standard yield farming protocols like Compound or Aave have an APY of 0–5%. Then there are high reward yet high-risk instruments like dHEDGE which has exotic strategies like SNX Debt Mirror having a 20–30% 3-month return rate. dHEDGE allows an investor to mirror the strategy of top-performing crypto investors with complete transparency. It’s important that every investor does his/her due diligence before investing.
Typically, first-time investors would have the appetite of investing and seeing returns in a span of a 2 month period. The following graph indicates the return (Y) that an investor would make in a 2-month timeframe when (s)he starts off with X USD before all 4 steps. Note that because of the high gas fee on Ethereum and low APY on Aave, users wouldn’t even be able to break even their investments in 2 months.
Takeaways for investors
- DeFi on the ethereum mainnet is a high quantity game. Gas fee would account for 30–70% of your principal amount if you were to start off with a smaller balance. A first-time investor should be ready to spend a few hundred dollars to learn and get used to the Ethereum mainnet.
- To avoid a high gas fee, investors should consider bridging assets to Polygon. While bridging, investors should make sure that they bridge a large amount so that they don’t have to pay a transaction fee again and again in case of bridging small amounts.
- Ethereum does have the maximum number of DeFi apps but Solana, Tezos, and Terra have also created a good ecosystem of DeFi apps. They also offer significantly lower transaction fees. However, first-time users should spend time on the Ethereum network itself in order to build comfort with legacy DeFi apps.
- DeFi is new right now. With time, returns would stabilize at a lower APY. This can be seen in the case of yields generated on Ethereum based protocols (Maker, Aave, Compound). Investors can consider using DeFi apps on newer chains like Solana, Tezos and Terra, which offer higher APYs at the moment due to their limited usage.
- Before investing in any DeFi protocol, investors should do their own due diligence and understand the risks involved.
