How should crypto financial institutions steadily profit in the wave of DeFi?

*This article is sourced from: *ChainNews

Written by: Da Men, Founder and CEO of 1Token and BitLink; Phil, Business Director of 1Token and BitLink
DeFi stands for Decentralized Finance in English, and in Chinese, it is called "去中心化金融". Broadly speaking, DeFi refers to blockchain-based finance that does not rely on traditional financial institutions such as brokers, exchanges, or banks, but rather conducts financial activities through smart contracts on the blockchain.

A narrow understanding of DeFi is liquidity mining (also known as DeFi yield farming or DeFi mining) on decentralized markets. It is a method of earning more digital currency through holding digital currencies by locking them in smart contracts on the blockchain to provide liquidity to the market, enabling lending and trading to others. In return for providing liquidity, the liquidity provider (LP) will earn interest or fees.

Liquidity mining itself is not a new concept; earlier centralized trading platforms like FCoin had order book liquidity mining, rewarding users who placed orders on the order book with certain token incentives to encourage liquidity provision. The recent large-scale explosion of DeFi began in 2020 with Compound's lending liquidity incentive program—both lenders and borrowers can earn COMP token rewards.

The value of token rewards initially exceeded the borrowing spread, allowing users to deposit and borrow large amounts simultaneously to earn token rewards, thus attracting a large number of professional users. This was the early DeFi yield farming / DeFi mining. Since then, other DeFi projects have proposed innovative plans to enhance the liquidity of their ecosystems, such as the well-known YFI, Uniswap, Sushiswap, and later Pancakeswap, MDEX, which emerged on other chains.

As mentioned in the previous article “Understanding the Market Structure and Asset Types of Cryptocurrency Institutions”, funds hope to invest in good assets to achieve appreciation; assets need more money to achieve their goals.

DeFi mining has now become one of the mainstream assets in the cryptocurrency circle. Due to its generally high yields, many lending and liquidity mining projects have emerged, initially offering annualized mining incentives exceeding 1000%, and later stabilizing at 10%-50% annually, far surpassing traditional assets. Projects have evolved from Ethereum's native chain and Ethereum L2 to BSC and HECO chains; protocols include lending-oriented COMP and AAVE, aggregation-oriented Yearn, and trading-oriented Uniswap, Sushiswap, MDEX, etc.

Currently, the total locked value (TVL) of the top 10 DeFi smart contracts has exceeded $50 billion and continues to grow. These projects provide excellent income-generating assets for cryptocurrency financial institutions that are highly sensitive to yields and operate with great flexibility.

I. Basic Classification of DeFi Mining

Commonly seen DeFi mining can be mainly divided into single-coin lending mining, dual-coin AMM mining, "single-coin" leveraged mining, and gun pool mining. Other types include synthetic assets like Synthetix, perpetual contracts on MCDEX, and the anticipated emergence of order book trading liquidity mining, etc. Below are introductions to the four main types.

1. Lending Mining (Single-Coin Mining)

Lending mining is similar to depositing money in a bank to earn interest on demand/fixed deposits and is considered risk-free mining. Here, "risk-free" means there are no other risks apart from the technical risks of the mining smart contract itself (such as being hacked), as technical risks are inevitably present in all DeFi protocols.

The income model of lending mining comes from borrowing and lending, where the fund provider collects interest, and the borrower pays interest. The LP's earnings come from the interest on the loans.

It is evident that the advantage of lending mining lies in its relatively low risk, but it also has the corresponding disadvantage of lower yields. Therefore, some platforms additionally reward platform tokens as LP incentives, such as lending protocols like Compound.

At the same time, users can repeatedly earn lending mining rewards through "nested" operations. Generally, lending mining involves depositing coins into the corresponding contract and continuously earning rewards, while some lending protocols will mint tokens to represent the digital currencies deposited by users in the system. For example, depositing DAI into Compound yields cDAI (i.e., Compound DAI); depositing Ethereum into Compound yields cETH. Continuing the "nested" operations, cDAI can be deposited into another protocol, which will mint a third token to represent cDAI, and so on.

This type of operation is particularly common in lending protocols (Curve, Compound, and AAVE), intended to continue obtaining liquidity from the locked portion, while both depositing and borrowing have farming incentives, allowing advanced players to cleverly use multiple deposits and loans to obtain multiple interests.

2. Dual-Coin AMM Mining

Liquidity mining based on the Automated Market Maker (AMM) model involves depositing two different digital currencies into a decentralized exchange (DEX) liquidity pool to become a liquidity provider. This liquidity pool provides funding/liquidity support for the trading platform, allowing other trading users to exchange/trade tokens and pay fees. LPs can earn fee rewards and/or platform token rewards based on their share.

This is the operational basis of Automated Market Makers (AMM), which are divided into several different market-making functions (e.g., Uniswap V2, Uniswap V3, Balancer V2, Curve V2, etc.), which will not be elaborated on here.

Here, it is important to mention the concept of impermanent loss, which occurs during liquidity mining on AMM due to token prices deviating from their initial prices, causing the LP's assets in the AMM to change (generally, the quantities of the two tokens increase and decrease respectively). If we calculate the current assets and initial investment using a mixed basis (i.e., comparing the total assets of the AMM LP with simply holding the initial two tokens), we will find that the current assets cannot be fully exchanged back to the initial investment, and this difference is the impermanent loss; the greater the price deviation, the greater the impermanent loss. However, if the price returns to the initial price, the current assets and initial investment will be identical, and the impermanent loss will cease to exist.

Of course, considering that AMM has mining income (such as fees), the final DeFi mining profit is the mining income minus the impermanent loss. Generally, it is expected that impermanent loss is smaller for stablecoin pairs, such as the USDC-DAI pool on Uniswap, because their theoretical value is 1 USD. Empirically (not investment advice), the order of impermanent loss is stablecoin-stablecoin < mainstream coin-mainstream coin (with a certain correlation) < mainstream coin-stablecoin < non-mainstream coin-stablecoin/mainstream coin (even inversely correlated tokens).

For example, in Uniswap V3, many players are entering Uniswap V3, providing liquidity within a certain price range. The concentration of funds increases the expected farming returns, making it a hotspot for DeFi mining.

3. Leveraged Mining ("Single-Coin" Mining)

The reason "single-coin" is in quotes here is that the operation of leveraged mining involves depositing a single type of coin into leveraged mining protocol A, but the protocol borrows more assets through external lending protocol B to mine single-coin or dual-coin pools of protocol C for profit. This is essentially similar to the logic of leveraged trading on centralized exchanges, where the protocol stakes coin A and borrows more assets for mining or investment.

For example, borrowing another coin from a preferred lending protocol B in the market, matching the amounts of the two coins, and depositing them into AMM trading protocol C, with profits coming from interest subsidies on lending protocol B and AMM fee income from protocol C, thus achieving higher returns.

Theoretical yield = (Protocol C fee income - Lending protocol B interest expense + Lending B interest subsidy) / Initial non-leveraged principal.

The advantage of leveraged mining lies in its convenience, providing one-stop services while magnifying returns. The downside is that users need to bear multiple risks. First, there is contract risk: if any of the contracts A/B/C have issues, leveraged mining will be affected. Second, there is the risk of liquidation due to excessive debt ratios in lending protocol B. Third, if protocol C is an AMM liquidity mining, its impermanent loss will be further magnified by the leverage effect. Therefore, investors must understand the liquidation rules of each protocol before investing, to avoid losses due to significant asset fluctuations and to properly hedge against impermanent losses. In summary, leveraged mining has higher management costs, and for large funds, the overall benefits may not be as good as they appear.

For example: Booster, Alpaca, etc.

4. Aggregators / Gun Pools ("Single-Coin" Mining)

The most classic example is Yearn Finance (nicknamed Auntie), launched in 2020, which serves as an aggregator for DeFi yield services. It can search various protocols in the market for users and obtain the best current interest rates for assets (not necessarily a single pure protocol, but possibly a series of operational combinations). Even when the interest rates of these assets change, the smart contract will automatically update to reflect the highest current rates. Other aggregator projects include Coinwind aggregators that have emerged on other chains.

High yields naturally come with higher risks than "bank deposits". The main risk of such projects is the risk of DeFi project contracts being attacked or stolen, including both the aggregator protocol itself and the protocols being aggregated.

II. Risks of DeFi Mining and Corresponding Strategies

All protocols carry technical protocol risks, and relevant risks can be searched in the media using keywords like "DeFi hacked / attacked". Based on past experience, protocols that have been running for a long time and have large locked amounts generally have lower technical risks.

Beyond protocol risks, the main DeFi risks discussed are liquidation risks and impermanent loss risks. The table below summarizes the risk sources of different mining protocols:

1. Liquidation Risk: Different protocols have different liquidation risks, generally occurring in staking lending or leveraged protocols. For example, Compound defines a Collateral Factor of 75%, meaning if the collateral ratio falls below 1.33 (i.e., LTV exceeds 75%), Compound will put the collateral up for auction and transfer the debt. Another lending protocol, AAVE, has varying liquidation risks depending on the coin type.

It is important to note that DeFi protocol liquidations may incur fees of up to 10% of the liquidation value. Therefore, users should proactively guard against risks, maintain sufficient collateral ratios, and monitor the collateral ratios of various lending protocols in real-time to avoid liquidation.

2. Impermanent Loss: Impermanent loss is the enemy of DeFi AMM farming, as briefly introduced earlier. Let’s conduct a quantitative analysis to compare the impermanent losses of Uniswap V2 (the classic constant product formula) and the currently most popular Uniswap V3, assuming no fee income is considered. Uniswap V3 aims to concentrate liquidity within a smaller price range to generate greater returns, while also bringing higher impermanent loss risks.

Assuming the current ETH price is $2000, depositing 10 ETH and 20k USDC, when the ETH price drops to $1000 or rises to $3000, assuming a mixed basis calculation based on the net value of the initial assets of 10 ETH and 20k USDC:

From the above example, it can be seen that the level of impermanent loss for dual-coin AMM pools providing liquidity within a certain price range is magnified compared to infinite ranges, thus requiring simultaneous use of centralized exchanges for hedging and monitoring overall profits and exposures.

For controlling the risk of impermanent loss, the mainstream method currently available is to hedge Delta using centralized exchanges (such as Binance) through perpetual/futures/spot trading. The principle of the hedging strategy is to set risk control parameters such as exposure or thresholds for price fluctuations, and automatically execute hedging strategies based on positions in the DEX. The hedging strategy generally consists of three steps:

1. Predicting future market trends (within the next mining cycle, estimating the price range fluctuations, and identifying potential highs and lows);
2. Setting parameters for the automatic hedging strategy based on backtesting of expected market trends;
3. Designing corresponding measures when market trends exceed expectations;

There are quantitative teams in the market providing impermanent loss hedging services, typically charging a fixed annual interest or sharing in the net mining profits, such as offering quantitative hedging services (whether options or futures/spot hedging) in exchange for AUM annualized costs of 10-25% as returns.

III. Operational Methods of Institutional Investors in DeFi Mining

Institutional investors have the following characteristics:

1. Large capital volume with diverse sources, which may require funds with different risk preferences or flexibility in time periods;

2. Fundraising in batches, possibly only raising funds in a single coin (for example, a phase U-based fund or a single coin-based fund), requiring position balancing when entering dual-coin mining;

3. Diverse asset inputs based on the attributes of the funds, investing in various mining venues, single-coin / dual-coin, on-demand / fixed-term, large coins / small coins, U-based / coin-based, etc., and for different types of assets, they need to:
* Keep accounts with a global view of the asset side
* Implement risk control to ensure overall risk is manageable
* Handle settlement, accounts receivable and payable, and profit distribution

4. Overall risk preference is conservative, hoping to bear almost no contract risk and manageable impermanent losses, while not wanting to incur any liquidation losses, thus they will:
* Mine in mature pools, such as Compound and Sushiswap, to minimize technical contract risks
* Hedge against impermanent losses to reduce exposure
* Over-collateralize and monitor in real-time to avoid liquidation

For example, a phase DeFi mining fund team raised 5 million USDT (assuming at that time 1 ETH = 2500 USDT), aiming to enter the ETH-USDT pool on Sushiswap for liquidity mining, with the funds divided as follows:

Collateralized lending can also be done here, as futures are generally at a premium, so USDT is typically used to exchange coins for futures hedging. If using coins to exchange for USDT, it is more advisable to use collateralized lending. If only ETH is raised, one can go to MakerDao or centralized collateralized lending platforms to exchange for DAI, and then use ETH + DAI for mining on Uniswap.

Daily needs include:

1. Monitoring net value, exposure, and leverage ratio
2. Hedging impermanent losses once exposure reaches a certain threshold
3. Supplementing or reducing positions when leverage ratios reach certain thresholds
4. Accounting for realized and unrealized profits from farming based on the fund's base assets and presenting them to investors

IV. Tools Used in DeFi Mining

There are already DeFi aggregator tools in the market that provide mining suggestions based on publicly available market data or read wallets from blockchain addresses. Here are a few common websites:
DeFiPulse, APY999, which aggregate market interest rate levels to guide asset allocation;
Debank, DeFiBox, which aggregate basic market analysis and provide DeFi asset readings based on addresses;
Messari, a comprehensive website that includes research and on-chain data aggregation;

The above websites are very useful public tools, but they are not sufficient for institutional investors. 1Token provides a more comprehensive solution for institutions, summarizing the functions for the asset side of DeFi mining as follows:

1. Comprehensive accounting and flexible settlement from the funding side to the asset side

Funding Side
Shares of funds from different investors entering at different times;
Tiered funding (senior / junior);
Records and calculations of various cost items;
Real-time profit and loss analysis and settlement of earnings during profit sharing.

Asset Side
Only requires binding a DeFi address (public key) to monitor the asset status and impermanent loss in DeFi in real-time, along with the hedging positions and assets in centralized exchanges;
Integrating DeFi and centralized exchange assets, even external financing or collateralized lending, calculating profits and losses based on initial capital input, and finally calculating profit sharing based on complex settlement terms.

2. Risk control for various assets, especially DeFi assets
* Liquidation risks of futures-spot hedging accounts;
* Collateral ratio risks and alerts for single-coin pools;
* Impermanent losses and exposures due to price fluctuations in AMM mining;
* Considering the exposure after hedging against impermanent losses;
* Real-time and expected profits and losses, net value, based on real-time prices and positions;

3. Trading execution / smart algorithm hedging tools
* When risk control thresholds are triggered, alerts are sent for managers to manually hedge, or hedging conditions/thresholds are set for smart hedging on centralized exchange contracts or spot markets (parameters adjustable, automated/semi-automated operation). For example, if the Delta exposure threshold for a coin is reached, hedge all Delta exposure or part of it, or delay x minutes/hours (to avoid unnecessary repeated hedging during "spike" market conditions);
* 1Token also provides backtesting services based on historical data, allowing clients to select the most appropriate parameters under various market conditions based on expected future market trends;

In summary, 1Token covers the entire process from the funding side to the asset side, serving financial institutions that use DeFi mining as their asset side, allowing investors to see their investment shares and unrealized profits and losses in real-time, while managers have a clear understanding of the status and risks of all assets in their portfolio, making impermanent losses and liquidation losses fully controllable.

V. 1Token Provides One-Stop System Solutions for Various Cryptocurrency Financial Institutions

The 1Token CAM system provides software system support for medium to large financial institutions in the global cryptocurrency circle. Currently, leading financial institutions in the domestic sector, such as Bixin's FOF/MOM funds, Matrixport's FOF/MOM funds, FBGOne's asset management business, and BitLink's quantitative trading fund, as well as multi-strategy funds, FOF/MOM, or prime brokerage PB in the US and Europe, are all clients of the 1Token CAM system.

The CAM system has three coverage areas:
1. Coverage of various institutions, including buy-side, sell-side, and custodians in the cryptocurrency circle. Specific business lines include wealth management/asset management, DeFi miners, FOF/MOM, PB, structured product sellers, lending platforms, mining pools, institutional miners, manual/quantitative funds, OTC liquidity providers, etc.;
2. Coverage of major modules, including trading, clearing, risk control, quoting, transfers/wallets, and permission modules;
3. Coverage of major asset categories in the cryptocurrency circle, including funds, (structured) derivatives, lending/financing, DeFi mining, computing power/mining machines, etc., as well as traditional securities and derivative assets.

In terms of breadth:
The 1Token team has development experience in traditional markets for lending, financing, derivatives, etc., and experience in quantitative funds, institutional brokers, and institutional miners in the cryptocurrency circle. The core team of 1Token previously worked at Scivantage (acquired by Refinitiv), a well-known financial system provider in the US traditional market, serving well-known sell-side institutions in the traditional market such as Bank of America, Deutsche Bank, Vanguard, Scottrade, etc. Through nearly 10 years of accumulation, the 1Token system modules cover various asset types across all front, middle, and back office modules, while also being able to quickly support customized demands.

In terms of depth: +1Token's proprietary brokerage system and quantitative fund system (with multiple different DeFi quantitative strategies) have sustained an average daily trading volume of over 1 billion RMB for three consecutive years, peaking at over 5 billion RMB, fully demonstrating the robustness of the system.

Considering that the clients of 1Token CAM are primarily medium to large financial institutions that are very concerned about data security, the system supports localized deployment to protect data privacy, and sensitive information such as API keys is stored in separate modules.