The world of Decentralized Finance (DeFi) can seem alluring at first, especially with promises of passive income through yield farming and staking. Our ability to soar through this new landscape will depend on a clear-eyed understanding of the mechanisms at play and the risks they pose. ThrowingToken.com is here to help demystify DeFi yields. It breaks down important terms like APY, APR, and impermanent loss, identifies risks and dangers, and lays out actionable methods to minimize risk. Li Wei is a blockchain content strategist and educator who translates radical ideas into relatable concepts. He translates them into actionable insights for both new and seasoned investors.

Understanding APY and APR in DeFi

In DeFi or traditional finance, APY (Annual Percentage Yield) is a simple way to gauge your return on investment. Conversely, APR (Annual Percentage Rate) shows you how much it will cost to borrow money. In DeFi, these concepts are just as important, but they play out in a very different environment.

APY is a measure of how much interest you will earn on a deposit or investment over one year’s time. It already takes into account the amazing power of compounding. Compounding as the definition implies, with compounding, interest that has been earned is reinvested, creating additional interest on the original deposit and the interest that has accrued. This can significantly boost returns over time. APR, by contrast, is the yearly cost of borrowing that money. It measures the interest rate as well as all other required fees related to the loan. APR is the less used term in DeFi yield farming. It is important to understand its importance when analyzing borrowing rules or leverage levels.

It’s worth pointing out that advertised APY in DeFi are rarely what they seem. Those APYs you see advertised on social media? The ones that lure you in with unrealistic return rates? Those are typically short-term introductory APYs. These token rewards can’t be sustained indefinitely. Investors should carefully evaluate the underlying sources of yield and consider the potential for these rewards to decrease over time.

Impermanent Loss: A DeFi-Specific Risk

Impermanent loss (IL) is a unique risk associated with providing liquidity to Automated Market Maker (AMM) protocols like Uniswap or PancakeSwap. It happens when the price of the tokens you’ve deposited in a liquidity pool change relative to one another.

Causes and Consequences

Impermanent loss happens when the price of a token within a liquidity pool diverges from its price outside the pool. This divergence creates an arbitrage opportunity. Arbitrageurs rush to exploit it by buying the underpriced token out of the LP and selling it on another exchange. This common-sense process to rebalance the pool is long overdue. It’s not without consequence; liquidity providers will always lose out compared to those who just hold the tokens. This loss is “impermanent” as it only becomes realized once the liquidity provider withdraws their funds from the pool. If the price ratios return to their pre-withdrawal equilibrium, the loss vanishes.

Volatility and Mitigation

The more volatile the assets in a liquidity pool, the higher the risk of impermanent loss. A pool with two major stablecoins greatly reduces their exposure to impermanent loss. Alternatively, a pool that combines a stablecoin with a highly volatile altcoin is far more prone to impermanent loss.

Example Calculation

Suppose a new user adds Token A and Token B to a liquidity pool, in each case worth $10. Their combined deposit is worth $20. In our example, if the price of Token A suddenly doubles, our favorite arbitrage traders will rush in. Because Token B’s price doesn’t change, they’ll need to buy Token B from the pool to rebalance the ratio. When the user redeems their liquidity, they might get $15 in Token A. Or they could receive the equivalent of $5 in Token B, increasing the total to $20. If only they had simply kept the tokens, because those tokens would have increased in value to $30. That’s $20 for Token A and $10 for Token B! The $10 difference represents the impermanent loss.

Common DeFi Risks and How to Mitigate Them

Aside from impermanent loss, the DeFi ecosystem isn’t short of other dangers that investors need to watch out for. ThrowingToken.com is focused on clearly explaining risks and how to reduce them in order to preserve invested capital.

  • Rug Pulls: These are scams where project creators abandon a project and run away with investors' funds.
  • Smart Contract Exploits: Hackers can exploit vulnerabilities in smart contracts to steal funds.
  • Flash Loan Attacks: Attackers borrow large amounts of capital and manipulate token prices to drain liquidity pools.
  • Front-End Attacks: Hackers compromise the user interface of a DeFi platform to steal private keys or redirect transactions.
  • Liquidity Pool Manipulation: Malicious actors manipulate the asset ratios in a liquidity pool to drain funds.

Risk Mitigation Strategies

Staking in DeFi refers to the process of locking up crypto assets to support a blockchain network or protocol, in return for earning rewards. It’s important to grasp both the nuances of staking rewards and how staking comes with its own risks.

  • Due Diligence: Thoroughly research DeFi projects before investing. Look into the team, the project's code, and its security audits.
  • Smart Contract Audits: Verify that the project's smart contracts have been audited by reputable security firms.
  • On-Chain Insurance: Use on-chain insurance protocols to protect against specific risks like smart contract failures or impermanent loss. Nexus Mutual and Cover Protocol are examples of platforms offering such coverage.
  • Collateralized Debt Positions (CDPs): Deposit collateral to borrow, mitigating risks associated with borrowing and lending in DeFi protocols.
  • Smart Contract Vulnerability Detection Tools: Utilize tools like Mythril, which uses symbolic execution to detect vulnerabilities in smart contracts, reducing the risk of exploits.
  • Diversification: Don't put all your eggs in one basket. Diversify your DeFi investments across multiple platforms and protocols.
  • Start Small: Begin with small amounts of capital to test the waters and gain experience before committing larger sums.
  • Stay Informed: Keep up-to-date with the latest news and security alerts in the DeFi space.

Understanding Staking Rewards and Associated Risks

Staking rewards in DeFi primarily come from two Ethereum layers: the Execution Layer (EL) and the Consensus Layer (CL). While the EL is in charge of transaction execution, the CL takes care of block validation and maintaining network consensus. Depending on protocols and market conditions, rewards rate fluctuates around 8-10%.

Staking Rewards: EL & CL

Many DeFi staking platforms require you to undergo a lock-up period, anywhere from 7-10 days. As a comparison, other platforms provide this same sort of flexibility, often with zero minimum lockup length. Staking for the maximum duration possible, such as up to one year, tends to earn you the most rewards. In comparison, staking for a shorter, one week period offers significantly lesser rewards.

Lock-Up Periods and Staking Duration

Staking on DeFi platforms like Stader could incur a percentage fee, for example a 10% flat fee. On top of that, gas fees can be quite significant, largely speaking for the Ethereum network. To make projections easier, investors can turn to staking calculators such as Figment’s, which is powered by the opaque rewards data.

Staking Fees and Calculations

Mitigating the potential downsides of staking means first understanding them and then taking action to reduce their impact.

Staking Risk Mitigation

Learn the differences between APY, APR, and impermanent loss. This information helps investors enter the DeFi ecosystem with confidence, understanding where they can safely engage and earn a market return. ThrowingToken.com challenges our users to always learn more, be careful, and play it safe when it comes to DeFi.

  • Slashing Penalties: Validators can face penalties for downtime or malicious behavior, leading to a loss of staked assets.
  • Validator Selection: Choosing a reputable and reliable validator is crucial to avoid slashing penalties and ensure consistent rewards.
  • Smart Contract Risk: Staking through smart contracts introduces the risk of exploits or bugs that could lead to loss of funds.

By understanding the nuances of APY, APR, impermanent loss, and other potential risks, investors can navigate the DeFi landscape more safely and make informed decisions. ThrowingToken.com encourages users to continuously educate themselves and exercise caution when participating in DeFi.