Defi yields & third party risk — Loft Financial
Defi yields or defi farming are all the craze. APYs that yield anywhere from 10% to 100% annually. Everyone wondering how is this possible. Some people don’t even question it, think it’s a default gold mine that they are first and have the right to loot. Sorry to break it to you, in finance there are no such free meals and we will see why below.
In simple words, the premium you are paying is due to risk. Risk is the most important concept in finance and regulates bond yields and stock prices. In bonds the risk is the risk of a default from a company or nation state. In crypto risk is usually tied to hacks or smart contract failures that result in loss of funds. This happens quite regularly and most crypto enthusiasts clearly underestimate its risk.
Crypto is only 10 years old but spectacular hacks have happened to the majority of exchanges and smart contract projects (TheDAO,MtGox,Binance,Bitfinex,Btc-e, the list is very long). The key here to understand risk is to visualize it. One the top of your mind how often does an exchange need to be hacked in order to make your Defi yield totally not worth it? Name a frequency measured in months or years for example and then read below for an analysis.
Risk calculation
When an investment has a 10% APY or call it as you want it’s the same thing here, that means that if you put $100 then in around 7 years you will have doubled your investment (because of compounding). If at any point during these 7 years there is capital loss due to a hack or whatever other reason you have gained nothing, obviously.
A good rule of thumb is: Do you expect the specific defi project or exchange to be hacked more than once in 7 years? If yes then the yield is absolutely not worth it! This is based on the notion of expected value . You can easily adjust the APY to calculate other scenarios. For example something that will give you back double your money in a year (APY 100%, very rare!) means that if the project doesn’t get hacked with probability once per year then the investment is worth it.
Other considerations
Even the above are optimistic scenarios because other things come into play. You lock your money in defi “farming” so there is opportunity cost and then there are usually quite high fees. On Ethereum it’s not uncommon to pay $150 for the initial transaction and $100 for the unlock transactions and these eat very much into the APY especially for smaller amounts making many of them not worth it.
Conclusion
Nothing is for free. Seriously.
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Disclaimer: The information on this site is for informational purposes and isn’t financial advice. We cannot guarantee that you will have the same results as we have nor can we guarantee that the information shared here is appropriate for you. This is not financial advice and not given by professionals.
Originally published at https://loftfinancial.com on April 16, 2021.
