Yam Highlights Risks in DeFi
VYSYN Ventures Weekly Insights #13
As we highlighted in our recent “The Anatomy of Altseason” and “Bitcoin Market Dynamics” releases, the growth of decentralized finance (DeFi) was an indisputable driver behind the recent price rise in the crypto market. The outsized returns available to DeFi users increased investor risk appetite and this played an important role in sparking both the altseason and Bitcoin price appreciation.
A healthy performance that started in DeFi seems to have come full circle as DeFi is once again recording almost parabolic increases. The Total Value Locked (TVL) in DeFi is approaching the $6 billion mark and the price increases of crypto tokens tied to DeFi protocols have been growing at an even faster rate.
In the latest VYSYN release, we highlight the primary proponents behind the DeFi rise. We also explore how the risks of DeFi can backfire on investors and best practices that speculators can use to sensibly expose themselves to a growing asset class.
The Fuel for Further DeFi Price Increases
Phenomenal price appreciation across DeFi assets has been showing no sign of slowing down. The ascendancy of the FTX DeFi Perpetual Futures product — a contract which tracks the performance of a basket of DeFi tokens — has been accelerating in August with a 49% growth over just 15 days.
We previously detailed that the DeFi rise played an important role in sparking wider crypto appreciation but why does it continue to outperform when other assets also hold bullish outlooks? After increases in Bitcoin and altcoins, many investors are likely seeking even greater returns on their capital and are betting their capital on vogue niches like DeFi.
Sentiment data shows that crypto investors are more bullish than they have been since Q2 2019. This suggests that they are willing to take increased risk for outsized returns. The Crypto Greed and Fear index tracks the sentiment of crypto investors and highlights a marked uptick in optimism since the start of August.
The DeFi Niche
One of the seeds of the DeFi success is the niche the technology has found itself in. DeFi offers products comparable to those in traditional finance but with outsized returns for extra risk.
The borrowing and lending activities which can be carried out in traditional finance only yield minuscule rates of return. With DeFi being a nascent and experimentative technology, investors are currently being compensated for the risks they are taking as they provide liquidity to these protocols.
Returns available in the traditional financial markets have approached 0% and sometimes under. Central banks lowering benchmark interest rates for almost a decade to alleviate debt burdens has put downward pressure on the returns available.
By comparison, there are commonly opportunities for lenders in DeFi protocols to earn rates of above 10%. DeFi users can also boost the possible returns by leveraging their exposure via using borrowed tokens in one protocol to lend to another protocol.
YAM Highlights the Risks
A recent development in DeFi also highlighted that outsized returns do not come without taking extra risks. Compound kicked off a “liquidity mining” euphoria in DeFi.
Liquidity mining incentivizes participation in DeFi protocols by rewarding those who interact in the protocol with the native token of the project. Yam Finance followed suit with their own liquidity mining programme and quickly accrued a value of $750 million in locked liquidity.
However, a critical bug was found in the protocol which flooded the protocol with Yam tokens and caused governance issues. The excessive number of Yam tokens meant that the quorum for voting on governance changes could never be met and Yam tokens and the value locked in the protocol quickly plummeted. This all happened within 48 hours of the project launching.
Leading DeFi Performers
Despite YAM backfiring on the many that invested, many projects have been outperforming amid the recent hype. Compound had benefited from the initial Yam hype and had both COMP price and lending rates on the protocol spiking.
However, the price had sharp declines as the ramifications of the Yam bug became clear. The price had been rebounding in trading over the past day and continued upward trending looks likely.
The token of the biggest DeFi protocol by TVL — Maker — similarly recorded significant price appreciation on August 12th and August 13th around the launch of YAM. It has been trending downward since the Yam failure but the recent price increases vastly outperformed the majority of DeFi projects.
Practical Implications for Potential DeFi Speculators
If you are not already active in the DeFi space but have been considering entering, there are some important practical implications in this week’s piece. Nobody is disputing that there is currently a lot of opportunity for earning potentially large returns in DeFi.
DeFi has been extremely volatile and the hype surrounding this emerging area has resulted in significant upside potential for investors. However, blindly taking risks will leave investors more vulnerable to events such as the YAM hack.
If investors are exposing themselves to a project that they have limited understanding of, it is advisable to have strict risk parameters in place. Keeping the entire exposure to one given project at 1% of the total value of a portfolio limits the downside risk while also giving significant upside exposure. If the project fails, the investor loses 1% of their portfolio whereas they will observe a significant increase if 100x plus returns are materialised.
If investors hold a deeper understanding of the project and the technology underpinning the project, it may make more sense to increase their exposure. In this case, the investor is aware of the unique risks and rewards of the given project and can tailor their exposure based on this.
It is also possible to gain exposure to DeFi without investing in any protocols. Products such as the FTX perpetual futures contract allow investors to bet on the success of a basket of DeFi tokens without having to own the underlying assets.
We will be monitoring the most important developments in DeFi and crypto in this newsletter. Don’t forget to subscribe!