How to Evaluate Yield Earning Opportunities in Decentralized Finance (DeFi)

Key Takeaways

• Cryptocurrency investors need to know how to earn a yield using decentralized finance protocols.
• Investors should be familiar with the protocols they use and how they generate yield to ensure their funds are safe.
• DeFi users need to accurately calculate their returns and evaluate the APR or APY of a specific earning protocol.

Overview

Decentralized finance has revolutionized the traditional finance world by introducing trustless monetary transactions. Through smart contracts, cryptocurrency networks can quickly and efficiently facilitate peer-to-peer transactions, which allow for lending, borrowing, insurance, liquidity provision, and other important financial agreements. These protocols create high utility for a certain smart contract cryptocurrency and incentivize new investors to enter the space to earn yield.

However, the low entry price for developers and creators to introduce their protocols makes it risky to trust all decentralized applications (dApps). Investors must perform thorough due diligence on the protocols of their choice and understand the ins and outs of how they are making a return on their investments. Fresh protocols with low user counts or unrealistically high yield estimations can indicate a potentially malicious project that may steal user funds.

APY vs APR

Understandably, some individuals could conflate the words APR and APY. Both are employed in the computation of interest for credit and investment goods. Additionally, when applied to your account balances, they greatly impact how much you earn or must pay.

However, although APR and APY may sound similar, they are distinct and not interchangeable. In contrast, APR, which stands for annual percentage rate, APY, or annual percentage yield, considers compound interest. APR does not consider the compounding of interest within a specific year. APY does take into account the frequency with which the interest is applied—the effects of intra-year compounding.

Lending and Borrowing

There is a significant demand in traditional and decentralized finance to lend or borrow money. In cryptocurrency, a healthy lending market means a highly liquid market with various cryptocurrencies offered. Borrowers must post collateral and can withdraw a certain amount of cryptocurrency depending on the protocol. Their collateral deposit will be lent out to others and earn a yield denoted in APR or APY. Similarly, they must pay a fee to borrow, denoted in a different APR or APY. Depending on these figures, the DeFi user’s position will be net positive or negative, and they must adjust accordingly to avoid being liquidated.

The clear-cut functionality of a lending protocol makes it a relatively safe place to invest your money in decentralized finance. Although there is still protocol attack and smart contract risk, you can be sure that your money won’t be lost due to the malfunction of the lending protocol’s financial model.

Liquidity Pools

Liquidity pools are the backbone of the decentralized finance world and are a bit more complicated than lending protocols. They use the AMM or Automated Market Maker system to facilitate trades and keep accurate prices. Liquidity providers earn a trading fee on each trade made within that liquidity pool. The amount of trading volume in a pool over a certain period can be extrapolated into APR and APY estimates. Liquidity provision covers other exchanges like derivatives and can be a solid investment with a hefty return. A great example of a decentralized derivatives exchange with liquidity pools is SynFutures.

Insurance Protocols

Insurance protocols allow decentralized application users to purchase and lend money for the insurance of other protocols. In case of protocol hacks, failures, or other malfunctions, investors can file a claim with the insurance protocol. On the other end, investors can lend money to insure other people's investments and earn a return.

Conclusion

Cryptocurrency investors and decentralized finance enthusiasts should be wary of the protocols they use. Users should not blindly trust the protocol to deliver an unrealistic yield and should clearly understand how their investment is used.

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