Investing in DeFi comes with enticing opportunities, yet it’s essential to be aware that there are unseen expenses that could notably diminish potential profits. These costs go beyond the initial gas fees.
In contrast to established payment processors like Visa and Mastercard which charge consistent fees for merchants and consumers, blockchains utilizing smart contracts function differently. On networks such as Ethereum and Solana, along with other EVM-compatible platforms, transaction costs are adaptable. As a result, the amount you’ll pay to execute a transfer depends on the current level of congestion within the blockchain and the priority you assign for swift completion.
Currently, the average gas fee on Ethereum, the preferred blockchain for decentralized finance (DeFi) applications, is 28.46 gwei or approximately $0.95. This figure has significantly dropped post-London Hardfork update, which boosted the network’s capacity and made layer-2 solutions more cost-effective. Given the importance of affordability, this development comes as a relief, especially for those in developing economies who may otherwise be priced out due to high transaction costs.
Instead of focusing solely on gas fees, it’s important to be aware of other potential costs that could affect an investor’s returns. Here are four common unexpected expenses to keep in mind:
- Impermanent loss. Impermanent loss (IL) refers to when the profits gained from staking tokens in a liquidity pool are smaller than the gains that would have been realized by holding these cryptocurrencies directly. It’s known as “impermanent” because the price of digital assets can eventually recover. Losses will only be confirmed if an investor pulls liquidity from the pool when this happens.
- Loss-versus-rebalancing. Traditional automated market makers constantly rebalance pools to maintain ratios, but LVR ensures liquidity providers don’t capture all potential gains during this process versus a rebalancing portfolio. If crypto prices quoted by AMMs are out of date, with digital assets trading at a higher premium on more liquid platforms, arbitrageurs have an opportunity to exploit this and turn a profit.
- Slippage. Arguably, one of the most common problems in crypto more generally—and not just in defi—is slippage, which refers to how market fluctuations affect final trade prices. Let’s imagine that an investor attempts to buy Ether at $3,000, but a sudden market move pushes its value upward to $3,100 before that order is filled. This action would result in a slippage of $100. Slippage is especially important to look out for when placing high-volume trades on illiquid pairs. A large order in a low liquidity pool can drastically affect prices when the trade executes.
- Maximal extractable value. Here, savvy actors exploit AMM inefficiencies or timing games to profit at the expense of other participants. MEV has become an important metric in sophisticated Defi strategies. In the context of Ethereum’s proof-of-stake network, it refers to validators who change the order of transactions within a block to maximize revenue.
What’s the answer?
The risks inherent in the decentralized finance (defi) world are significant and should be thoroughly considered before investing. These risks could negatively impact liquidity providers who invest their own funds into defi projects, potentially leading to disappointing returns or even losses. Such outcomes may deter participation and hinder the development of a thriving and resilient defi community.
In the world of decentralized finance (defi), there’s no quick fix for getting rid of hidden costs. Developers must craft protocols that address intricacies and improve user education about potential hazards simultaneously. For instance, investors can minimize impermanent loss by adjusting their portfolio allocations, favoring less volatile assets, and staying informed about market conditions.
It’s important to grasp various Automated Market Making (AMM) models and their associated trade-offs. Newer protocols are working to lessen the impact of Liquidity Variance (LVR) and enhance investors’ total gains. Exploring platform rebalancing tactics can aid in determining the optimal location for your liquidity. Furthermore, safeguarding a Limited Partner (LP) position through hedging can minimize impermanent loss. Setting reasonable slippage limits also dampens the effect of price changes during transactions.
When engaging in trading activities, it’s essential to consider the effect of your trades on prices. If the price shift is significant, you may want to split your trade into smaller parts to minimize the impact. To prevent unwanted price movements after submitting a trade, investors can opt for more modest slippage settings. By employing trading platforms such as LlamaSwap, 1inch, or Matcha, you’ll have access to multiple markets and thus secure the most advantageous execution. Additionally, utilizing an RPC service that safeguards against Miner Extractable Value (MEV), like Flashbots Protect, can help reduce transaction costs.
In simpler terms, some modern Oracle systems such as Pyth operate using a push system instead of the commonly used pull system like Chainlink. This shift grants protocols greater control over pricing updates and offers real-time prices directly on the blockchain. If users of a single protocol could be seamlessly paired for complementary trades, they would avoid price impact, slippage, and MEV, resulting in increased profits for liquidity providers.
Improving defi protocols ultimately benefits them by providing stable returns and fees, keeping users from switching to competitors when more attractive deals arise, and ensuring long-term sustainability. Streamlining infrastructure makes defi more accessible for those intimidated by its complexity, making a positive first impression crucial as new users may not return if they find the experience unfavorable.
Fresh approaches, such as on-chain portfolio administration and streamlined trade transactions, are gradually leading to a more equitable marketplace for liquidity suppliers. Keeping up-to-date with the most recent advancements in the Decentralized Finance (DeFi) sector is crucial. By doing so, you’ll be well-equipped to maneuver through DeFi with assurance and optimize your profits.
Sunil Srivatsa serves as the founder and chief executive officer of Storm Labs, the innovative team behind Cove Protocol, the pioneering on-chain portfolio management system. In addition, Sunil functions as a founding partner at eGirl Capital. Previously, Sunil established Saddle, an influential open-source StableSwap boasting over $2.2 billion in trading volume. Prior to these accomplishments, Sunil held the position of senior software engineer at Uber, where he contributed to infrastructure security, autonomous vehicles within the Advanced Technologies Group (ATG), and real-time analytics.
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2024-04-15 04:17