DeFi: staking, lending, liquidity pools
DeFi replicates financial services through programs on a blockchain. The advertised returns come from nameable sources, and where they don't, they come from later participants.
DeFi stands for financial services with no bank: lending, swapping, posting collateral, all through programs running on a blockchain.
With staking, you post coins as collateral to help run the network and get a share of newly created coins in return. With lending, you lend and get interest from borrowers. With liquidity pools, you supply two assets for swapping and get a share of trading fees.
In all three cases, there's a nameable source. That's exactly what you need to ask about. If nobody can explain who's generating the return, it's coming from the next round of depositors.
The risks are distinct and often underestimated: bugs in the code, loss of posted collateral on misbehavior, lockup periods on withdrawals, and with liquidity pools, a loss that doesn't exist anywhere else. That's the topic of the next lesson.
The sources of return need separating. Staking returns come mostly from the issuance of new units, and so are only genuinely valuable to the extent they redistribute dilution from non-participants. Returns from lending and trading fees, by contrast, come from actual willingness to pay by third parties.
Risks include bugs in the contracts, faults in the price feeds used, dependence on admin keys with sweeping powers, and chained risks when collateral gets reused across protocols. Audit reports address only the first point, and only for a specific code version.
Especially worth watching are offers where yield gets paid mostly in the project's own token. The stated return then hangs on that token's price, whose supply is continually increased by the payout itself. Such structures produce high nominal return figures alongside a falling token price, and are the most common reason for the gap between advertised and actual return.
Summary
- Always ask who's generating the return.
- Staking returns mostly come from new issuance, not value creation.
- Yield paid in a project's own token produces high numbers alongside a falling price.
Did you get it?
Where do staking returns mostly come from?
From the issuance of new units, meaning redistribution from non-participants.
What do audit reports cover, and what not?
They check code at a specific version, not price feeds, admin keys, or chained risks.
Why are returns paid in a project's own token misleading?
Because the payout increases the token supply, and the nominal return persists even as the price falls.
Related
- Checking a whitepaperStage 3
- Order books, market makers, high-frequency tradingStage 4
- VolatilityStage 4