Automated asset management in DeFi: pros and cons

Despite a prolonged bear market and a string of ‘black swan’ events, the decentralised finance sector continues to evolve. The expansion of possibilities for preserving and growing capital is aided by cross-chain bridges, L2 solutions and liquidity inflows from CEX.

We examine the features of automated asset management, popular yield aggregators and the risks DeFi investors should watch for.

Features of asset management in DeFi

Crytpocurrencies are characterised by high volatility, so trading carries substantial risk. Not surprisingly, many investors are drawn to the prospect of passive income that does not require a high entry threshold, high fees and constant market monitoring.

Asset management via DeFi platforms has several advantages over TradFi counterparts:

• composability of decentralized applications;
• potentially high investment returns;
• the permissionless nature of the space, enabling open access and keeping market participants in control of their funds.

Composability is a key aspect of ‘financial Lego’.

Interoperability allows various projects to use other dapps and smart contracts to create new services and use cases. As the ecosystem grows with new apps, the number of interconnections increases, further stimulating innovation and growth.

Unlike TradFi, DeFi asset management offers transparency — thanks to blockchain all funds and operations are visible at a glance. For monitoring across networks and apps, there are many portfolio trackers such as DeBank.

Another major advantage is on-chain autonomy. Users have full control over their funds and do not rely on intermediaries.

Noted crypto investor DegenSpartan notes that a non-custodial approach to asset storage minimises counterparty risk and significantly lowers overheads.

good question

imo one should perma hold MORE crypto as a % of their NW the richer one gets, not less

the bearer nature of crypto also zeros 3rd party risk while makes the cost of custody on 1m or 10m or 100m or 500m not a 10-25 bps situation, but the cost of a hardware wallet https://t.co/rVmHF1UiO9

— 찌 G 跻 じ MBA, CFA, FRM, CFP, NGMI, HFSP, HENTAI ?️ (@DegenSpartan) April 29, 2023

Smart contracts automate many functions, removing the human factor typical of TradFi and, in many cases, the slow, bulky and inefficient processes associated with it.

Despite the advantages discussed above, the growth dynamics of the DeFi segment remain volatile. Total value locked (TVL) peaked in late December 2021, surpassing $300 billion. An all-time high (ATH) was recorded shortly after Bitcoin reached the $69 000 mark.

Since then the indicator has fallen by more than 70% and as of 14 June 2023 stands at $82.26 billion. In the report “2023 State of Crypto” by a16z difficulties on the path to mass adoption of cryptocurrencies are noted. One of them is that market participants have grown mainly in the wake of a price rally.

The report also notes a declining role for the United States in the Web3-space due to excessive regulation. Between 2018 and 2022, the share of crypto developers based in the United States fell by 26% relative to the global figure.

Popular DeFi yield aggregators

Alongside platforms for liquid staking, crypto lending and DEXs, yield aggregators play a significant role in the DeFi segment. Such services automate farming, using a range of strategies.

Enzyme Finance

One of the early yield aggregators — Enzyme Finance (formerly Melon Protocol), which began operating in 2017.

The service is integrated with many well-known dapps, including 0x, 1inch, Aave, Balancer, Compound, Curve and Uniswap.

Enzyme Finance allows creating Vaults — customised on-chain asset management instruments.

Yearn Finance

Another classic yield aggregator — Yearn, founded by blockchain developer Andre Cronje in July 2020.

In the platform’s first iteration, Vaults automatically directed deposited stablecoins to lending services, offering users relatively high APY. Over time, more sophisticated strategies for various assets emerged, making greater use of DeFi composability.

For example, a USDT-based Vault employs one of the simplest strategies — Aave Lender Optimizer, which deposits stablecoins into Aave. The interest earned on the lending platform and stkAAVE tokens are periodically withdrawn and reinvested back into the ‘vault’. This creates a compounding effect — market participants earn returns not only on their initial contribution but also on previously earned funds.

In the Factory section, users can create their own Vaults. In addition to Ethereum, Yearn supports Optimism, Fantom and Arbitrum.

TVL of the platform stands at $415 million (as of 14 June 2023). At the end of 2021 the figure exceeded $6 billion.

Beefy Finance

On the second place by TVL in the Yield Aggregator category of DeFi Llama is another popular service — Beefy Finance, originally launched on BNB Chain in 2020.

The aggregator operates similarly to Yearn Finance: the user deposits tokens into the chosen ‘vault’ -> funds are locked in liquidity pools on external platforms -> the accrued interest is reinvested, and so on.

Nested

There are dozens of yield aggregators — DeFi Llama lists around a hundred. Gradually, next-generation platforms with more advanced and even somewhat intricate strategies are appearing.

One such service is Nested. It lets users create and copy other market participants’ crypto portfolios, similar to the social trading platform eToro.

User financial instruments come in the form of non-fungible tokens (NestedNFT) and can include up to twelve assets. Each time a crypto-portfolio is copied, its creator receives a reward.

The platform is integrated with various networks, including Arbitrum, Avalanche, BNB Chain, Ethereum, Polygon and Optimism. Nested has already created more than 30 000 crypto portfolios.

Sommelier

Users of this service deposit tokens into \\”vaults\\”, where there are automated rebalancings taking DeFi opportunities into account.

A popular tool on the platform is Real Yield ETH Cellar. It employs:

• tokens of liquid staking (LST): stETH, cbETH, rETH;
• Wrapped Ether (WETH);
• lending services Aave and Compound;
• leading non-custodial exchange Uniswap.

The automated strategy entails:

• leverage staking: a continuous cycle of swapping ETH for LST, using the latter as collateral on Aave or Compound and additional borrowings on these lending services;
• providing funds to pools using ETH and LST on Uniswap v3 with dynamically adjusted ranges of concentrated liquidity to maximise yields.

The pitfalls of DeFi

The services discussed above are undoubtedly attractive. They offer many interesting strategies for earning passive income. All that is required of the user is to choose the instrument best matching their risk tolerance and deposit funds. There is no need to delve deeply into market analysis or interact with many platforms and tokens — automated algorithms will do it all.

In general, the sector has changed significantly over the past few years — the interfaces of many platforms have become more intuitive, despite the complexity of strategies and support for multiple networks. Even novice crypto investors with modest capital who have a basic understanding of Web3 wallets such as MetaMask can engage with yield aggregators.

Nevertheless, keep in mind the risks — in recent months hackers have breached many DeFi platforms, including Sturdy Finance, 0VIX, Merlin, SafeMoon and Euler Finance. Non-custodial wallets and cross-chain bridges are not immune to such incidents, as recent events with Atomic Wallet and Allbridge show.

There are reportedly dozens of attack vectors on DeFi protocols. Among the most common:

• manipulations using flash loans (examples: Value DeFi, Nirvana, Cream Finance);
• reentrancy attacks (Omni, Sentiment, Orion Protocol);
• manipulation of oracles (Deus Finance DAO, Solend);
• cross-chain attacks (Wormhole, Transit Swap);
• fake projects and scams (Fintoch, Swaprum);
• rug pull schemes (Dragoma, AnubisDAO).

DeFi Llama hosts a section listing attacks on various protocols, detailing their characteristics and losses. Total investor losses exceed $5 billion.

The Block’s data.