Big Short 2.0: Yield farming on DeFi apps? Here’s the risk no one talks about
After ICOs in 2018, DeFi applications are seemingly positioning themselves to be the next 100x coin baggers in 2020; complete with shiny websites, world-changing promises, and sparking dreams of early-retirement for those who dare.
While the above does not apply to every project, DeFi is now being whispered as the new opportunity in crypto-circles and “yield-farming” — a term that did not exist outside of about a 100 ears last year — is now the cyberpunk’s favorite pandemic pass time after sourdough bread.
But huge returns bring huge risk, with the latter not being spoken about enough. Some, like Ethereum’s Vitalik Buterin and ex-Messari product head Qiao Wang, are trying to appraise the community about understanding the risks they take before putting in any funds.
For all purposes; DeFi applications, and cryptocurrencies as an extension, remain an unchartered territory, and are majorly still in their early development/teething stages.
Yield farming faces tail risk
Messari’s Wang tweeted this week about how yield-farming is a negatively-skewed strategy, which in financial terms, means the probability of a black swan event — one that can wipe the whole account within seconds — is higher than the potential gains.
Many yield farmers are about to learn that returns aren't necessarily symmetrically distributed and that yield farming exhibits negatively skewed returns.
Other examples of negatively skewed strategies:
– Long S&P
– Short VIX
– Mean reversion-based stat arb pic.twitter.com/cogBoHCTHw
— Qiao Wang (@QWQiao) June 23, 2020
This type of strategy provides slow and steady gains, think mutual fund payouts, and index investing, but a drastic event stands to wipe those profits and then some.
Bitcoin trading and venture fund (VC) investments are positively skewed, which as Wang notes, gives a lot of smaller losses to investors but promises a home run with just a few right market calls.
To illustrate, VCs are infamous for losing millions on obscure startups, but just one IPO listing, or a buyout by a larger fund, means big profits that allow their business to keep running.
DeFi is falling in the negative skew category, with perhaps one recent example justifying how easily and quickly could everything go wrong for investors.
Between a rock and a hard market
In March this year, Bitcoin fell over 45 percent over two trading sessions in an event now colloquially known as “Black Thursday,” with the highly-correlated cryptocurrency market falling by a similar percent.
But MakerDAO investors faced the most pain. The DeFi platform — regarded by some in cryptocurrency forums as the “future” of decentralized finance — was caught unaware after a sudden drop in ETH prices exposed the platform’s risk management policies at the time.
Investors lost millions in ETH, DAI, BAT, and USDT as hackers took advantage of “zero-bid” offers. Rapidly falling ETH prices and rising GAS values failed to update on Maker auctions, leading to a situation where certain ETH collaterals were purchasable at 0 DAI (comparable to 0 USDT).
Apparently ethereum transactions were not being executed due to network congestion, thus liquidation auctions for MakerDAO weren't being executed, thus someone was able to step in as the only bidder to "buy" $8,000,000 for $0. https://t.co/fNfs0yugtP pic.twitter.com/cdh31FzsYU
— Jameson Lopp (@lopp) March 18, 2020
Notably, Maker’s inherent platform security was uncompromised — unmodeled, and unforeseen financial behavior caused the harm.
Black swan risks cannot be modeled
The above indicates the financial risk is not necessarily due to a poor platform. A platform can be robust, well-designed, feature the best-in-class technology, but still fall victim to an event that no one has modeled yet.
Current market favorite DeFi projects promise “risk-free” yields, which come largely from lending funds to other traders who, in turn, reinvest the “loans” in other leveraged speculative assets.
So if you are making a fuck load of money right now farming DeFi yields, be thankful for the poor souls who just got liquidated by Arthur.
— Qiao Wang (@QWQiao) June 20, 2020
In short, farming yields by loaning risky traders the funds to speculate over a speculative asset class is not a sustainable model.
Honestly I think we emphasize flashy defi things that give you fancy high interest rates way too much. Interest rates significantly higher than what you can get in traditional finance are inherently either temporary arbitrage opportunities or come with unstated risks attached.
— vitalik.eth (@VitalikButerin) June 20, 2020
To protect themselves; investors must, as the adage goes, be prepared to invest only what they can afford to lose despite any promises made over how “risk-free” the yields are.
Cause promises like the above can lead to moments like what this unfortunate trader faced:
F for our fallen farmer pic.twitter.com/ROcWakC5fO
— 찌 G 跻 じ ⚡️ ? (@DegenSpartan) June 21, 2020