Recently, cryptocurrency and blockchain technology have become some of the most popular concepts in the technology industry. The innovative aspects of the blockchain are now being applied to various sectors of the economy and have set the unprecedented stage for decentralized finance (DeFi), non-fungible tokens (NFTs) and the metaverse.
Decentralized Autonomous Organization (DAOs) have emerged as another dominant aspect that stems from the blockchain. DAOs refer to a collection of individuals or organizations who pool resources together into developing a smart contract that powers DeFi and other blockchain-related endeavours.
Background of DAOs
Slock, a German blockchain protocol, became the first idea of a blockchain-based organization in 2015. The idea behind Slock was to create a venture capital system where investors could make key decisions using smart contracts. This would have eliminated any organic structure, with the only form of human participation coming from developers who will be writing the smart contracts codes. After coding, every other thing would be run via the rules of the blockchain.
The next major event related to a DAO occurred two months later following an infamous hack that leveraged on a leak, carting away roughly $50 million. This prompted the developers to create a fork. With a more foolproof protocol, a new network was formed and the smart contract was coded to reimburse investors.
Another significant mark in the evolution of DAO was the creation of the ConstitutionDAO, a movement that comprised 31 members, including John Elrich. The DAO allowed its members to make donations on the Ethereum network to buy a copy of the U.S. constitution. It was formed to compete at a Sotheby’s auction of the U.S Constitution, and got the spotlight it deserved despite losing the auction.
What Exactly are DAOs?
A DAO, or a Decentralized Autonomous Organization, simply refers to a group of people focused on a specific mission and working in coordination based on pre-existing rules encoded on the blockchain. The most notable benefit associated with DAOs is transparency. DAOs are more transparent than traditional institutions because anyone can have the opportunity to see all actions and funding associated with them. This helps in limiting the risks of corruption and censorship that can occur within traditional companies. For instance, members can have access to financial statements which are often audited by external parties. These reports do not completely expose the health of the company’s finances. Though traditional companies are beginning to embrace blockchain technology, they often make use of private book-keeping, giving access to only a selected few.
DAOs, on the other hand, make use of public blockchains and all information associated with the organization such as balance sheets, governance and more are clearly recorded on the blockchain. This way, shareholders can easily access the organisation’s financial statements whenever they choose. The DAOs public blockchain takes every single entry into consideration.
For example, during conflicts, the only way these kinds of disagreements can be resolved is when legal agreements are set up to ensure rules are binding. This will definitely give a clear representation of DAOs, where the smart contacts serve as legal agreements and the people serve as shareholders. Rules cannot be made without consulting with the stakeholders. This is what also makes DAOs different from traditional companies where rules are made only by executives.
Governance in DAOs
Decentralized organizations practically take advantage of the functionalities of blockchain to offer self-enforcing rules. Smart contracts store the rules, while the protocol’s native tokens help in securing the network and voting rights.
Below is an outline of how governance in DAOs work.
Understanding the governance problem is the first step in creating a DAO. Developers analyze the governance problem before developing the smart contract codes to serve as the foundation of the DAO.
The tokenomics in the governance model must be presented. This gives the foundation for the monetization of the DAO.
The final stage is the launching of the DAO with the same token stakes for the shareholders and developers. This ensures there is a balance of power.
The overall precedents in developing DAOs create a pathway for transparency and autonomy. As such, the number of tokens a user holds is equivalent to their voting power, giving those with more tokens more privileges to introduce new governance proposals.
With the equal distribution of power in DAOs, there is a reduced number of new proposals, ensuring stability in passing new proposals with the affirmation of the majority of shareholders.
How DAOs Work
To understand how DAOs work, it is important to understand that DAO governance rules are created by its community using smart contracts which form the basic framework for DAOs. The smart contracts codes are visible, verifiable, and can be publicly audited, ensuring members are fully aware of what is happening in the protocol.
Once a DAO’s rule has been coded, the project is funded and fiscal inflow and governance rights will be determined. To raise funds, tokens are issued to users who then get voting rights that are proportional to the value of their assets. After this, the DAO will be deployed successfully.
When investors decide to start their DAO journey, they must understand that several DAOs exist and each of them serves specific purposes. For example, Uniswap allows its users to vote on fee distribution, while Compound lets users vote on the distribution of protocol fees for bug fixes and protocol upgrades. As such, investors can join the network to earn rewards.
There are other protocols that focus on policy treasury just like Shark DAO. This protocol allows token holders to pool funds to buy other blockchain-based assets such as NFTs. This is unique because shareholders would be able to access assets that may otherwise be expensive for other investors.
Many of the DAOs out there are autonomous, enhancing transparency because proposal details are easily accessible. And when voting takes place, the records are made public to all shareholders. Investors do not have to worry about communication with DAOs as most of them use Discord servers.
It is important for investors to understand that DAOs have some unique challenges. They include:
Onboarding issues: Investors who are not tech-savvy often find it difficult to join DAO communities. Hence, it is important that DAOs make their systems accessible and user-friendly.
Partial efficiency in voting governance: Some voting governance proposals are partially efficient, without any form of improvement in compensation contribution.
Regulatory issues: Many new blockchain protocols do not give an opportunity for legal and regulatory control.
Categories of DAOs
There are different types of DAOs, with all of them serving a particular purpose to ensure that critical matters are addressed, proposed and implemented following the protocol’s rules.
Below are several categories of DAOs, as well as examples of organizations that fall under them:
Investment DAOs
Investment DAOs are decentralized organizations that share similar features with traditional investment funds that operate with pooled funds. The only difference is that a single centralized authority does not decide the rules. Rather, investment DAO token holders can vote on what the pool of funds should be invested in.
Some notable examples of Investment DAOs are:
The LAO – is structured as a member-directed venture capital fund in the U.S and registered as a Delaware limited liability company(LLC).
MetaCartel ventures – is a sub-DAO under MetaCartel DAO which invests in nascent decentralized applications.
Grants DAOs
Grant DAOs are designed to fund new projects mainly within the decentralized finance ecosystem. These DAOs often stem from the philanthropic arm of larger projects in the DeFi space. However, some exist independently.
Common examples include:
Uniswap Grants – A DAO that manages the disbursement from Uniswap’s community treasury. It supports the growth of new projects around Uniswap and the DeFi space by funding hackathons and protocol development.
Gitcoin – an independent platform that funds developers and builders that create open-source applications.
Moloch – served as a framework for several new DAO.
Protocol DAOs
Protocol DAOs are the most common types of DAOs and are found behind major decentralized finance protocols. They are often used as an ownership and governance mechanism of lending protocols, yield optimization and several others.
Common examples include:
Uniswap – the top decentralized exchange on Ethereum. Uniswap’s governance system was launched in September 2020, giving UNI token holders the power to vote or delegate votes that controls the platform’s fees, treasury, etc.
Aave: a decentralized lending platform that enables users to lend and borrow major crypto assets.
Collector DAOs
Popular examples of collector DAOs include:
PleasrDAO – a collector DAO that pools funds together to acquire collectible items such as NFTs, music, real-life artwork, and more. While this DAO can be considered an investor DAO, the major difference is that it focuses only on art and collectibles.
Flamingo – a sub-DAO that stemmed from LAO. This DAO focuses on NFT investment opportunities to support the growing NFT and metaverse sector.
Social DAOs
Social DAOs are similar to country clubs where members gain entry into a social circle by paying membership fees in the form of purchasing a certain number of DAO tokens. Members of this circle share similar interests and the purpose depends on the DAOs.
Some notable examples include:
Bored Ape Yacht Club
Friends with Benefits
Frequently Asked Questions
Are DAOs truly decentralized?
Decentralization is a major characteristic of DAOs and in most cases, all details of DAO can be viewed by all community members.
What are the different membership models in DAOs?
The two types of membership models in DAOs are token-based and share-based models.
How are DAOs governed?
Governance of DAO completely relies on self-enforcing protocols called smart contracts, and governance can be on-chain or off-chain.
2020 stands as a year that changed the global financial landscape, leading to the emergence of decentralized finance (DeFi)
DeFi is a collection of financial applications built on the blockchain. With the World Bank estimating that 1.7 billion people across the globe remain unbanked, DeFi aims to promote financial unity, ensuring that everyone gets access to financial services – from remittances to loans.
Crypto has remained a buzzword for quite some time, but only in the last few years have crypto holders been able to put their crypto to work and access financial services. Just like instances where traditional financial institutions offer loans to customers capable of depositing collateral, the cryptocurrency industry is not left out. Borrowers can simply sign up on any of the numerous lending protocols to access a loan, providing collateral in the form of crypto.
This article explores cryptocurrency lending and the top lending platforms in this ecosystem.
What is Crypto Lending?
Crypto lending is the process where investors deposit cryptocurrency into a protocol to be lent out to borrowers in return for yield. Interest rates are often compounded weekly, monthly or yearly and designated in annual percentage yield (APY). Interest can depend on the lending protocols, as well as the asset in question. It is not rare for interest to be as high as 20% APY.
There are two major components associated with crypto lending. These are deposits that earn interest and crypto loans. Crypto deposits work in a similar way to those of financial institutions where users deposit cryptocurrency and the lending protocol pays them an interest in APY. The deposited crypto is often loaned out to borrowers to be used for other forms of investment.
On the other hand, crypto loans are often collateralized and users are required to deposit at least 100% in crypto collateral to borrow digital assets.
Crypto loans are of four types and each comes with its own risk.
Types of Crypto Loans
There are four types of crypto and they include:
Collateralized loans: These are the most popular types of loans and work such that deposited cryptocurrency is used as collateral for the loan. In some protocols, over-collateralization is required so that borrowers can access only a specific percentage of the deposited collateral, usually below 90% of the loan-to-value.
Crypto line of credit: Some crypto platforms now offer a cryptocurrency line of credit, rather than following the traditional loan pathway. The crypto line of credit is a collateralized loan where users borrow up to a certain percentage of deposited collateral. These loans come with a set of repayment terms and users only pay interest on funds withdrawn.
Uncollateralized loans: Though not popular, uncollateralized loans operate the same way as personal loans. To qualify, borrowers must fill out a loan application form, verify their identity and complete their creditworthiness review. These loans pose a great risk to lending institutions because the borrowers do not provide collateral that can be liquidated if the borrower defaults.
Flash loans: Flash loans are common in most cryptocurrency exchanges because these loans are borrowed and repaid in the same transaction. These loans are extremely risky and often used to take advantage of arbitrage opportunities in the market, such that a user can buy crypto at a lower price in one market and instantly sell at a higher price in another.
Some of the risks associated with crypto lending include margin calls, liquidity, non-regulation, and high interest rates.
How Does Crypto Lending Work?
To understand how crypto lending works, it is important to note that there are three parties involved – the lender, the borrower, and the DeFi protocol, which acts as the set of rules and logic that govern the transaction. The borrower must deposit some supported cryptocurrency which ultimately serves as collateral before borrowing any crypto. In some cases, interest rates may be paid in kind or with the native token of the platform. In situations where interests are paid in kind, there may also be bonus payments.
The safety of crypto lending is not always clear. In instances where the loans are collateralized and the borrower defaults in repaying the loan, the lender can get back their money by liquidating the borrower’s collateral. Interest rates are often much higher compared to those of traditional financial institutions.
In other instances, borrowers may suffer some risks because the collateral can lose some percentage of its value and be liquidated. When users deposit crypto in a lending protocol, they earn a significant amount of yield which is often much more compared to traditional financial institutions.
Top Crypto Lending Platforms
Crypto lending platforms are divided into two major types – centralized and decentralized. Each of these platforms has its own mode of operation and characteristics.
Centralized Crypto Lending Platforms
Centralized finance (CeFi) platforms simply refer to trading platforms that are controlled by a specific group of individuals who manage the platform and take decisions regarding the protocol at any time. Exchanges such as Coinbase, Binance, and Crypto.com are examples of these exchanges and offer more user-friendly options. These platforms operate just like traditional institutions and offer a perfect set-up for new crypto investors because they are not just easy to navigate but also present simple interfaces and streamline the process of buying and selling crypto coins.
These platforms are also unique because, in addition to providing buying and selling services, they offer crypto lending services, ensuring that their users have access to borrowing/lending facilities.
Features of CeFi Loans
Loans offered by centralized finance platforms tend to be unique due to the features they present. Below are some of them.
Loans are often handled by the exchange: Lending transactions that involve centralized finance protocols are not handled in a peer-to-peer manner, rather the exchange itself acts like an escrow and streamlines the lending process. This gives users access to several lending options such as multiple liquid pools.
Know-Your-Client (KYC) is needed: Before issuing any kind of loan, centralized exchanges are required to verify their users’ identities. As such, setting up an account takes a lot of time.
Anonymity: Just as with decentralized platforms, CeFi loans are anonymous. However, this anonymity only applies to the borrower and not the exchange. Due to the verification process that is always completed by the borrower, the exchange can see what each user does at any time. This makes the process of crypto lending between two or more users easy.
Interest payments: As CeFi platforms give out loans, it is important to understand that these loans do not come from their coffers, rather crypto holders take on the risk to earn yield by lending their tokens to others.
Easy-to-use interface: CeFi platforms offer easy-to-use interfaces which make them a great starting point for new crypto lenders who are interested in understanding how the whole lending process works without learning a new process.
Higher fee structure: It is important crypto users understand that they indirectly pay for using CeFi platforms in the form of higher fees. These fees are comparatively higher than those offered by DeFi platforms.
Popular CeFi Lending Platforms
Currently, there are several centralized exchanges that offer crypto loans. While the crypto crash that happened in the second quarter of May has disrupted some (for example Celsius), below are the some popular CeFi lending platforms:
Binance
Nexo
Crypto.Com
Block Fi
Binance
Binance is the world’s most popular cryptocurrency exchange and remains a solid choice for crypto lenders. This platform supports the lending of various crypto tokens including USDT and BUSD. Every registered Binance user is entitled to lending coins on the platform. The loan term usually varies between 7 and 180 days, and the platform calculates the interest hourly depending on the hours the coin was borrowed.
Lenders who plan to lend their tokens will have them stored in a timed deposit of 14 days and they would not be able to withdraw the tokens during that period. This time frame is shorter compared to other platforms. Lenders must also understand that the interest fees are either fixed or floating.
Some reasons why lenders choose Binance include:
The Binance platform supports the lending of several cryptocurrencies.
Security is Binance’s watchword. While its lending services are safer than most others, users must understand that the concept of ‘’not your keys, not your wallet’’ still applies to centralized exchanges.
There are instances where interest rates are excellent on certain assets, giving lenders more rewards.
When it comes to lending, the Binance interface is easy to navigate, making it a top choice for new crypto lenders.
Nexo
Nexo remains a top choice for crypto lenders because, besides the simple user interface, the platform presents a loyalty program which lenders can benefit from. Nexo gives its users an opportunity to deposit stablecoins and other cryptocurrencies in return for yield.
Nexo lenders receive interest rates that are directly proportional to the loyalty level on a daily basis. Interest rates can be in the form of stablecoins or other cryptocurrencies that are supported by Nexo. Nexo also supports earning on fiat currency, and all interest rates are fixed.
Some reasons why lenders choose Nexo are outlined below.
Lenders can earn up to 12% interest rates on stablecoins, giving them an opportunity to earn more interest on tokens deposited on the platform.
In addition to stablecoins and other cryptocurrencies, users can also lend fiat money.
Unlike other platforms, interest payments are done on a daily basis.
Gemini
Gemini gives lenders the opportunity to earn up to 8% or more on crypto assets they lend to borrowers. Gemini does not only lend assets to borrowers but also to financial institutions. Interest rates are paid to Gemini users on a daily basis, giving them the opportunity to accumulate their interest in variable rates.
Below are reasons why lenders choose Gemini:
Interest rates usually range from 8% and above.
Gemini pays lenders interest daily.
On the same day users deposit their tokens, they start accumulating interest at 4:00.p.m
Both financial institutions and retail borrowers can access loans on Gemini.
BlockFi
BlockFi is a popular CeFi lending option as it remains the only independent lender with institutional backing that offers huge benefits to lenders. The interest rate offered by BlockFi depends on the type of token and the amount deposited. Users can earn interest on both stablecoins and other types of crypto, giving lenders an option to choose from. Usually, interest rates on BlockFi are fixed.
Some reasons why lenders choose BlockFi include:
The average APY on tokens users lend to borrowers is 8.5%, depending on the type of token deposited.
Tokens that users can lend to borrowers include Bitcoin, Ethereum, USDT, etc.
Stablecoins can be used for lending on the platform, serving as an opportunity for users to earn diverse returns.
Decentralized Crypto Lending Platforms
Decentralized crypto platforms are those that are not controlled by a central authority, creating more room for decentralization and anonymity. When lenders offer their tokens for crypto loans, on these protocols, they interact directly with the borrower rather than waiting on the exchange to serve as a third party. This way, when a lender offers the tokens to borrowers, they retain custody of their coins. This is generally more reliable than handing custody of the tokens to a third-party platform.
Features of DeFi Lending platforms
There are some features that make DeFi lending platforms unique. They include:
Peer-to-peer lending: Though DeFi lending takes place in a peer-to-peer manner, the transaction takes place over an exchange, prompting a secure and safe environment for users who lend their tokens to others.
Anonymity: Because lending transactions take place on a decentralized exchange, users can easily interact to lend or borrow tokens without disclosing their identities to anyone.
Interest payments: Users will receive interest for lending tokens to others. Even though the rates vary, users can still earn extra yield from their tokens while retaining custody.
Borrowing pools: DeFi platforms often have liquidity pools where users can provide liquidity to decentralized exchanges (DEXs) and earn fees
Non-custodial: Unlike centralized exchanges, users do not have to worry about transferring custody of their collateral to a third party.
Security: Tokens deposited into the liquidity pool are backed by robust smart contracts and technological infrastructure.
Popular DeFi Lending Platforms
There are a lot of DeFi lending platforms in the cryptocurrency ecosystem. Some of them include Aave, MakerDAO, Compound, dYdX, Atomic, Uniswap, and PancakeSwap.
Aave
Aave is an open-source decentralized protocol that offers users access to liquidity pools where they can lend their tokens to others in return for interest. This platform offers varying interest rates for different yields and interest rates vary for each token.
The interest rates paid to lenders often range around 1% and 3%. While interest rates change regularly, some tokens are associated with much higher yields.
Some reasons to choose Aave include:
Flexible interest options as the rates can be fixed or floating.
Borrowing can somewhat be flexible as Aave also offers flash loans.
Aave offers a risk framework (A+ to D-) that displays the rating for various assets on the platform.
Nexus Mutual offers loan insurance on Aave.
Compound
Compound is another DeFi protocol with liquidity pools for different assets. When a user lends tokens, they go into the liquidity pools and are merged with other users’ tokens. Borrowers then assess the liquidity pools and later pay what was borrowed with interest rates.
Compound allows users to earn interest in the same token they provide to the lending pool. With interest rates being fixed or variable, earnings differ with tokens.
Below are some features of Compound:
Lenders earn interest in the same token that was offered to the liquidity pool.
Loans can be insured using Nexus Mutual.
MakerDAO
With MakerDAO, borrowers and lenders combine to generate DAI, a stablecoin that is pegged to the U.S. dollar. The MakerDAO network is built on the Ethereum network and offers users flexible interest rates that range from 0% to 8.75%.
Below are some reasons why lenders choose MakeDAO.
In the event of volatility, users can use asset management tools such as DeFi Saver to ensure vaults are sufficiently collateralized.
MakerDAO vaults can be easily tracked because they are integrated into other asset management tools.
Decentralized Governance: a community of MKR token holders govern the Maker Protocol
Frequently Asked Questions
What platforms offer crypto lending services?
There are several platforms that allow users to lend their tokens to borrowers in exchange for interest fees. These platforms are categorized into centralized and decentralized platforms. Popular examples include Nexo, Binance, Maker DAO, Aave, etc.
What do borrowers use crypto loans for?
Borrowers use borrowed tokens for a range of purposes such as collateralized debt positions, margin trading and so on.
Do crypto interest rates fluctuate?
Crypto lending interest rates change depending on a number of factors such as the utilization ratio of underlying capital pools. Also, the popularity of a liquidity pool will have an impact on rates.
Over the last few years, millions of dollars worth collateralized assets have been liquidated in decentralized finance (DeFi). While most of them occurred daily, others with larger liquidations happened in waves.
The greatest of such events is the Black Thursday that happened on Thursday, March 12, 2020, where a total of 399 liquidations occurred in MarkerDAO with over $10 million worth of collateralized assets liquidated on the same day alone. The crash resulted in $550,000 worth of liquidations on Aave and $5 million on Compound.
Given that these scenarios do not happen often, it is of utmost importance that crypto enthusiasts understand how liquidations happen in popular DeFi lending and borrowing protocols, and these events can be prevented.
This guide highlights the process of liquidations in the Aave protocol and how they can be minimized or prevented.
What is Liquidation?
In finance, liquidation is the process where a business ends and its assets to claimants are disrupted. In some cases, it occurs when a company becomes insolvent and cannot meet up with its relevant obligations.
In the case of lending and borrowing protocols, liquidation is a process that occurs when the value of a borrower’s collateral depreciates in comparison to the value of a loan. It often happens when the collateral decreases in value or a borrower’s debt increases in value against each other, that is, when a borrower’s health factor goes below 1.
The collateral vs loan value ratio is often shown in the health factor. During the process of liquidation, up to 50% of a borrower’s loan is repaid and the addition of that value and liquidation fee is taken from the collateral available. Therefore, after liquidation, the amount liquidated from the debt is repaid.
Just as with loans, providing collateral has been an existing norm for borrowers. For instance, if a borrower needs a significant amount of loan, the individual is often asked to provide collateral such as a house or any other landed property which will give the lending institution a way of recovering their money from the borrower in the event that the loan cannot be repaid.
In reality, the lending institution only has this guarantee provided that the collateral itself is maintained at a steady value. If the value of the collateral crashes, the lender would lose the security of the collateral. Normally, assets used for collateral maintain somewhat of a steady price so the issue is rare.
It is entirely different with crypto as collaterals face greater risk and volatility.
Taking loans in DeFi requires providing crypto collateral, the volatility notwithstanding. Borrowers often experience a higher degree of freedom and new borrowing opportunities with DeFi. However, it is important to note that it poses a higher degree of risk which is often borne by the borrower. The value of Ethereum or AVAX used as collateral today may completely change next week, causing the collateral to fall in value and taking security away from the lender. It is not unusual for collateral to fall in value, however, it is more pronounced in DeFi protocols due to the volatility of crypto assets.
How Liquidations Occur on Aave
The collateralization ratio is one of the most important factors in Aave liquidations. The system considers the liquidation point and each collateral type has a minimum collateralization ratio. Once your position falls below the minimum collateralization ratio, the position in the vault will get liquidated.
In Aave, once a borrower’s position falls below 50%, it can be bitten at a time without any form of auction. This means a single person can liquidate an unsafe position and win the collateral at a specific discount rate.
There are certain factors associated with liquidations on Aave:
The liquidation penalty often varies based on the type of assets and ranges from 5 to 15%. ETH is specifically pegged at 5%, and this is lower compared to some protocols such as Compound and MakerDAO.
Recently, Aave introduced a safety leeway called the liquidity on top of the maximum loan-to-value ratio. This ratio varies between assets. In a situation where a borrower reaches 100% of their borrowing power, they automatically would not be able to borrow any more funds. However, such users will have some room left until liquidation occurs.
With Aave, an interface exists where uncollateralized positions can be liquidated right in the application.
Below are some notable figures concerning liquidations on Aave (the following numbers are made up for simplicity):
Symbol: Aave
Loan to value: 50%
Liquidation threshold: 65%
Liquidation bonus: 10%
The following is an example of an Aave liquidations:
Ann deposits 12 ETH and borrows 6 ETH worth of USDC.
If Ann’s Health Factor drops below 1 her loan will be eligible for liquidation.
A liquidator can repay up to 50% of a single borrowed amount, that is 3 ETH worth of USDC.
In return, the liquidator can claim a single collateral which is ETH (5% bonus).
The liquidator claims 3 + 0.15 ETH for repaying 3 ETH worth of USDC
How to Overcome Liquidations on Aave
Overcoming liquidation involves doing two basic things. To instantly make a position safer the borrower can either add more of the supplied collateral or repay a part of the debt. If a borrower does any of these, their collateralization ratio increases and debt power is reduced. More often than not, the major way borrowers prevent liquidation in the Aave ecosystem is by repaying a part of the debt to unwind their position and reduce their debt.
It is important to understand that the impact of these strategies depends on the collateral rules behind each asset and each protocol.
Repaying to Unwind position and Reduce Debt.
As one of the major Ethereum DeFi protocols, Aave has become increasingly popular and is often used by DeFi traders as a mechanism for leverage when taking short or long positions with certain assets. The scenario involves the option of paying back debt with an already supplied collateral.
By completely or partially repaying borrowed assets, users can unwind their existing positions. The Repay feature works in both Aave, MakerDAO, and Compound, and can be found in their respective dashboards in DeFi saver.
The Repay option in one transaction does three things:
Withdrawal of supplied collateral (e.g ETH)
Swapping supplied collateral for the borrowed asset (e.g exchanging ETH for UDDC)
Using the new funds to repay debt (e.g repaying UsDC debt).
In Aave, Repay can be used with any pair of borrowed assets. When borrowers keep their health factor above 2, it gives them more of a margin to avoid being liquidated.
There are two unique tools that can help with this. The HAL tool enables borrowers to track and receive notifications about their health factor (HF). Secondly, DeFi Saver helps users auto-liquidate their loans.
Borrowers should even pay attention to fluctuations in the prices of stablecoins that are being used as collateral. For instance, in the rare occurrence that USDC falls below $1.00, the borrower’s health factor would be impacted.
Frequently Asked Questions
Can you get liquidated on Aave?
Yes, anybody can get liquidated on Aave, provided they are taking out loans and providing collateral. In the case of liquidators, these traders often develop their own solutions and bots to become the fastest in liquidating loans and receive a liquidation bonus.
How can I participate in Aave liquidation?
Anyone can participate in Aave liquidation by:
Using the liquidations module in the Aave app
By calling the liquidation call directly in the lending pool contract.
What is the liquidation threshold in Aave?
The Aave liquidation threshold is the percentage at which a loan is defined as undercollateralized. This depends on the asset in question. For instance, if the Aave token liquidation threshold was 75%, it would mean that when Aave’s value rises above 75% of the collateral, the loan is undercollateralized and is under threat of liquidation.
How much is Aave’s liquidation penalty?
The liquidation penalty, sometimes regarded as liquidation bonus, often varies depending on the asset used as collateral. Borrowers can find every assets’ liquidation fee in the risk parameters section.
What is the benefit of borrowing from Aave?
When investors borrow from Aave, they are able to obtain a working capital without selling their assets. Most times, users borrow for unexpected expenses, leveraging their holdings, or for new investment opportunities.
What is a good health factor for Aave?
A good health factor for Aave liquidation is above 1.
Cryptocurrency has become one of the most lucrative investment avenues. In this decentralized market, there’s an increasing need for decentralized finance platforms where crypto users can exchange tokens, save, trade, invest, lend and even borrow.
Compound Finance has seamlessly emerged as one of the most sought-after decentralized finance (DeFi) applications on the market as it bridges several financial gaps. The platform offers its flocks of users numerous functionalities with which they can easily steer their way in the vast DeFi ecosystem.
Its competitive advantage is its compound interest feature which permits users to earn compound interest on their assets.
The ability to earn compound interest on stationary cryptocurrencies found in digital wallets wasn’t possible due to the outdated conventional finance system. However, protocols like Compound Finance have turned this outdated financial system on its head.
From its features to variables interest rates, ROI to the pros and cons, here’s your very own guide to Compound Finance. Call it your Compound Finance review.
What is Compound Finance?
Founded in 2018 and headquartered in San Francisco, California, the Compound Finance protocol is an algorithmic open-source, decentralized finance application. It’s an autonomous interest rate protocol based on the Ethereum blockchain that enables developers and cryptocurrency traders to explore myriad financial opportunities related to the lending and borrowing of digital assets. Because it is decentralized, Compound Finance’s system is void of middlemen. So cryptocurrency transactions go directly from lender to borrower. However, several factors come into play which we’ll be discussing in detail.
Compound Finance Features
Compound Finance has features coveted by other DeFi platforms. Some of these include:
Community Governance
Compound Finance prioritizes the users in its community so much that these community members maintain the platform. At Compound Finance, users have more than a voice. They have the power to instigate changes within the forum through interactive user features like voting rights, delegation, or proposals. Through the platform’s protocol token, COMP, token holders can delegate and assign voting rights to themselves or other addresses. Holders of COMP can also charge votes sent from others to delegates. However, it’s important to note that the COMP balance of the sender determines the number of votes sent to any representative.
Compound Finance has opened up its governance so that anyone with 1% of COMP delegated to their address can propose a governance action. These proposed actions are executable codes to be implemented. They could be anything from changing a market’s interest rate model to changing the collateral factor of an asset or anything the administrator can modify. Once initiated, these proposals go through a three-day voting period during which enfranchised users, or fellow COMP holders can vote for or against the said proposed, aiming for a decentralized form of democracy. If at least 400,000 votes favor the proposal, it is placed in the Timelock and will be implemented after two days.
Community Security
The Compound DeFi platform, like any other network, is subject to vulnerabilities by its users or other entities. The application employs fortified security measures to checkmate the manifestation of these vulnerabilities into threats. In addition to the platform’s advanced protocol security system, which includes high-profile security auditors like OpenZeppelin and Trail of Bits, Compound DeFi implores its users to find bugs on its site. Thus, increasing the site’s security priorities. As an incentive, Compound is offering $150,000 as a bounty to any individual or developer that can find bugs on the DeFi platform.
Simple Interface
The user interface on the Compound Finance website is minimalistic and appealing. Its design features are advanced and intuitive too. The features and options on this site are legible and easily accessible. The labels are also self-explanatory. For instance, you can see how much you’re lending on the left and the amount borrowed on the right. The design also lets you see both types of markets at a glance.
Improved Versions
According to its founder, Robert Leshner, Compound Finance is motivated by the need to create a financial infrastructure on which developers and applications can rely. This is why the platform is constantly being improved. Since its launch in 2018, the Compound protocol has updated versions twice. The most recent version, Compound III, launched in August 2022 and came with significant improvements to the previous versions. For instance, in this version, a user’s collateral remains their property and cannot be borrowed or withdrawn by anyone else, which makes it safer and reduces counterparty risk.
Supported Crypto Assets
Compound supports financial activities via various cryptocurrencies called assets. Currently, the platform supports 20 cryptocurrencies, including USDT, UNI, WBTC, YFI, etc.
Presently, the Compound III version permits users to borrow USDC using assets like ETH, WBTC, LINK, UNI and its very own COMP as collateral.
How Does Compound Crypto Work?
Compound Finance is a killer DeFi protocol with about $2.3 billion worth of assets locked up and accruing yield across 20 markets. As expected, this platform works much differently from other types of loan markets. On Compound Finance, lenders lend cryptocurrency assets to borrowers via a liquidity pool. Essentially, they fund this pool, and the borrowers borrow from it.
Compound Finance’s liquidity pool is not a bank account but a chain of smart contracts. These smart contracts are automatic and contain conditions of the buyer-seller agreement represented by digital algorithms, with which the agreement is executed void of any third party. Through these algorithms, Compound’s smart contracts automatically generate interest rates with due consideration of the demand and supply of assets at any given time.
Like any other market, there are fluctuations in the value of cryptocurrencies, affecting their demand and, thus, interest rates. These fluctuations incentivize lenders to lend more. It also discourages borrowers from over-borrowing even though Compound Finance has no limit for lending or borrowing.
What you can do on Compound DeFi
Compound permits users and developers to perform several types of financial transactions. Here’s how to earn interest on Compound:
Deposit
Compound users can make deposits into their wallets which can accrue interest. Here’s how it works. First, you’ll need to connect a crypto wallet to the platform. There are a handful of funding institutions which Compound supports, like Ledger, Anchorage, etc., as seen below.
Once connected, users can access their funds in these wallets, with which they can then purchase cryptocurrency assets. However, users can only make deposits through these Ethereum web wallets as the Compound DeFi operates in the Ethereum blockchain. Also, on this platform, assets are called cTokens. So, if you deposit ETH into Compound DeFi, it becomes cETH. Likewise, other assets like DAI, which becomes cDAI, etc. These cTokens are redeemable 1:1 with the underlying asset as they represent a portion of the liquidity pool. As borrowing increases, these cTokens accrue interest and are redeemable to more of the underlying asset. Hence, users earn compounded interest on their cryptocurrencies by leaving them in their wallets.
Compound Crypto Lending
Compound crypto lending is relatively easy on Compound DeFi. It’s one of the easiest ways to earn compounded interest on the platform. To lend assets on Compound Finance, you’ll need to unlock said cryptocurrency asset and sign a transaction through your web wallet. So, assuming you want to supply AAVE, you’ll need to enable it, as seen below.
Once done, Compound will add your capital to the liquidity pool, and you’ll start earning interest in real time after the assets are converted to cTokens. It’s worth noting that lenders on the Compound Finance protocol earn interest every Ethereum block, which translates to 15 seconds. Hence, if you lend on this platform, your interest accrues every 15 seconds, which compounds significant amounts.
Borrow
Compound Finance users can borrow cryptocurrency to their heart’s content. These assets could vary as the platform offers flexible interest rates and repayment plans. On Compound, the value of assets you lend influences your borrowing limit. Hence, the more you lend or invest, the more you can borrow. Previous versions of Compound Finance operated under this over-collateralization principle which made borrowers supply more in collateral than they needed to borrow. The Compound Finance III version prevents collateral from being borrowed or withdrawn by someone else. In this version, users can borrow more with lower fees, less liquidation risk, and lower penalties.
You might ask yourself, ‘what do you need to borrow crypto from Compound?’
To borrow cryptocurrency like AAVE tokens, you’ll need to deposit collateral to cover this Compound crypto loan. After this, you’ll earn a borrowing power or limit, influencing the value of assets you can borrow. It’s imperative to note that each cryptocurrency asset adds a different amount of borrowing power. The process only takes a few minutes, and your wallet will be credited in no time.
Repay
After borrowing an asset, the next course of action would be its reimbursement. To repay an asset on Compound Finance, users have to enable it first. Here’s an image representing what repaying a stablecoin as DAI looks like:
After you’ve clicked on ‘Enable’, you’ll be required to approve the transaction using your chosen web wallet. Then click on ‘Repay’ and approve the transaction.
Withdraw
Withdrawing on Compound Finance is easy. After repaying all your loans, you can withdraw your collateral or interests. All you need to do is select withdraw to your previously chosen web wallet.
Rates On Compound Finance Protocol
As previously mentioned, Compound Finance’s computerized algorithms determine one’s APY and interest rates. However, the rule of thumb does influence the calculation of these rates. Here’s an overview of the interest rates on a handful of cryptocurrencies in supply and borrow markets.
Compound Finance Fees
Compound Finance fees are minimal and affordable. First off, the platform charges zero trading fees. It also charges zero slippage fees. Thus, Compound Finance charges its users nothing to buy, sell, withdraw or deposit their cryptocurrencies. The only fees developers and users of Compound pay are the transaction fees or gas, which differ depending on the transaction day, time and market conditions. Gas fees are applied whenever a user initiates either of the following transactions:
Minting
Borrowing
Transfers
Asset Liquidation
Repayment.
In addition to this, the Compound Finance Protocol does not require a minimum deposit on registration.
Pros and Cons Of Compound DeFi
What is the key benefit of using Compound? What drawbacks can you expect on Compound? This is the section you’ve been waiting for:
Compound Finance Pros
Range of Earning Opportunities
There are several ways to earn interest on Compound. You can lend multiple types of cryptocurrency with varied rates of return and accrue interest every 15 seconds! You can also try yield farming which earns you a high APY.
No Verification Assessments
Unlike traditional financial institutions, which require lengthy documentation and verification processes like KYC, credit records, or AML, Compound doesn’t require such paperwork. This gives a liberating experience and is the platform’s competitive advantage.
No Trading Fees or Slippage
Compound doesn’t charge its users trading or slippage fees. Users are, however, subject to affordable gas fees.
Support Forum
Compound Finance has a collaborative forum on Discord where users can receive support in real time.
Fortified Security
Compound is one of the safest DeFi platforms on the market. Its advanced team of security verifiers and auditors, formal verifications and bug bounty programs keeps the platform tightly secure.
Rewards! Rewards! Rewards!
Compound traders can easily earn COMP rewards on all transactions they make.
Simple UI/UX
Compound’s design, user interface and experience is simple and promotes easy navigation.
Compound Finance Cons
Ethereum-exclusive
Compound Finance operates solely on the Ethereum blockchain and doesn’t support other chains.
Limited cryptocurrencies
Compared to its competitors, Compound offers a limited number of crypto ERC-20 options for users to lend or borrow.
Unstable markets
Like the stock market, the cryptocurrency market is equally unstable and unpredictable, increasing traders’ risk.
No mobile app
Compound Finance operates via its website. The platform has no mobile application.
Final Thoughts
Overall, Compound Finance enables developers, traders and crypto enthusiasts to earn compounded interests in several tokens at minimal gas fees. Its smart contracts, decentralized nature, security measures and numerous functionalities have taken the blockchain beyond payments, thus making it a preferred choice in the DeFi space. Compound Finance is bridging the gap of seamless, peer-to-peer crypto investments and is a force to be reckoned with in the DeFi ecosystem.
FAQs
What does Compound Finance do?
Compound Finance is a decentralized peer-to-peer finance platform where users can earn interest on their crypto assets by depositing them in their wallets. Compound Finance permits traders to borrow, lend and trade cryptocurrencies, thus maximizing their earning potential.
Does DeFi give interest?
DeFi, or decentralized finance, allows financial products to be built on a public blockchain, offering interest rates to lenders and the ability to take loans for borrowers. The absence of a middleman and the unprecedented financial control over one’s assets make DeFi’s interest rates higher in comparison.
Is Compound Finance safe?
The security measures established by Compound’s protocol make it almost impenetrable. It is one of the safest DeFi platforms in the blockchain, as the tendency for a hacker to gain control of the smart contracts (liquidity pool) is highly unlikely.
The cryptocurrency industry is filled with maximum risk, hence investors must properly conduct research before being fully immersed.
It is important to note that through decentralised finance (DeFi), crypto investors can generate streams of passive income. This is often through staking, providing liquidity, and yield farming.
One of the major risks associated with liquidity provision is impermanent loss. And the more the slippage in the prices of assets in a liquidity pool, the more losses an investor incurs.
The guide fully explores the concept of impermanent loss in its entirety, including how to calculate and overcome it.
What is Impermanent Loss?
Impermanent loss (IL) is a common phenomenon in crypto where the price of a token fluctuates (rises or falls) after an investor deposits it in a liquidity pool. Impermanent loss is directly related to yield farming.
Yield farming is the process of lending tokens to a decentralised protocol’s liquidity pool in order to earn rewards. Yield farming should not be interchanged with staking, where investors are requested to inject money into the blockchain to confirm and validate transaction blocks in order to earn staking rewards. Yield farming entails investors depositing tokens into a liquidity pool.
The rewards from liquidity pools vary with the protocol involved. But since yield farming seems to be more profitable, some investors now find holding coins unattractive.
The risk of impermanent loss is directly tied to the amount of liquidity provided and the total number of tokens in the liquidity pool. In a liquidity pool, tokens are usually paired. It could be a stablecoin such as Tether’s USDT or Ethereum-based tokens such as Ether (ETH). Certain pools with stablecoins that have a narrow price fluctuation are often less vulnerable to temporary losses. This means liquidity providers often face a lower risk of impermanent loss with stablecoins.
While liquidity providers who deal with automated market makers (AMM) are vulnerable to future losses, they tend to provide liquidity to volatile pairs because trading fees can compensate for these losses. For example, Uniswap has a trading fee of 0.3% with liquidity pools that are highly susceptible to volatility and impermanent loss.
It is important to understand that impermanent losses are impermanent because as token prices fluctuate, the prices of the tokens may eventually return to the value at the point of the deposit. Should investors remove their money before this time, their losses will be permanent.
How Do Impermanent Losses Occur?
Impermanent loss occurs when there is a difference between the value of the liquidity provider’s tokens and the underlying tokens that if they weren’t paired in the pool. When a pool’s smart contact is created, the balance of each token will be zero. In order to facilitate trades, the proof must be seeded with an initial deposit of each token, either ETH/USDT or DAI/ETH.
The first liquidity provider sets the initial price of the proof and is incentivised to deposit an equal value of both tokens into the pool. For instance, if a liquidity provider with 10 ETH wants to provide liquidity to a 50/50 ETH/USDT pool, such an investor will need to deposit 10 ETH and 10,000 USDT (this is if the price of ETH is 1,000 USDT).
Assuming the pool has a total value of 100,000 USDT, i.e. 50 ETH and 50,000 USDT, such an investor’s share will be 20% of the pool, using this simple equation:
10ETH (10,000 USDT) + 10,000 USD X 100 = 20%
————————————————-
100,000 USDT
However, if the liquidity provider deposits tokens that are in a ratio that is different from the market rate, an arbitrage opportunity is immediately created and leveraged by an external party. If they believe the current market price is incorrect, they could arbitrage it and add more liquidity to the pool until the desired level is reached.
The percentage of a liquidity provider’s participation is important because when deposits are made into a pool through smart contracts, they are instantly rewarded with liquidity provider (LP) tokens. Such investors can withdraw their portion of the pool (e.g. 20%) using the LP tokens. Because investors are entitled to a certain portion of the pool and not a definite quantity of tokens, they are susceptible to impermanent loss, which happens when the value of deposited tokens changes compared to the time when they were deposited.
Liquidity providers must understand that the larger the degree of change, the more impermanent loss they will be exposed to. This is because the fiat value of the withdrawal would be further from the value of the deposit. However, such losses can be recovered because prices can return to how they were at the point of deposit on the AMM. Trading fees can cover the risk of exposure and hence act as a reward for the risk.
How to Estimate and Calculate Impermanent Loss
Estimating impermanent loss is just as simple as introductory concepts in blockchain technology. Given the volatile nature of cryptocurrencies, price movements become unpredictable. The same can also be said for impermanent loss, leaving liquidity providers with the ability to only estimate the intensity. This implies that impermanent loss can keep changing until an external measure is taken. As such, if an investor decides to withdraw their funds after slight price changes or not, impermanent loss can become permanent.
In other cases, liquidity providers can get prices that are higher than envisaged, providing an opportunity for arbitrage trading. For instance, if the new price of Ether rises, there will be an opportunity for arbitrage traders to buy the coins at a cheaper rate. Because the new ETH price will be different from the previous price in the liquidity pool, the ETH can be replaced with another token and deposited until the ratio arrives at a new rate. This method of estimation often takes place in standard liquidity pools, enabling investors to assess the approximate value of an impermanent loss concerning a deposit in a cryptocurrency wallet.
Similarly, impermanent loss can be calculated using the constant formula. The formula states that:
ETH liquidity x token liquidity = Constant product.
Following the previous example where 1 ETH was 1000 USDT, let’s assume that it doubled to 2000 USDT. Since a smart contract algorithm adjusts the pool, the above formula can be used to manage the assets.
Using the same example where the pool is 50:50 ETH/USDT, the constant will be 2,500,000, i.e 50 x 50,000 = 2,500,000.
With the same formula, the price of ETH can be determined. i.e.
Token liquidity/ETH liquidity = ETH price
50,000/50 = 1000.
But, since the new price of Ethereum is 2000, the formula for ETH liquidity and token liquidity will be:
ETH liquidity = square root (constant product / ETH price)
Token liquidity =square root (constant product x ETH price)
Therefore, the ETH liquidity and token liquidity at the new price of 2000 will be:
ETH liquidity = Square root (2,500,000/2000) = 35.35 ETH.
If this was to be verified with the constant product formula, where ETH liquidity x token liquidity = constant;
Then 35.355 x 70,710.6 = 2,500,000.
While the old liquidity is 50 ETH and 50,000 USDT, the new liquidity ratio will be 35 ETH and 70,710 USDT.
At this point, the liquidity provider might choose to withdraw their 20% share of the liquidity pool. Taking their share from the updated amount, the investor will have 7 ETH (i.e 20% of 35 ETH) and 14,142 USDT (i.e 20% of 70,710 USDT). The total value of assets withdrawn will be 7ETH X 2,000 USDT + 14,142 USDT = 28,142 USDT
These differences occur due to the manner AMMs manage the market, and it is called impermanent loss.
How to Avoid Impermanent Loss
Avoiding impermanent loss is quite difficult for liquidity providers due to the rapid changes in the price of crypto assets. However, several strategies exist for managing impermanent loss. These strategies include the introduction of trading fees, maintaining low volatility, eliminating complexities in liquidity pools, and single-sided liquidity pools.
Introduction of trading fees
Trading fees can be described as charges collected from traders who service the liquidity pool. Ideally, when considering impermanent loss, it is important that liquidity providers ensure a portion of the trading fees is included in the liquidity pool. When trading fees are collected from traders, a certain percentage of the total fees can be given to liquidity providers just to enhance the proper management of the protocol. The amount, in some cases, is sufficient to compensate for the impermanent losses.
In DeFi protocols where more trading fees are collected, cases of impermanent loss are reduced.
Maintaining low volatility
Impermanent loss is more common in token pairs with greater volatility. To wade off an impermanent loss, investors can choose liquidity pools with token pairs exhibiting lower volatility. Such digital assets are often stablecoins such as USDT and DAI. Other cryptocurrency pairs with variations of a certain token can help to maintain low volatility.
Investors who practice this strategy must ensure that the cryptocurrency pairs follow nearly the same price movements.
Eliminating complexities in liquidity pools
Complexity in liquidity pools is one of the reasons why impermanent loss occurs. Complexities happen due to an equal split needed by most liquidity pools. And as long as complexities exist, impermanent loss will remain.
To eliminate these complexities, some decentralised exchanges now allow several variations of liquid pool ratios to neutralise the overall effect. One such exchange is Balancer. Unlike other decentralised protocols that create liquidity pools for single pairs such as ETH/USDT or ETH/DAI, Balancer offers the ability for LPs to deposit liquidity into multiple ratio weights, and up to 8 tokens in a pool.
Single-sided liquidity pools
One of the ways through which impermanent loss occurs is when two different extremely volatile crypto assets are deposited in a single-sided liquidity pool. While some decentralised exchanges now offer liquidity pools to take the stake on only one side, the other side of the liquidity pool is still inaccessible to the liquidity provider.
This strategy ensures there are no risks of impermanent loss as the user only provides access to one side of the liquidity pool. Since an oracle provides the decentralised exchange with price feeds, the liquidity pool automatically adjusts when prices fluctuate.
Other strategies that can guard liquidity providers against impermanent losses include:
Choosing crypto pairs that do not expose liquidity to market instability and temporary loss. This is far better than opting for crypto assets that have high volatility and unstable history.
Liquidity providers should always research the market for high volatility. This gives an insight into which assets are the riskiest.
How Impermanent Loss Protection Helps Liquidity Providers
Impermanent loss protection can be viewed as an insurance cover. Liquidity provision is profitable on AMMs if the yield of farming exceeds that of temporary loss. In situations where investors incur losses, the impermanent loss protector can be used to protect against impermanent loss.
To activate this protection, an investor must stake some tokens. A perfect example of an exchange where the IL protection works is the Bancor exchange. When an investor makes a new deposit, Bancor Network provides insurance coverage that lasts 100 days at a rate of 1% per day. If a temporary loss occurs within these 100 days, such investment is covered at the time of withdrawal. However, if a withdrawal is made before the expiration of the 100 days maturity, such an investor only gets partial compensation against impermanent loss.
Merlin by VALK identifies liquidity pools on major DEXs and for Uniswap V3, it analyses open and closed positions since the first executed transaction by that wallet. It allows the filtering of information by protocol and transaction (e.g., added liquidity, exchange, deposit, borrow and more). Merlin’s unique analysis calculates total yield and total P&L related to the position, shows
inner transactions, and checks whether the investor is in range or not
Importantly, Merlin calculates the impermanent loss and presents the full picture for both unclaimed and claimed fees. Soon, Merlin will allow investors to claim fees directly from its interface without having to switch platforms
Impermanent loss is a phenomenon that occurs when a user deposits tokens in a liquidity pool and the market value of such token fluctuates considerably while in the pool. The difference in the value at the time of deposit and when the change occurs is called impermanent loss.
Is impermanent loss permanent?
Impermanent losses are usually temporary because as the price fluctuates, the value of the deposited tokens in the pool can return to the initial deposit price. Losses only become permanent should the liquidity provider withdraw the token before the market recovers.
What is a liquidity pool?
A liquidity pool is where lenders can deposit specific pairs of assets as liquidity. This allows DeFi users to swap tokens easily. Such pools are often found in decentralised exchanges.
What are stablecoins?
Stablecoins are cryptocurrencies whose value is pegged to a particular fiat currency, collateralised by fiat assets, other digital assets, or algorithmically. Examples are USDT, USDC, BUSD, cUSD, DAI, etc.
What are decentralised exchanges?
Decentralised exchanges are protocols that facilitate DeFi actions such as swapping, liquidity provision and market making. They are managed by smart contracts on the blockchain and participation occurs via peer-to-peer interactions directly from the user’s wallet, without the influence of an intermediary. Examples include PancakeSwap, Uniswap, Balancer, and dYdX.
What is staking?
Staking is the process where an investor lends tokens to a DeFi protocol/consensus mechanism, where these tokens are locked in a vault for a given period in order to earn rewards.
Lido is a non-custodial liquid staking protocol (operated according to smart contracts) that has been employed by several cryptocurrencies, including Solana, Ethereum, Polygon, Kusama, and Polkadot.
Lido removes the difficulties and risks associated with the maintenance of the staking infrastructure. This is accomplished by enabling users to delegate their digital assets, in any quantity, to professional node operators.
To reward their commitment to investing their crypto assets, validators may be rewarded with tokenised, liquid staking derivatives called Lido-staked assets (stAssets). These stAssets, in turn, may be traded or utilised as collateral across many popular decentralised finance protocols amongst validators to earn additional investment yield.
The Lido decentralised autonomous organisation (DAO) will hold the voting rights to bring in node operators into the system, who will be responsible for managing the staking process.
At the point of writing, Lido is the second largest protocol based on its total value locked (TVL), as well as accounts for nearly one-third of all Ethereum that has been staked.
Staking is a method for cryptocurrency enthusiasts to generate investment yield by agreeing to invest in a specific sum of their tokens. This crypto-economic concept has been in the spotlight in the last two years due to the proof-of-stake (PoS) consensus mechanism emerging as the dominant approach for validating transactions on blockchain networks. In particular, the PoS mechanism contributes to the reduction of energy usage and also enhances throughput by having validators (also known as stakers) commit a certain amount of their crypto assets as collateral when introducing new blocks. As a result, these validators may be rewarded in the future for their risk-taking efforts through receiving a tokenised derivative called Lido-staked assets (stAssets), which comes in the form of either shares or rebase. These liquid staking derivatives, in turn, can be used as collateral on various decentralised smart contracts or be traded.
Nevertheless, the majority of PoS networks possess high entry barriers for prospective validators as the minimum capital requirements to get started with staking are very high. On top of that, various technological complications surround the staking procedure, with extended asset commitment periods causing unwillingness and the lack of buy-in amongst potential validators. Consequently, an entirely new sector known as staking-as-a-service has emerged to offer cryptocurrency investors an easy, flexible, and capital-efficient access point to staking. Lido, in particular, is the current market leader for this sector.
On that point, VALK offers a complete ecosystem of decentralised digital tools to assist crypto enthusiasts in becoming better investors. For example, Merlin, VALK’s Smart DeFi portfolio tracker, can determine the effectiveness of its investment strategy by calculating the total yield and profits earned from a portfolio in USD, providing analysis on major protocols such as Lido.
A Brief Overview of the Lido Staking Protocol
Lido is a decentralised finance (DeFi) application used by numerous cryptocurrency smart contracts. Its DAO was established in 2020 by a team of noteworthy figures and institutions such as ParaFi Capital, P2P Validator, Stani Kulechov (popularly known as Aave), and the Twitter personality Jordan Fish (@cobie). Coincidentally, its launching was only a number of weeks after the creation of the Beacon Chain back in December 2020.
The initial objective of such initiatives was to address a number of issues relating to user experience identified during the Ethereum staking procedure (which involves committing a significant investment of at least 32 Ether upfront until the Ethereum 2.0 blockchain network has been entirely constructed); such as the technical issues surrounding the transaction validation approach.
In general, the Lido DAO holds the responsibility of governing five different Lido liquid staking PoS protocols, namely Ethereum, Polygon, Solana, Polkadot, and Kusama. Although these networks have significant variations in their design, they still share similar high-level mechanics for their liquid staking protocols to remain compatible.
With that, there are two key groups of stakeholders involved in the Lido liquid staking protocol. The first group would be the users (also known as stakers), whilst the second group are called node operators (or validators). Meanwhile, the main components for such protocol would be the staking smart contracts, the Lido-staked assets (stAssets), together with the third-party DeFi integrations (such as Curve).
Upon accumulating considerable traction, Lido became a multi-chain liquid staking protocol, whereby it became compatible with Solana (September 2021), Kusama (February 2022), Terra (March 2021), Polkadot (June 2022), and Polygon (March 2022). Moving forward, the Lido DAO maintains an interest in diversifying its validator pool by bringing in more legitimate node operators via proper system governance.
How Does the Lido Staking Protocol Operate?
Node operators are fundamentally the individuals taking charge of the actual staking process. At the point of writing, node operators are introduced or kicked out of the system via a voting process within the Lido DAO committee. Considering that Lido is also a non-custodial protocol, meaning that node operators will not be given the privilege to access user funds directly, this means that these individuals will need to use a public validation key to authenticate transactions having staked assets. Thus, as part of ensuring the alignment of personal interests, Lido node operators are rewarded with a commission based on the staking rewards earned from the delegated funds.
On that note, the selection process for prospective node operators begins with the Lido Node Operator Sub-Governance Group (LNOSG), in which applications for such roles open up whenever Lido is developing a new blockchain network or it the LNOSG holds the opinion that an existing network may benefit from having more node operators. To dive deeper into the selection process, the LNOSG assesses node operator candidates based on a number of factors such as but not limited to their track record, reputation, and past works (with particular attention placed on the reliability, security, and originality of their validator sets). Once this step has been finalised, the LNOSG will share a list of shortlisted candidates with the Lido DAO to undergo a token-holder voting process. In this step, much emphasis is typically placed on the candidate possessing a robust validator set, given that earnings and penalties will be even across all stAsset holders in any given liquid staking protocol.
All in all, users delegate their staked assets to node operators via employing Lido’s smart contracts. In particular, these three critical smart contracts are namely the staking pool, the NodeOperatorsRegistry, and the LidoOracle.
To aid investors with committed digital assets to liquid staking protocols, VALK has created a dashboard called Merlin, which provides well-rounded analytics of the investors’ positions. Specifically, Merlin can automatically calculate PNL related to selected protocols such as Lido, Compound, Uniswap V3, and Aave, and provides an overview of positions related to over 2,500 protocols, showing positions and transaction history.
What Are the Advantages of Staking with Lido?
Generally speaking, staking with Lido enables users to stake their crypto assets without needing to interact with other decentralised finance applications. Given that Lido is a non-custodial protocol, this basically means that Lido permits users to retain complete control over the cryptocurrencies they have staked. In other words, Lido users will not need to have a certain amount of their digital assets locked up for a certain period nor face any penalty fees for early withdrawals (unlike other cryptocurrency staking protocols). As a result, the Lido staking protocol provides greater flexibility to stakers in comparison to self-staking or exchange staking.
Not to mention, users have the choice of staking as many or little as they please and earn the corresponding rewards, unlike Ethereum staking protocols that mandate a minimum investment of 32 Ethereum coins. Besides that, users may be able to receive financial rewards every day, with the stAssets being a valuable multipurpose token that can be utilised for yield farming on Curve Finance or as collateral for DeFi loans.
Overall, one may consider participating in the Lido staking protocol as an alternative opportunity that enables users to contribute to upholding the Ethereum blockchain network (as well as the Ethereum 2.0 network) whilst benefiting from relatively lower investment risk. In essence, Lido staking offers beginner users a decent entry point into the world of staking as well as a sweet taste of getting rewarded in stAssets too.
What Are the Risks Linked to Staking with Lido?
Even though the development of the Ethereum 2.0 blockchain network has garnered numerous supporters as well as passionate advocates, there is always the possibility that achieving the vision of this project may face multiple delays, not be implemented according to the official plans, or in the worst-case scenario, not be fully realised. Other than that, as the Lido DAO has broad exposure to the Ethereum blockchain, any challenges or setbacks encountered regarding its execution timeline and/or operations could cause risks to the Lido staking protocol. Nonetheless, assuming Ethereum 2.0 is executed in a smooth manner, Lido will play a central role in the world’s largest PoS blockchain network, thereby enhancing its value and operability.
Not to mention, there are definitely risks associated with employing smart contracts for this system, as all smart contract networks will be vulnerable to third-party hacking or implosions caused by self-inflicted failures. Decentralised finance platforms like Lido are especially susceptible to cybersecurity breaches because these platforms provide exit transactions which, in some instances, could be initiated by permissionless means to their users. Regardless, the Lido staking protocol has been regularly audited by industry veterans in the blockchain network security space, such as the likes of MixBytes, Sigmaprime, and Quantstamp. Thus, users can still retain some degree of confidence in the legitimacy of the Lido staking protocol.
Consequently, if you happen to be interested in potentially participating in the Lido staking protocol, it is strongly advised that you conduct your own due diligence on every cryptocurrency you invest in on top of the decentralised finance apps that you are looking to use. In particular, your research scope ought to cover the degree of vulnerability across different smart contracts alongside the economics of each protocol.
How Can You Start Staking with Lido?
All in all, every cryptocurrency user will just need to follow a few simple steps in order to get started on staking with Lido.
Link your wallet to the Lido app
First of all, users will have to go to the site “stake.lido.fi” and connect their crypto wallet with the Lido app. Essentially, users will only need to read and agree to the specified terms and conditions followed by clicking on the “connect wallet” button to complete the process.
Meanwhile, it is imperative to bear in mind that users have the choice of selecting any of their compatible wallets. It will be required to possess a certain number of cryptocurrencies in that wallet before it can complete the syncing process.
Choose the amount of cryptocurrency you would like to stake
Once you have successfully linked your crypto wallet with the Lido staking DeFi app, you need to pick the amount of cryptocurrency you wish to stake and click to submit. Do also take note certain apps may charge varying transaction fees during this step. Also, there is typically a disclaimer concerning the 10% reward free, in which it would be applied to the monetary rewards earned and not the deposited quantity. In addition, it is also worth noting that the Lido app will reveal the current annual percentage yield (APY), every single detail surrounding your transaction, and the number of stAssets you are eligible to be rewarded with.
Verify the transaction from your crypto wallet
Just before the transaction is finalised, your crypto wallet will instruct you to verify and confirm the completion of your transaction. In this scenario, MetaMask is a popular go-to wallet as users will be able to view every detail of the trade in their digital wallets.
Concluding Thoughts
Overall, it is no surprise that great responsibility comes with great power. On that note, the Lido staking protocol will play an influencing role in safeguarding the successful development of the world’s largest Layer-1 blockchain directly and indirectly.
With that, the long-term impact of Lido’s central role in the Ethereum blockchain network and the whole cryptocurrency ecosystem will primarily rely on the decisions made by the Lido DAO. Nevertheless, it cannot be denied that the stakeholders in the Lido ecosystem mainly think of the projects in years instead of days or weeks. This thereby suggests a strong projected staying power of this protocol in the future.
If you want to dive deeper into this fascinating space, VALK’s Smart DeFi Portfolio Tracker, Merlin, offers investors a detailed overview of their DeFi positions across different protocols include liquid staking solutions such as Lido Finance. Merlin, in turn, aims to assist investors in monitoring their investment portfolio for the long term.
Frequently asked questions (FAQs)
How do you stake on Lido?
In general, any individual possessing a crypto wallet and specific cryptocurrencies will be able to consider staking with Lido’s protocol. All they need to do is connect their digital wallet to the Lido app, pick the cryptocurrencies they are interested in staking and confirm the transaction from their wallet to the staking protocol.
Is Lido good for staking ETH?
The Lido staking protocol has been widely acknowledged for the decent rewards it offers users who staked Ether (ETH) over a certain period. As a matter of fact, the Lido staking protocol has been considered a lower-risk alternative to getting started with Ethereum staking whilst contributing to ensuring the security of the Ethereum 2.0 blockchain network. In a nutshell, using the Lido staking protocol to stake Ether can be an excellent way for one to earn passive income from idle Ether coins.
What can you do with Lido-staked ETH?
When users stake their Ether coins with the Lido staking protocol, the protocol will distribute stETH rewards in a 1:1 manner. This stETH, in turn, can be used as collateral to apply for DeFi loans or be traded for a different crypto asset.
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