Starting to save with DeFI

With interest rates near all-time lows, it has been a struggle to earn any decent safe return on cash. Of course, 2021 was full of huge returns on risky assets, with the S&P 500 up almost +25%, BTC +60%, ETH +400%, and all the crazy moves in memecoins and NFTs, but if you have a part of your portfolio that is looking for steady, nearly risk-free returns, it is not easy to find a good, safe alternative.

While DeFI is far from risk-free, it could work as an alternative to get steady returns with less market risk than in the rest of crypto markets. To test out this idea, I have decided to allocate part of my cash portfolio into a few different DeFI strategies that should be market-neutral, in the sense that they don’t really depend on the overall crypto market going up or down. I will document my experience here including everything else I learn during this process, including the tools I’m using to track the portfolio and taxes (for an US-based investor).

There are a lot of different terms here, so let’s make it a bit more clear what we are trying to achieve here:

consistent: while we don’t need constant returns every month, it is also not very helpful if our strategies have a lot of variability in their returns. One way we can track this is by calculating the volatility of the strategies (standard deviation of the returns) and making sure that it is low (< 5% annualized)

market-neutral: the returns should not depend on whether the price of BTC, ETH or any other coin goes up or down. We will get there by using stablecoins (USDC, USDT, DAI, etc) for most of our strategies or, when using more volatile coins, making sure we hedge the exposure in another market.

beats other cash-alternatives: it doesn’t make sense to go through all this effort if at the end we are earning 1–2%/year. A low-risk Investment Grade mutual fund will yield around ~1.5% and we need to do better than that

after-tax: for US-based investors, the taxation of DeFI investing strategies is pretty convoluted and very punitive. So whatever strategy we follow, it needs to work on an after-tax basis

preserving liquidity: those strategies should not lock our capital for a period much longer than 1–2 months as this should be an alternative for other highly-liquid cash investments like fixed income mutual funds

As our goal is to have market-neutral returns, all those strategies will depend a lot on using stablecoins. I won’t delve into too much detail into what are the risk of using StableCoins, but you can get a lot of good information about it here.

Overall, when using stablecoins you have to trust that the coin has enough collateral behind it that allows it to preserve its peg to the USD. This can be achieved either using actual USD-denominated assets as collateral (USDC, TUSD, USDT) or by using crypto as collateral (DAI, VAI, etc).

There is some inherent risk by using stablecoins — if for whatever reason (fraud, market moves, etc) their collateral is not enough to maintain the peg, their value will collapse and you will lose a lot of money. So any DeFI strategy needs to give you a significantly return over a traditional fixed income strategy to compensate for that risk.

DeFI strategies

Here are some of the different strategies I will be pursuing — I will follow up with an in depth article on those as I go along:

Securitized Lending: this is the simples strategy possible. You deposit your stablecoins into some contract and you earn some interest back on it. All those loans are fully collaterized with crypto, meaning that you are pretty much safe as long as the protocol is secure and crypto doesn’t collapse overnight

Liquidity Provision: this is a more interesting strategy, where you supply a pair (or more) of crypto assets for a protocol where they will be used to provide liquidity for traders wishing to switch one crypto for another. Depending on the assets used this strategy is not really market-neutral but we can mitigate the market risk by borrowing/trading in different markets.

Token farming: this is usually done in combination with the two strategies above. By supplying liquidity to different DeFI protocols such as Compound, AAVE, etc we receive governance tokens of those protocols as an incentive which we can then sell in the market and earn an additional yield

Chain/Protocol Arbitrage: borrowing/lending rates vary quiet a bit across protocols and blockchains and we can take advantage of that by borrowing one asset in one chain versus lending it (or a similar one) at a higher rate elsewhere

Any other DeFI strategy I’m missing? Leave your ideas in the comment below!

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