2023 poses a challenging investment climate for traditional asset management. 

Given the investment climate, it is imperative for discerning asset and wealth managers to consider other viable alternatives to craft optimal and diversified investment strategies for their clients. 

DeFi presents one such vista of investment opportunity for asset managers. The ecosystem is strongly supported by growing liquidity, and also boasts greater transparency and stability over management fees on long-term funds. 

According to Zion Market Research, the global DeFi industry’s market revenue was $11.96 billion U.S. dollars in 2021 and is projected to reach $232.2 billion by 2030 with a CAGR of almost 42.6% between 2022 and 2030.

It is evident that DeFi is rich with opportunities for asset managers to upgrade their clients’ portfolios against the backdrop of the present turbulent investment climate.

Yet DeFi can be confusing for the uninitiated, especially given that it is saturated with a  conundrum of protocols. This article therefore serves as an introductory guide for asset managers exploring DeFi protocols, helping them make informed decisions on how to leverage DeFi to optimize their clients’ investment portfolios.

What are DeFi protocols?

DeFi protocols are smart contract-based programmes that determine how digital assets are deployed on a blockchain network. They enable a broad range of DeFi applications, such as the management of decentralized exchanges (DEXs) and the lending and borrowing of assets.

Specific to asset management, certain DeFi protocols serve as viable alternatives to traditional financial instruments. Apart from facilitating transactions, some of these protocols can potentially generate yield and deliver returns on investment (ROIs), making them ideal for asset managers to leverage for their investment strategies. 

Below are the core characteristics of DeFi protocols that make them ideal for asset management:

• Transparent: Unlike traditional finance that tends to be opaque in its operations, DeFi protocols are fully transparent, offering asset managers comprehensive visibility over their asset holdings, associated transactions, and their overall performance.
• Composable: Asset management is made up of many moving components. From growth and liquidity and income and hedging, asset managers offer many different strategies to their clients. In DeFi, protocols are designed to be interoperable, enabling asset managers to easily combine and link the protocols they select without needing to raise the management fees they charge their clients.  
• Trustless: Know Your Customer (KYC) processes are commonly deployed for security purposes in traditional finance, and this often entails the need to share sensitive personal information. DeFi significantly reduces the need for KYC, allowing asset managers to simply connect their wallets and directly interact with the most relevant protocols.
• Automated: Some DeFi protocols are designed to be automated, allowing asset managers to collateralize, rebalance, and liquidate assets without manual input.
• Accessible: DeFi protocols are open to everyone regardless of status or financial standing. With minimum requirements to deploy, asset managers are able to access protocols with minimal friction. 

Compared to traditional finance, DeFi places greater emphasis on transparency and accountability. This makes DeFi especially attuned to the work of asset managers, who must have full visibility over their investments’ performance in order to make adjustments to their strategies where necessary.

Categories of DeFi protocols

With a high-level understanding of DeFi protocols in mind, this section will now cover the key categories of finance-oriented protocols available in the ecosystem today. The below list is by no means exhaustive, given that DeFi is a nascent space where innovation happens in perpetuity.

1. Decentralized exchanges

Decentralized exchanges (DEX) are peer-to-peer marketplaces where users directly trade cryptocurrency assets with each other without the involvement of a third party intermediary or custodian. Some popular DEXs on the market include Uniswap, SushiSwap, PancakeSwap, and Curve Finance.

Unlike their traditional counterparts – centralized exchanges – that depend on intermediaries such as banks and payment processors, DEXs are run by smart contracts that execute rules to govern the transaction process. These rules are designed to be transparent and immutable, significantly reducing the risk of compromise by bad actors.

Some DEXs are also Automated Market Makers (AMMs), deploying smart contracts to automatically adjust the prices of digital assets based on demand and supply.

2. Liquidity pools

Liquidity pools are the foundation of DEXs. Derived from users locking their digital assets into DEX-linked smart contracts, liquidity pools supply the liquidity necessary for DEXs to operate. In exchange for providing liquidity, liquidity providers (LPs) are rewarded with a percentage of the fees accrued from transactions carried out between buyers and sellers on the DEX.

By leveraging liquidity pools in their strategies, asset managers will be able to offer their clients a safer and relatively risk-free option to invest their digital assets to earn guaranteed returns.

3. Lending

Lending in DeFi is similar to traditional lending services offered by banks and financial institutions. However, unlike traditional lending, DeFi lending is done in a completely trustless manner with no intermediaries involved.

Instead of banks, cryptocurrency owners themselves are the ones who supply the loans by locking their assets on the DeFi lending platform. Lenders are then typically issued a corresponding amount of the protocol’s native token as collateral. 

When borrowers take out a loan on the platform, lenders earn the interest and fees accrued from the transaction. Borrowers can also benefit as the cryptocurrencies they loan can be applied to other DeFi protocols to earn yield.

DeFi lending serves as a powerful protocol for asset managers to help their clients earn interest by loaning their digital assets.

4. Yield farming and liquidity mining

Also known as liquidity farming, yield farming entails the lending of cryptocurrencies to a liquidity pool. Users who lend cryptocurrencies are rewarded with interest and cryptocurrencies.

However, as its name implies, yield farming is specifically performed with the intention of maximizing yield accrued from lending and staking. Yield farmers are typically flexible with their strategies, switching between different protocols at a high frequency of up to once a week.

Liquidity mining is a subset of yield farming. Although liquidity mining is similar to yield farming, it is generally more stable and passive as users lock their assets in one pool without periodically switching to different protocols.

Asset managers can take advantage of yield farming and liquidity mining to offer their clients two routes in planning their digital asset investment strategies. This strategy takes into account the varying risk appetites of different clients, giving asset managers an edge with customization.

5. Staking

Staking is another popular protocol type that is used to generate passive income from cryptocurrencies. 

Unlike yield farming and liquidity mining, however, staking is derived from Proof of Stake, which is one of the few consensus mechanisms used on blockchains. Staking requires users to lock their cryptocurrencies in a given blockchain to validate transactions and vote on protocol changes. To this end, users’ locked cryptocurrencies represent their “stake” on the blockchain network.

Users will then receive rewards proportional to the amount of cryptocurrencies locked up and the network fees accrued from their nodes. Relative to yield farming, staking is less risky as users do not transfer their assets across different platforms - this limits their overall risk exposure by a significant extent.

Staking is a viable instrument that asset managers can deploy for risk-averse clients. As the reward payouts tend to be more stable and consistent, staking can serve as a safe starting point for clients who are new to DeFi.

6. Collateralized Debt Position

Collateralized Debt Position (CDP) protocols entail the locking of cryptocurrencies as collateral in a smart contract to generate decentralized stablecoins. 

This concept was first introduced to the DeFi ecosystem via MakerDAO in 2015, which was designed as a system where users lock cryptocurrencies like Ethereum (ETH) to mint its stablecoin DAI. In general, the value of the collateral locked in a CDP must always exceed 150% of the value of the minted stablecoins - in this sense, MakerDAO enables overcollateralized loans.

Stablecoins generated through a CDP are essentially decentralized loans backed by the value of the collateral. Should the user wish to unlock the collateral, they will need to repay the stablecoins along with additional stability fees. By design, stablecoins are intended to have a 1:1 peg against the USD, offering users a stable option in the volatility of the larger DeFi market.

Stablecoins can also be utilized on other protocols (eg: lending) to generate interest, making them viable tools for asset managers to help their clients earn interest on their investments.

7. Options

Decentralized options fundamentally operate on the same principles as traditional options. By examining the core elements of options, it is possible to visualize how DeFi options function similarly to their traditional counterparts. 

Below is an overview of how DeFi options operate:

• Type
  • Calls: Give users the right to buy an underlying cryptocurrency at a requisite price on or before an expiry date
  • Puts: Give users the right to sell an underlying cryptocurrency at a requisite price on or before an expiry date

• Style
  • American: Allow users to execute their options contracts before the expiry date. 
  • European: Allow users to execute their options contracts after the expiry date. Most DeFi protocols adopt this style of options, although a few have also implemented the American style.

• Settlement method

• • Cash settlement: At expiry, the cash value of the option is paid out via an equivalent sum of USD, BTC, ETH, or other cryptocurrency.
  • Physical settlement: At expiry, the option must be paid out via the delivery of its underlying cryptocurrency.
    • Example: A physically-settled Bitcoin (BTC) option must be paid out with a delivery of BTC.

What are the top DeFi protocols?

As this article has thus far demonstrated, DeFi protocols perform different functions and therefore offer different solutions. This section covers the top ten DeFi protocols in the market by total value locked (TVL), as compiled by leading TVL aggregator DeFiLlama.

Note: This section is not intended to serve as a guide on which DeFi protocols asset managers should deploy. It is instead meant to provide asset managers with a top-level overview of the leading protocols in the DeFi ecosystem. 

1. Lido

Lido is a liquid staking platform for Ethereum (ETH). Unlike the regular staking mechanism, Lido enables users to stake their ETH without locking their assets in place - this means that users can also participate in other on-chain protocols while their stakes are active.

This is made possible by a system that issues stETH tokens to users when ETH is staked. These stETH tokens can be used like regular ETH, allowing users to leverage other protocols to potentially generate more yield on their cryptocurrencies.

To this end, Lido is ideal for users who want to maximize the potential yield they can earn on their staked cryptocurrencies by simultaneously participating in other protocols.

2. MakerDAO

MakerDAO is a CDP protocol that enables users to lock any suitable Ethereum-based cryptocurrency (eg: ETH, ZRX, WBTC, MANA, etc.) or other stablecoins (eg: USDC, TUSD, etc.) to mint its stablecoin DAI. This process is essentially a type of overcollateralized loan, where the value of the cryptocurrency or stablecoin locked in MakerDAO must always exceed 150% of the value of the minted DAI. 

As a stablecoin, DAI is designed to have a 1:1 peg against the USD. With DAI, users can participate in other protocols such as lending and staking to earn potential yield. Should they wish to regain their locked cryptocurrencies or stablecoins, users need to repay an equivalent amount of DAI alongside a stability fee. 

Users can also directly influence MakerDAO’s operations by purchasing its governance token MKR. By owning MKR, users are given the right to propose, vote, and implement updates on crucial on-chain mechanisms such as the collateralization ratio and stability fee.

3. Curve Finance

Curve Finance is a DEX collection of liquidity pools on Ethereum that facilitates efficient trades for cryptocurrencies and stablecoins. Designed to be low-risk in nature, Curve’s algorithms are optimized with low slippage and fees to help users maximize the returns on their trades.

At present, Curve enables swaps for a wide range of stablecoins, including USDC, USDT, DAI, and LUSD.

4. Aave

Aave is a non-custodial liquidity protocol. Liquidity on Aave is derived from users lending their cryptocurrencies to the platform, who are then rewarded with interest and transaction fees. Users can also participate in Aave as borrowers, where they can take out loans either in an overcollateralized or undercollateralized manner.

Aave is an open-source protocol, meaning that anyone is free to access it and build any applications or services to complement its functionality. Aave currently has three versions: V1, V2, and V3. Given the immutability of its smart contracts, none of these versions overwrite each other and instead exist simultaneously.

5. Convex Finance

Convex Finance is a yield farming extension of Curve Finance, designed to empower users to maximize the rewards they earn from supplying liquidity into its liquidity pools. Instead of supplying liquidity directly into Curve’s liquidity pools, users can do so via Convex to earn greater rewards.

As an additional reward for supplying liquidity to Convex, users also earn CVX tokens. CVX is the protocol’s native utility and governance token, which enables users to determine Convex’s direction by voting on development proposals.

In addition to participating in Convex’s governance, users can also stake their CVX tokens to generate even more yield.

6. Uniswap

Uniswap is a DEX that enables users to provide liquidity and trade ERC20 tokens on Ethereum. This protocol is operated by a series of persistent and immutable smart contracts, designed to be completely decentralized and resistant to censorship from third-party entities.

Utilizing the automated market maker (AMM) model, Uniswap replaces the buy and sell orders in the traditional order book system with a liquidity pool of two assets that are valued relative to each other. 

The relative prices of these assets automatically change depending on demand. As an example, consider a liquidity pool that has USD 10 million of ETH and USD 10 million of USDC. Should a trader choose to swap USDC for ETH, the AMM automatically increases the value of ETH to reflect the uptick in its demand.

Uniswap currently has three versions: V1, V2, and V3. Similar to AAVE, the immutability of Uniswap’s smart contracts means that none of these versions overwrite each other, each one existing in perpetuity for as long as Ethereum is active. 

7. JustLend DAO

JustLend DAO is the leading lending protocol for TRON, facilitating the trade of unique TRON assets like TRX, TRC20 stablecoins (eg: USDT, USDC, USDJ, and TUSD), and other TRC20-based tokens between lenders and borrowers.

Lenders who supply TRON assets to JustLend DAO’s liquidity pools earn interest and transaction fees when borrowers take out loans on the protocol. 

JustLend DAO also has an on-chain governance system, where users can earn its governance token JST from performing trades. With JST tokens, users are given the authority to propose, vote, and implement changes such as system parameters, new markets, or even new features. 

8. PancakeSwap

PancakeSwap is the leading DEX on BNB Smart Chain, tying multiple DeFi functions under one protocol. These functions are broadly divided into three core pillars: Trade, Earn, and Win.

Under the Trade pillar, PancakeSwap enables users to perform token swaps between different BEP-20 tokens through automated liquidity pools. This can be done either through its conventional exchange (for regular cryptocurrencies) or StableSwap (for stablecoins).

The Earn Pillar is where users are able to participate in yield-generating mechanisms such as staking and yield farming on PancakeSwap. Finally, PancakeSwap’s Win pillar allows users to participate in competitions to win prizes such as collectible NFTs or BNB tokens.

9. Instadapp

Instadapp is an aggregator of multiple DeFi protocols, intended to serve as a single point of integration for users to leverage the yield-generating potential of DeFi. In this regard, Instadapp serves as a “DeFi manager” who recommends yield farming strategies to users and executes them on their behalf.

In essence, Instadapp streamlines the tedium of yield farming, which often requires users to periodically transfer their assets across multiple protocols to maximize returns. Instadapp executes the yield farming process on its users’ behalf in exchange for a 20% performance fee.

10. Compound Finance

Compound Finance is an Ethereum-based lending protocol that allows users to lend and borrow cryptocurrencies. Here, lenders loan cryptocurrencies to borrowers by locking their assets on Compound, earning interest and transaction fees in the process. 

Lenders who lock their assets in Compound Finance receive an equivalent amount of the protocol’s native token cToken as collateral. COMP is Compound’s ERC20 governance token that users can buy and trade to vote on the protocol’s network decisions. 

Similar to AAVE and Uniswap, Compound Finance spans multiple versions that do not overwrite each other due to the immutability of its smart contracts. At present, there are three versions of Compound Finance: Compound, Compound v2, and Compound III.

Find out more about how Levain empowers your institution to get a head start into The DeFi Future.

Get in touch at levain.tech/contact-us.