What are Yield Aggregators?
Passive Income at the Highest APRs.
Introduction
Yield aggregators, also known as ‘auto-compounders’ or ‘yield optimisers’ are tools that hunt for protocols/pools to maximise yields on invested capital. They also automatically re-invest interest gained on yields, which for an individual user, would be inefficient due to gas fees. By doing this process in batches across all participants, gas fees become negligible and the protocol as a whole makes a profit.
The Power of Liquidity
Before we discuss how Yield Aggregators work, it helps to first understand why liquidity is so important in DeFi. Many decentralised finance platforms forgo the traditional order book that centralised trading platforms use to fill buy and sell orders. Instead, they provide the other end of these orders through a ‘liquidity pool’. In this system, external users provide the assets that are being traded. In return, for every trade made through the liquidity pool, these depositors receive a percentage of the transaction fee. Trades are now instant for users and investors can grow their crypto assets by providing liquidity.
However, for those supplying the liquidity, there’s a problem of impermanent loss (IL). Simply put, if a price of an asset climbs, due to how liquidity pools balance deposits, you would have made more money by holding rather than supplying liquidity. For more information about impermanent loss, read my previous article here. Various DeFi protocols utilise various measures to combat IL, which in turn help yield aggregators maximise their profits.
Yield Strategies
Aside from auto compounding, there are other ways that these protocols generate yields. Here are a few of the popular ones:
Spiral Lending — Short selling assets is fairly hard to do through DEXs at the moment, so many investors do it through lending protocols. For example, they could deposit ETH to borrow USDC to take a short on ETH. Once ETH drops, they can pay back some of the USDC for a profit. Protocols offer attractive rates for unbalanced pools and as the protocol itself takes on the risk of “losing” lends, it’s a big draw for yield hunters. You’re free to re-invest the Liquidity Provision tokens (LP tokens) you get from providing liquidity into other pools, or even on other platforms which creates a ”spiralling” effect as you build more and more positions through a single source of investment. The downside is any point of failure will cause the whole chain to break and result in losses.
Governance Farming — The most “famous” type of yield generation, and popularised by Convex finance’s idea to take control of Curve’s reward provision. We’ll go over the exact mechanics in the next section of this article, but put simply, investing capital in a DeFi protocol will also pay out in their governance token as an incentive to use their platform. This token can then be used to influence the platform in your favour, giving higher rates to those who provide liquidity to a certain pool.
Weighted Liquidity Provision — A slightly more risk-averse style of yield hunting compared to spiral lending and more suitable during volatile markets that are at the mercy of IL. Most common liquidity pools are balanced at 50/50 of their assets, but by changing this ratio to favour the more stable of the two assets, you reduce IL. This does come at the cost of higher slippage, however, which reduces APR and trade volume.
The Curve Wars and Convex Finance
Let’s now take a look at one of DeFi’s most famous Yield aggregator, Convex Finance, which relies heavily on Curve.
As a quick summary, Curve is an AMM that allows users to trade stablecoins with one another at the best rates currently available. For providing liquidity for these trades, users can earn fees as well as $CRV, which is a governance token for their protocol. The real power of $CRV is on their Curve v2 platform, which allows users to set up their own pools and direct incentives using $CRV. In short, projects looking to allow trading of their tokens without large slippage can buy $CRV to direct funds in Curve to their pools.
However, to do this, users need to lock up their $CRV in Curve to gain access to these voting rights. The lock-up can be from one week to 4 years. The longer you lock up, the more power the $CRV you hold represents. This is where the founders of Convex Finance saw a massive opportunity.
They realised that many projects would want the utility that $CRV provides but without the 4-year committal they would have to make. They created $cvxCRV, which is a token that a user receives for staking $CRV on their platform. This token will represent a larger amount of $CRV as time goes on, as Convex locks up all the $CRV they receive for 4 years. The user will be able to take out his $CRV at any time, due to the surplus $CRV Convex generates.
Convex on the other hand now has a lot of control over Curve’s incentives, which it decided to capitalise on by creating its own governance token, $CVX. Projects that want to direct liquidity to their pools can now buy $CVX instead to direct the protocol’s voting power on Curve, for the fraction of the price it would cost to buy $CRV tokens directly, as well as not having to lock up for 4 years. Genius really.
Closing
In a world where finance has been seemingly worked out and computers are now outperforming even the most experienced technical investors, a space where creative thinking and finance meet is pulling a lot of new talented investors. I’m personally looking forward to what DeFi offers us next, and I suppose how many billions it manages to make too.
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