This article takes you to understand the income aggregator in DeFi

This article summarizes the ideas in the paper Systematizing Knowledge: Yield Aggregators in DeFi.

Since the DeFi boom in the summer of 2020, liquidity mining has become the most popular activity for cryptocurrency holders. The amount locked in asset management agreements is well over $3 billion in May 2021, reaching $2 billion at the time of writing.

While there is a group of projects claiming to deliver huge returns in the short term, yield aggregators such as Idle Finance, Pickle Finance, Harvest Finance, and Yearn Finance are working hard to create sustainable revenue streams for the DeFi community. I couldn't help being curious:

• Where do these gains come from?

• What currency Lego does the Yield Aggregator use?

• What is the general mechanism behind these aggregators (if any)?

• What are the benefits and risks of putting your money in an income aggregator?

In my joint paper "Aggregators in DeFi" with Jiahua Xu (UCL Center for Blockchain Technology) and Toshiko Matsui (Imperial College London), I answer the above questions and propose a general framework for yield aggregators. Let's explore the most "degenerate" part of DeFi together - liquidity mining.

Introduction

Introduction

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Where does the benefit come from?

There is no free lunch in the world, so where does the income provided by the aggregator come from? There are three main sources.

loan demand

Liquidity mining plan

Liquidity mining plan

Early adopters typically receive governance tokens representing ownership of the protocol. This incentivizes people to deposit funds into the protocol, since the tokens that are rewarded often come with governance functions. This feature is generally considered valuable because it gives token holders a say in the future strategic direction of the project. Essentially, early users are rewarded for helping the project grow and taking the early risks of possible bugs in smart contracts. Typical examples are Sushiswap and Yearn Finance.

revenue sharing

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Mechanisms behind the strategy

Now that we know where the revenue comes from, how do users get revenue through the revenue aggregator? Let's use a fictitious "SimpleYield" yield aggregator as an example to explain the diagram below.

- Yield Aggregator Mechanism -

In Phase 0, funds are pooled within a smart contract. A pool usually contains only one asset, although there are newer protocols that support multiple asset pools. Users deposit assets into the pool and are rewarded with tokens representing their share of the pool. For example: deposit ETH into SimpleYield's ETH pool and receive syETH tokens representing the corresponding share in the pool.

In Phase 1, the assets in the fund pool are pledged to borrow another asset on lending platforms such as Compound, Aave, or Maker. This stage is not necessary and can be skipped. The main purpose of this step is to use another asset (not the original asset in the pool) to execute the liquidity mining strategy. For example, the ETH in the SimpleYield ETH pool can be used to borrow the stablecoin DAI through Maker.

Phase 2 involves yield strategies of varying degrees of complexity. As shown in the diagram below, at this stage people are offering either non-yielding assets (red tokens) or yielding assets (green tokens). Over time, green tokens generate income and increase substantially. For example, the SimpleYield ETH pool uses ETH to borrow DAI and then deposits DAI into Compound. Through Compound, SimpleYield obtained yield-generating cDAI tokens and COMP tokens from Compound’s liquidity mining program.

- Execution process of single strategy (SC refers to smart contract) -secondary title

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Now that we know how yield aggregators work, the focus of the protocol is on Phase 2, as that is where the yield is actually generated. Let’s take some examples of liquidity mining strategies. Note that the examples given here are relatively simple, and the strategies used in real life will be much more complex.

Changes in the value of the pool are simulated in a controlled market environment. The results of the simulations can be found in this paper.

simple loan

The example mentioned in the previous section is a simple lending strategy. Users deposit funds into the Loanable Fund Protocol (PLF), earning interest and governance tokens rewarded by liquidity mining.

spiral lending

The spiral lending strategy aims to earn as many governance tokens as possible through liquidity mining. The aggregator can deposit DAI into the loanable funds agreement, use this deposit to borrow DAI, and then deposit the borrowed DAI into the loanable funds agreement. This process can be repeated many times, depending on the amount borrowed and the interest rate. Simulation results show that if the cycle is too many times, there will be a high risk.

Liquidity mining with AMM LP tokens

AMM LP tokens will generate income because transaction fees are kept in the AMM pool. If this AMM also runs a liquidity mining mechanism, users can also get governance tokens as rewards in addition to transaction fee sharing. This strategy is also considered riskier because impermanent losses can wipe out most of the gains when the price of the underlying asset changes.

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Idle Finance

Idle Finance is one of the earliest revenue aggregation protocols, launched in August 2019. Currently, Idle Finance only adopts a simple lending strategy, distributing the funds in the pool to multiple PLFs (Compound, Aave, Fulcrum, dYdX, and Maker). The protocol offers a "best return" strategy and a "risk adjusted" strategy. The former aims to maximize returns through the above-mentioned platforms, while the latter will consider risk factors to optimize the risk-reward ratio.

Pickle Finance

Pickle Finance launched in September 2020, offering two yield products: Pickle Jars (pJars) and Pickle Farms. The former is a liquidity mining robot that uses user funds to earn income; the latter is a liquidity mining pool that allows users to earn PICKLE governance tokens by staking different types of assets. pJars adopts the strategy of "Using AMM LP Tokens for Liquidity Mining". Liquidity miners deposit Curve LP tokens or Uniswap/Sushiswap LP tokens into the pool, and generate governance tokens through liquidity mining.

Harvest Finance

Harvest Finance was launched in August 2020, providing users with compound interest income through its FARM liquidity mining mechanism. The agreement mainly has two strategies: single asset strategy (including "simple lending" strategy) and LP token strategy (including "using AMM LP token for liquidity mining" strategy). 30% of the pool proceeds are used to buy FARM on the open market, and then go back to the FARM stakers, not the pool.

Yearn Finance

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- Total lock-up amount (data source: https://defillama.com/home) -

advantage

advantage

• Users do not need to formulate strategies independently, and can use strategies formulated by other users to realize passive investment strategies.

• Since cross-protocol transactions are via smart contracts, fund transfers are done automatically, eliminating the need for users to manually transfer funds between protocols.

• risk

risk

• Liquidity mining strategies are never exempt from lending risk, whether they are borrowing other assets by pledging one asset, or simply providing assets to PLF. In the case of a high capital utilization rate (high loan amount/pledge ratio), if many lenders withdraw at the same time, there may be a certain number of fund providers who need to wait for the lender to repay the loan. This is called "liquidity risk". When a user borrows funds, there is a "liquidation risk" if the value of the collateral falls below a pre-set liquidation threshold.

• Liquidity mining strategies are usually built on a set of DeFi currency Lego, so there is a composability risk. Driven by profit, perpetrators will take advantage of technical and economic weaknesses to arbitrage.

• epilogue

epilogue

In the past year, a large number of yield aggregator protocols have emerged. Although their general framework is similar, each has its own style. Idle Finance launched its first version in 2019, which will deposit funds into PLF with the highest interest rate. Inspired by Compound's liquidity mining mechanism, Yearn Finance expanded this model in July 2020, launching more complex strategy Vaults in addition to Earn products. Afterwards, more types of liquidity mining mechanisms appeared. Harvest Finance and Pickle Finance specifically used LP tokens for liquidity mining.

Yield aggregators have always been a popular income method for DeFi users. But how long can this benefit last? As we can see, there are three main sources of benefit. While research on the sustainability of returns deserves a separate article, we can conclude that returns from governance tokens are relatively short-lived. Once the governance tokens are issued, this source of income is cut off. While new protocols can thrive by launching new token distribution programs, this revenue stream is unlikely to be sustainable. In contrast, borrowing demand is more sustainable, but it is highly dependent on market sentiment, especially that of non-stablecoins. Gains from revenue-sharing tokens appear to be the most durable, especially if DeFi maintains its recent growth rate.