The era of DeFi "laying and earning" is gone forever, what should investors do?

This article comes fromcoindesk, Originally by Jesus Rodriguez

Odaily Translator |

Odaily Translator |

Recently, the encryption market is still shrouded in clouds, and DeFi, as a rapidly emerging branch of the encryption field, has also been greatly affected. During this period, investors have witnessed the collapse of DeFi agreements such as Anchor on the Terra chain, the continuous shrinking liquidity on the pledge service platform Lido, and the bankruptcy of large asset management companies deeply involved in various agreements. The value that DeFi advocates runs counter to.As expected, the total lock-up volume of the DeFi protocol has dropped sharply, shrinking by nearly 70% compared with the historical high, leaving only about 74 billion US dollars in scale, and the native rate of return in the DeFi protocol has also shrunk significantly. Not only that,

"Lie earning" seems to be the main theme of the DeFi field during 2020-2022. The excessive leverage and aggressive incentive mechanism of stablecoins allow investors to obtain huge returns without having to understand complex financial knowledge. Because the process of generating Alpha is too easy, people ignore the control of the risk management mechanism. Now with the advent of the crypto bear market, the nature of DeFi has changed, and the relationship between Alpha returns and risks has also quietly changed.

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"Risk and Return" in Traditional Markets"How to balance risk and return" is an eternal theme of traditional capital market investment strategies. According to the "efficient market hypothesis" theory proposed by Eugene Fama in the 1970s, most markets are "inefficient" if only from the perspective of return on funds. While there is plenty of alpha in traditional markets, it can only be identified and captured with sophisticated strategies. Typically, traditional markets rely on intermediaries and a strong regulatory framework to prevent risks, while the value-at-risk model (VaR) is a simple indicator that is widely used to measure risk, which can quantify potential losses in investment portfolios. The reason why such simple statistical indicators can be used to quantify risk is entirely because there is a strong enough infrastructure in traditional markets to prevent large-scale systemic risks. Therefore, we found, but the situation in the DeFi field is completely different.

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"Alpha and Risk" Changes in the DeFi Field

In contrast, the financial environment of DeFi is very different and extremely inefficient, and there are great opportunities to capture Alpha corresponding to different risks. However, when the DeFi market developed into the first stage, we found that while the rate of return was too high, the risk was also too high, so the composition of the DeFi market began to change, which brought about a change in the relationship between risk and return, making It gradually catches up with other financial markets. Then, if we look at the development of DeFi from the perspective of the evolution of the "risk and return" relationship, it can be divided into the following three stages:

Phase 1: Extremely high returns and sophisticated risk management

The first stage of the DeFi development process is characterized by relatively easy to capture yields and "extremely obscure" risks (related to DeFi protocols). Since the DeFi protocol adopts a large number of incentive plans, high leverage of stable coins, and frequent trading activities, investors can easily obtain high yields at this stage. Under the automated market maker (AMM) mechanism, investors only need to provide simple liquidity or conduct leveraged lending transactions through loan agreements to obtain sustained returns higher than 15%-20%. This investment environment is obviously attractive Many traders and speculators have brought about the first phase of the DeFi hype cycle.

However, while the DeFi craze in the first stage brought investors high returns, it also revealed huge loopholes and risk exposures. Because many DeFi protocols are complex, people who understand the risks of smart contracts will exploit major loopholes in the protocol, causing major harm to the product and the economy. We have seen that attacks or impermanent losses manipulated by giant whales bring immeasurable economic risks to investors.It is no easy task to manage these risks, which requires a very deep understanding of the technical and economic behavior mentioned in the DeFi protocol. From this point of view,

The vast majority of transactions conducted under DeFi protocols lack proper risk management procedures.

The second stage: the high rate of return is no longer, and risk management becomes more complicated

Recently, the changes in the DeFi market have directly affected the rate of return generated by the agreement. Nowadays, there are very few agreements that can obtain double-digit returns only by relying on simple liquidity transactions. However, for all asset classes, the DeFi market is still the least efficient, so there are still many opportunities to capture high Alpha. But it is not as simple as you think to seize most of the high-return opportunities. It has very high requirements for complex financial logic knowledge (usually combined with different protocols) and in-depth understanding of the market. While it has become increasingly difficult to obtain high rates of return from DeFi protocols, the difficulty of risk management has not decreased at all. On the one hand, due to the rapid change in the DeFi field, the risk management process cannot keep up; on the other hand, due to the increasing complexity of the DeFi strategy, more loopholes have been brought, so higher requirements are placed on the complexity of the risk management model. Require.It can be seen that the high alpha rate of return at your fingertips no longer exists, coupled with high economic risks,DeFi protocols are no longer suitable for retail investors

, but only for more mature institutional investors and high-level traders.

The third stage: high return rate is no longer, risk management is simplerBut there is no need to be pessimistic, the DeFi market environment cannot always be full of risks. As the market develops further, DeFi protocols will gradually integrate local risk management functions to promote wider adoption of the protocol. It is gratifying that protocols such as Bancor, Euler, and Maker have appeared on the market today. These protocols combine native risk management mechanisms to realize initial ideas, such as the next-generation AMM that can provide automatic insurance for impermanent losses , and lending agreements that better protect against liquidation. Although the current market environment is relatively harsh, these first-generation risk management models will also face enormous challenges as expected, but they canIncorporate risk management as part of the native protocol

Once common risks can be natively managed by DeFi protocols, it will reduce the burden of risk management for investors, traders, and other market participants, so that they only need to focus on more complex forms of risk. In fact, this new risk-return structure in the DeFi market is very similar to the traditional capital market. In the traditional capital market, it is difficult to achieve a high Alpha rate of return, but most of the risk management measures have been integrated in the market infrastructure.

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Summary: The era of high returns on DeFi is over