💵 How to use DeFi and US dollar pegged stablecoins to generate over 19% per year
The world of crypto can be a wild and volatile place. But there is another side to this asset-class which allows you to generate passive income without having to speculate on whether prices will go up or down.
Of course this type of investment is by no means risk-free, and I will cover the main risks in a separate section further down in this guide. But before we get started, let’s jump into a few basic definitions so we are all on the same page.
DeFi:
DeFi stands for decentralised finance - this is the catch all term for a whole variety of decentralised financial services and applications which started on the Ethereum blockchain. These applications are supposed to operate without a trusted central party acting as the middle-man for the transactions.
The first and most famous success story in DeFi was Uniswap, an Ethereum-based decentralised exchange which enabled crypto trades to take place without a central limit order book. Later the field expanded to a number of other financial applications for borrowing, lending, insurance and many others.
Stablecoins:
A stablecoin is a crypto asset which is pegged to a fiat currency, usually the US dollar. As the name suggests this provides you with a stable asset to store your funds. Some of the most well-known and trusted examples of these include:
USD Coin (USDC)
Dai
Tether (USDT) - the first stablecoin but has attracted the attention of regulators due to various legal and compliance issues.
Binance USD (BUSD)
TerraUSD (UST).
Last January the US Office of the Comptroller of the Currency (OCC), ruled that federal banks are now permitted to use stablecoins for payments and other services. Some observers predict that stablecoins will soon have the same status as international payment networks like Swift.
APR vs APY:
You’ve probably already seen these two very similar looking terms on commercials for credit cards or savings accounts. The main difference is that APY is the annual interest rate which compounds, while APR does not.
Fees:
In the early days of DeFi (summer 2020), pretty much all the innovation and activity in the space took place on Ethereum. All this activity caused fees for even basic transactions to skyrocket.
Since then there have been a number of mini-boom periods on Ethereum, most notably with NFTs which have ensured that fees have remained high.
Some have argued that Ethereum should be regarded as a luxury product. Paying hundreds of dollars in one-off fees for purchasing an NFT worth tens of thousands or even hundreds of thousands of dollars is not a major concern for wealthy users.
But this is not practical for frequent DeFi transactions for relatively smaller amounts. As a result a number of competing blockchains have stepped into the market offering extremely low fees costing only a few pennies. I will look at three of these blockchains and their associated decentralised applications in the sections below.
Terra, UST and Anchor
What is Terra?
The core part of the Terra ecosystem is the free-floating cryptocurrency called Luna which is volatile like any other crypto asset, and the UST stablecoin. What makes Terra different is that the team does not hold dollar reserves in a central bank account like many other stablecoin projects such as USDC and USDT. Instead when there is new demand for UST tokens, Luna is “burned” or permanently destroyed and removed from circulation, causing the price to go up. This is the basic mechanism which maintains the stable price for UST.
What is Anchor?
Anchor is the most important dApp (often referred to as a protocol) on the Terra blockchain with $8 billion in total value locked (TVL) on the platform. TVL is a similar measure to assets under management (AUM) in traditional finance. Anchor is essentially a mixture of a savings account and money market for borrowers and lenders, offering similar services to a conventional bank.
Why is Anchor attractive?
At the time of writing Anchor offers about 19.46% APY interest (also referred to as yield) on UST stablecoins. By doing this you are using the platform to loan out your UST to other users. A major advantage is that this interest is also paid out in UST. This is unlike many other DeFi protocols which pay out the yield with highly inflationary “farm” tokens. These tokens can quickly lose value when many users simply sell as soon as it is received.
How to get started?
Step 1: Buy Luna at a major crypto exchange such as Binance. You will need this to cover your transaction fees. You should reserve about $5-10 for fees to be safe. The bulk of your funds can later be exchanged for UST in step 4.
A list of all supported exchanges can be found on CoinGecko’s Terra page. (Binance is the only one from this list I have experience with and is probably the most trustworthy option).
Step 2: Download the native Terra Station wallet (Your funds can be viewed in a web interface and a Google Chrome extension, see screenshot below):
Step 3: Transfer Luna to your Terra Station wallet.
Step 4: Exchange (swap) most of your Luna for UST - you can do this within the Terra Station web interface. But remember to leave a small amount of Luna in your wallet to cover fees.
Step 5: Click on the deposit button on the earn page of the Anchor app to start earning 19.46%:
Also, full detailed instructions outlining every step can be found in this excellent YouTube guide by Rex Kneisley.
Polygon, Avalanche and Aave
Polygon:
Polygon is a so-called “layer 2” scaling solution for Ethereum. In other words, Polygon operates a separate sidechain alongside the main Ethereum blockchain in order to process transactions much faster and cheaper. The cost of these transactions is near zero - typically less than a cent. The native token for Polygon called Matic is used to pay fees and vote on governance decisions.
Avalanche:
Avalanche is another major competitor to Ethereum. Fees are slightly higher than Polygon but still far lower than Ethereum. The blockchain’s main architectural feature is based around “subnets”. These are essentially application-specific mini-blockchains designed to make the whole platform more efficient. Avalanche also has its own native Avax crypto asset which is used in a similar way to Matic on Polygon.
Aave:
Aave is considered to be one of the most dominant “blue chip” money market protocols in DeFi with over $13 billion in TVL. It started on Ethereum but has since spread to Polygon and Avalanche, and is a very trusted name in DeFi.
As Aave was one of the earliest DeFi dApps and has built up a strong reputation over time, the rates it offers for stablecoins are less attractive than newer protocols like Anchor on the Terra ecosystem.
At the moment you can only make an annual return of 2-2.24%, but this is still a big improvement over the absolute maximum of about 0.5% in traditional banking.
Risks and Financial Sustainability
There are quite a few risks in crypto which don’t exist in traditional finance so let’s review them:
Stablecoin “de-pegging”
Algorithmic-based stablecoins like UST can lose its peg with the US dollar during periods of high market volatility. This happened to UST in Dec 2020 when the price dropped 15%, but later recovered. Read this blog post for more information on de-pegging.
Smart contract risk
There is always a risk that something can go wrong with smart contracts - the computer code which automates the various financial operations in DeFi.
By its very nature smart contract code is very complex. Despite regular audits, there is always the possibility of human error and bugs in the code which can be exploited by hackers.
Having said this, the longer an established protocol like Aave has been around, (it was founded in 2017), the lower the risk of a smart contract hack.
How is 19.5% APY on Anchor sustainable over the long term?
The short answer is, it’s not. The reason you are able to receive this rate right now is that on the other side of the transaction there are borrowers willing to pay higher than 19.5%. Borrowers are willing to do this because they are also being paid to borrow in ANC (the farm token of Anchor). This is a temporary incentive programme to increase TVL on the platform which will not last forever.
Again, the blog post mentioned above provides a detailed breakdown of the financial health of Anchor to evaluate the sustainability of the current interest rate. The author predicts that in the coming years the APY will have to be reduced to somewhere between 8-15% to keep the platform running smoothly. This is still far in excess of anything depositors are likely to receive in the traditional banking system.
Still, it is worth regularly checking on sites like Mirror Tracker which provides a dashboard to measure the yield reserve levels on Anchor. Also in crypto as in other higher risk investments, it is worth following the old rule not to invest more than you are willing to lose.
What did I miss? - These reports are a learning process for me and I’m very open to constructive feedback and suggestions.
What stock or crypto asset should I cover next? You can contact me by email: hellorobostox@gmail.com or feel free to leave your response in the comments below. You can also follow me on Twitter: @daneasterman.
Disclaimer: I am not a financial advisor, none of this report should be taken as financial advice. Instead this should be viewed as starting point to conduct your own research. I currently own a small amount of Luna, but do not hold positions in any of the other crypto assets mentioned in this report.