Opinion: Safeguarding Investors Against Concealed DeFi Expenses in 2024
Disclaimer: The opinions expressed in this article are solely those of the author and do not represent the views and opinions of crypto.news’ editorial team.
Decentralized finance (DeFi) presents exciting opportunities for investors, but there are hidden costs that can significantly impact potential returns, in addition to the upfront gas fees.
Unlike traditional payment processing firms like Visa and Mastercard that offer fixed fees, blockchains powered by smart contracts operate differently. Transaction costs on networks like Ethereum and Solana are dynamic, meaning the price for completing a transfer depends on the congestion of the blockchain and the priority set by the user.
Currently, the average gas fees on Ethereum, the most popular blockchain for DeFi protocols, stand at 28.46 gwei (approximately 95 cents). This has decreased considerably following the long-awaited Dencun upgrade, which improved the network’s scalability and reduced the cost of using layer-2 solutions. Affordability is crucial, particularly for consumers in emerging economies who may be priced out of participating in expensive transactions.
In addition to gas fees, there are other hidden costs that can impact investor returns. Here are four common ones to watch out for:
1. Impermanent loss: This occurs when the profits gained from staking tokens in a liquidity pool are smaller than holding these cryptocurrencies directly. The loss is temporary because the price of digital assets can eventually recover. However, if an investor withdraws liquidity from the pool during this period, the losses become confirmed.
2. Loss-versus-rebalancing: Traditional automated market makers (AMMs) continuously rebalance pools to maintain ratios. However, loss-versus-rebalancing (LVR) prevents liquidity providers from capturing all potential gains during this process. If crypto prices quoted by AMMs are outdated and digital assets trade at a higher premium on more liquid platforms, arbitrageurs can exploit this and make a profit.
3. Slippage: Slippage is a common issue in crypto and not limited to DeFi. It refers to how market fluctuations affect trade prices. For example, if an investor tries to buy Ether at $3,000, but the price rises to $3,100 before the order is filled, there would be a slippage of $100. Slippage is particularly important to consider when trading high volumes on illiquid pairs, as a large order in a low liquidity pool can significantly impact prices.
4. Maximal extractable value (MEV): MEV refers to the exploitation of AMM inefficiencies or timing games to profit at the expense of other participants. It has become an important metric in sophisticated DeFi strategies. In Ethereum’s proof-of-stake network, MEV involves validators changing the order of transactions within a block to maximize revenue.
To address these potential pitfalls, it is crucial to understand the DeFi landscape before getting involved. Liquidity providers who invest their own capital into DeFi opportunities can be disproportionately impacted by these costs, which may discourage participation and hinder the growth and stability of the DeFi ecosystem.
While there is no one-size-fits-all solution to eliminate hidden costs in DeFi, builders need to create protocols that address these complexities and educate users about potential risks and protective measures. For example, investors can rebalance their portfolios and rely on less volatile assets to reduce exposure to impermanent loss. Understanding different AMM models and tradeoffs is also essential, as newer protocols are emerging to mitigate LVR and enhance overall returns.
Investors should also consider hedging LP positions to mitigate impermanent loss, set realistic slippage limits, and break up large trades into multiple smaller ones to manage price impact. Trading on aggregators like LlamaSwap, 1inch, or Matcha can provide better execution by accessing liquidity across multiple venues. Additionally, using an RPC service like Flashbots Protect can help mitigate costs by protecting against MEV.
Newer oracle protocols like Pyth, which use a push-based model instead of the traditional pull-based model like Chainlink, offer more control over price updates and enable near real-time on-chain prices. If complementary trades between users of a single protocol could be directly matched, settling without price impact, slippage, or MEV could result in higher returns for liquidity providers.
Implementing these improvements is in the best interest of DeFi protocols. Offering consistent returns and fees can retain users when better deals emerge and ensure long-term sustainability. Simplifying infrastructure also removes barriers to entry for consumers who find DeFi intimidating. Creating a positive first impression is crucial, as users who find the experience offputting are unlikely to return.
New protocols with innovative solutions for on-chain portfolio management and efficient trade execution are creating a fairer environment for liquidity providers. Staying informed about the latest developments in the industry is essential for navigating DeFi with confidence and maximizing returns.
