The 90 / 10 Series
Hello Bubble Riders!
Given the present uncertainty of the market, and especially the recent turbulence in the crypto world, we’re perfectly timed to address the 90% portion of the 90 / 10 portfolio. Our last two articles have covered (1) the general idea of the 90 / 10 crypto portfolio and (2) how to optimize the 10% side which holds cryptos.
This article will start covering the 90% side and it’ll take a few parts (I’m planning on 3 at present). This one will cover the principles that (historically) have kept yield farming portfolios safe. At our own hedge fund, we used them to guide us successfully through the whole FTX collapse with what lawyers call “de minimis” exposure.
The core of yield farming (to recall) is that you would exchange your fiat for stablecoins and deposit those on decentralized exchanges. When people transact those coins, you get a cut of the fees. That’s the ideal strategy–though we’ll actually talk about 7 of them.
Now, I aim to be as realistic as possible in this guide. Here, then, are the top guiding principles in designing our yield farming strategy.
- Your primary goal is to avoid risk. If the 90% of your portfolio merely wobbles about making just 2% a year on average, then the 10% in crypto will still deliver most of your returns.
- Your secondary goal is to get high yields.
- Your tertiary goal is to keep your transaction costs down.
To explain that last point, you are likely to incur a 3% loss on your investment as you migrate your fiat currency onto the appropriate blockchains and deposit it. We’ll be focusing predominantly on the MATIC and AVAX protocols to keep these costs down, but there will still be slippage and exchange fees (and using ETH to some degree is practically unavoidable).
You’ve got to accept those costs up front.
A more sophisticated manager can lower those costs to below 2%, but there is a limit to what can be done.
Since this is going to be a lesson focused on principles, I thought I’d also include a “degen” option at the end. It’s a sort of “quiz.” I’ll show you the idea and come back to it in the next newsletter to explain the answer following the five principles (the “secrets” of the title) below.
Paid subscribers receive a 90 / 10 portfolio newsletter, but this lesson will explain a bit better why it’s so valuable. As a result, everyone can gain.
Let’s get started.
1 Five Primary risks
When you exchange your fiat currencies into stablecoins and then deposit them onto an exchange you face five possible risks:
- protocol risk
- coin risk
- platform risk
- counterparty risk
- concentration risk
Protocol risk is the risk that your protocol collapses–LUNA style. Coin risk is the risk that your coins collapse–UST style.
Platform risk is the risk that the platform where you are storing your funds gets hacked. Counterparty risk is the risk you take on that the other party involved in your deposit (say you lend them money) fails to hold up their side of the bargain.
Finally, there’s the “second order” risk that you concentrate your funds too much in one place. To explain that last one a bit more, putting too much money in one place opens your portfolio up to bigger losses from one of the four other risks.
Let’s take a moment to go through the solution to each one.
2 Protocols, Coins, and Platforms
To diminish protocol risk, try to stay on established protocols. Right now, those would include: Binance, MATIC, AVAX … and ETH. You could also look to Arbitrum and Optimisim to keep ETH costs down.
We’ve conducted an exhaustive study of all the main coins out there. The following are presently documented well as safe (meaning unlikely to collapse) stablecoins: BUSD, GUSD, USDP, USDC, USDT, DAI, and … USDD
That last one gets me. It works. I’m just surprised Justin Sun (the founder of the blockchain Tron, which USDD runs on) was able to pull it off … so far.
Finally, when you’re looking at crypto platforms to use (decentralized exchanges or vaults, for example), you want to look for two key features:
- must have audits by reputable firms
- must have been around for at least 6 months (ideally 12)
There was a wave of auditing firms in the 2021 bull market. They’re not all good. So, stick to reputable ones. You should go to their website to see how many audits they’ve done. Here’s what Certik’s website looks like (they are a giant in the industry).
Yea, they’ve evaluated $346b in crypto assets.
3 Counterparty & Concentration Risk
The last two risks are related.
Should you, for example, deposit your money on Maple? We’ll get into the details later, but here’s the M11 pool’s broader stats.
Hard to say at first. It’s helpful to know that they navigated this FTX collapse without one counterparty defaulting.
There’s an ideal “game theoretic” solution to this problem that I used to teach my university students, but it turns out to be practically impossible to implement because you just don’t know enough in real life.
Here’s a basic rule of thumb: only pick pools that you are 100% certain are going to be rock solid after doing your due diligence on them.
Then expect some percentage of them them to fail anyway.
This means, given the size of your portfolio, you are going to want 10 – 20 of these pools. If you don’t over concentrate yourself, then even if something goes wrong, you’ll be ok.
4 Impermanent Loss
This is the fundamental concept at the base of crypto yield farming. Todd Mei (Head of Research at 1.2 Labs) has a detailed and readable explanation of the concept here. Here’s my “crash course” on the topic.
Imagine an hour glass … but turned on its side.
When it’s perfectly flat, the sand doesn’t move anywhere. Those are like the coins you deposit to make transaction fees.
But if one of them is a crypto coin, like Ethereum, and another is a stablecoin, then ETH is going to move around. In this environment … it’s likely to go down in value.
What the pool does is “rebalance” exchanging the sable coin for the losing ETH coin. That’s how your pool can lose money even though it’s gaining a yield.
Your pool might start at $10,000 ($5000 ETH and $5000 USDC), but if ETH loses half its value then your pool is going to be worth about $7000. Even if you make 20% as a return, then, you’re losing money.
When ETH bounces back, your pool will rebalance the other way and you’ll be positive again. That’s why they call it “impermanent” loss. But it is real loss if you happen to cash out early or the crypto coin doesn’t bounce back.
One way around that is to pick pools with coins that don’t change much in value. Unfortunately, the yields on those pools tend to be about 2% … so we’ll be discussing 7 other strategies around this problem.
But, to be clear, the entire yield farming universe of strategies consists of nothing but a basket of ideas to solve this problem.
If the problem didn’t exist, then the high yields offered wouldn’t exist either.
5 Final Criterion
To wrap up the main principles, we’ll conclude with an obvious one: Do not mix strategies!
That means no “buying x coins to get y yield boost.” Some protocols will allow you to buy their coins to get 2x the yield boost–say Midas tokens or Maple tokens.
No. Don’t do it.
We already have a coin portion of the portfolio. This isn’t that portion. If you buy those tokens, now you’re making a bet on those coins in the hopes that they’ll go up. And that’ll add volatility to your portfolio–ruining the solid basis of yield farming returns.
Those are the 5 principles you need to keep in mind that will make your yield farming portfolio safe … and which make sense of the entire yield farming universe.
I’ll leave you with a puzzle to test your knowledge. I’ll even help you a little bit. Stablecoins usually bounce around between $.998 and $1.002. Some will move between 4% and 8% in a huge market decline, but for most of the time they’re stable.
Here’s a possible “degen” pool on DeForce.
If you deposit USDT, you gain 4.64%. You can then borrow against your deposit for 1.03%. You would be paid, then, about 3.61% to borrow money.
Suppose you are allowed to borrow 95% against your initial amount. That means that you could take your borrowed money and deposit it again. Take out a loan against the newly deposited amount and redeposit. Thus making a cycle of 20 deposits and borrowings.
You would be up a lot in annual percentage yield (APY). Why not do it? What could go wrong?
That’s all for this week. Over the past few days I wrote a number of pieces that are related to this post, so you might want to have a look if you’ve missed them.
That’s it for this week. Remember to join us on Discord if you haven’t already.
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