Everything You Need To Know About Using Stablecoins In DeFi | Part 1: Earning With Stablecoins
Welcome to Part 1 of Stably’s series on using stablecoins in DeFi. In this series, we’re going to explain how to use decentralized lending platforms, liquidity pools, and yield farming to take advantage of the lucrative opportunities afforded by stablecoins.
Inflation of the U.S. Dollar is at 8.5% as of May 2022, a rate not seen since the 1980s. This rate is significantly higher than the 1.6% at the beginning of 2021, and it’s only expected to continue rising, while high-interest savings accounts continue to pay an average of 0.5% to consumers. High-yield savings accounts, yielding about 0.06% on average, don’t even begin to cover such losses.
During this same time frame, the total value of stablecoins worldwide has grown from $36B to $180B. Stablecoins are cryptocurrencies whose value is pegged to an asset that has value in the real world, such as a U.S. Dollar. They act as a borderless currency that can not only bypass bank hours and bank fees but can be programmed to suit a variety of use cases.
Additionally, they’ve positioned themselves as powerful and accessible tools that combat inflation. This is because they typically offer significantly higher returns than high-yield bank accounts, and aren’t subject to many of the hurdles involved in making traditional investments, like accredited investor requirements.
Earning with stablecoins
In this series, we’ll introduce three of the most popular opportunities in DeFi where one can use stablecoins to earn a return:
- decentralized lending;
- supplying liquidity to liquidity pools; and
- yield farming.
In Part 1, we present a high-level overview of stablecoins and the plethora of earning opportunities they enable to beat the interest rates offered by high-yield bank accounts.
In Part 2 of this series, we explain how to set up an account with Stably Prime and deposit funds, exchange those deposited funds for stablecoins, and move your stablecoins to the right network.
Part 3 provides a simple guide to lending stablecoins for interest using automated money markets.
Finally, in Part 4, we discuss liquidity pools and how to supply liquidity to earn liquidity provider (LP) tokens, which can be staked for even greater earnings through yield farming.
Now, let’s explore the role of stablecoins in the ever-growing world of decentralized finance.
We’ll be covering how to obtain them, how they compare to the current state of high-yield U.S. bank accounts, and their utility as both earning tools and a hedge against inflation.
How to obtain stablecoins
Fiat currency can be swapped for stablecoins on a number of reputable Centralized Exchanges like Coinbase or Kraken.
These services offer ACH, debit purchases, and wire transfers, allowing users to purchase stablecoins that can be held or moved to their preferred crypto wallet. Once on a crypto wallet, users are free to swap, trade, lend, and borrow through a myriad of decentralized applications.
Choosing the Right Network
When withdrawing from an on/off ramp, you’ll need to select the blockchain you want to transfer your tokens to.
Each blockchain ecosystem offers its own earning opportunities, decentralized applications, and communities. Many utilize the same token set as Ethereum, but some are forging their own digital paths.
Networks like VeChain feature their own stablecoins to be used within their respective ecosystems – and as we continue further down this multi-chain path, a range of new tokens, platforms, and opportunities are sure to follow.
As such, it’s important to be aware of the risks and opportunities attached to each network and adjust your strategy accordingly. Once a preferred network or decentralized application (dApp) has been identified, Stably offers low-fee bridge solutions to and from a growing list of blockchains.
There’s an increasing amount of various blockchains in the market, but below are some of the ones supported by Stably.
One issue that Decentralized Exchanges have faced is that of liquidity. Decentralized lending protocols are one solution to this issue, that utilize smart contracts to provide borrowers with access to liquidity, and lenders access to competitive interest rates.
- Borrowers leverage this liquidity to invest their earnings through dApps.
- Lenders earn steady interest on their deposits while maintaining positions on their preferred networks.
Protocols like Aave and Compound enable users to deposit digital assets for greater returns than traditional offerings and even borrow against them to participate in the plethora of earning avenues Decentralized Finance (DeFi) provides.
It’s important to note that these interest rates are variable (though at times fixed), adjusting automatically to changes in volume and supply, but as stablecoins are consistently borrowed and lent – their returns are typically higher than more volatile assets.
This consistent liquidity flow makes stablecoins attractive earning tools for a variety of scenarios available on the decentralized web.
Providing Liquidity & Yield Farming
LPs not only earn passive income, but they also act as critical stakeholders in building self-sustaining, decentralized, automated market makers (AMMs).
AMMs use liquidity pools to enable users to swap tokens with the pool without the need for an intermediary. The liquidity pools often consist of a pair of tokens, such as ETH/BTC, although certain protocols enable multi-token pools. Algorithmic pricing is used to incentivize LPs to maintain consistent liquidity across each token pair.
Take a USDC-ETH pairing, for example.
Users provide equivalent values of USDC and Ether in exchange for an interest-bearing token representing their overall share in the pool.
This LP token can then be deposited, enabling participants to receive a portion of the trading fees, which are generated from transactions that utilize the pool. Using multiple dApps to compound earnings in this way is referred to as “Yield Farming.”
Types of Liquidity Pools
Liquidity pools come in a variety of shapes and sizes, but the vast majority operate under one of three models:
1. Two-token Pools
The two-token pair, with both tokens held in equivalent values, is the most commonly seen DeFi pool structure. As prices fluctuate, these pools adjust the quantities of both tokens to maintain their equilibrium.
2. Balancer Pools
Balancer pools weigh each asset in the pool individually, often by risk, wherein the least volatile asset holds the highest pool weight.
These pools aim to decrease the risk of investing in a variety of protocols by offering weighted indices of both popular and growing decentralized platforms.
3. Multi-token Pools
Multi-token pools are composed of three or more tokens, weighted equally. The most active of these pools can be found on Curve Finance, which is part of the Ethereum blockchain.
Both Curve’s 3-pool and 4-pool are composed of a basket of stablecoins, enabling users to manage the risk of any one token failing. These pools are also heavily traded, with numerous protocols offering direct integrations, ensuring consistent interest for liquidity providers.
Something every prospective liquidity provider should be aware of is impermanent loss. Impermanent loss occurs when the value of one pool token falls relative to its pair, decreasing the total value of the pool, and by effect, the value of each share of that total.
Say we have a pool consisting of two tokens with the same market cap and price. To provide liquidity both tokens generally need to be supplied in equal values.
If the value of one of these tokens then rises by 10%, the pool would rebalance to maintain the same proportion of tokens. As the total value of the pool increases, the value of each share rises with it, and one would miss out on the gains that they would have received from simply holding the token that rose. In essence, impermanent loss is this opportunity cost that arises and works in reverse when the price of token drops as well.
The more that prices between the tokens diverge in either direction, the greater the impermanent loss.
Why is the loss impermanent?
The loss is only realized or made permanent when the tokens are withdrawn.
Liquidity pools continue to readjust as token prices fluctuate. If they were to return to the values at which they were deposited, the loss would disappear, and you’d earn 100% of the trading fees that your share in the pool generated.
Decreasing the Risk of Impermanent Loss
One method of decreasing the inherent risk of impermanent loss comes in the form of stablecoin pairs.
These pairs are readily available across nearly every blockchain ecosystem, operating as central liquidity hubs for protocols to utilize.
Stablecoin pools typically offer lower, but more consistent returns than more volatile pairings. However, given that their value shouldn’t fluctuate, the risk of impermanent loss is far lower. Keep in mind, however, that just because the price shouldn’t fluctuate doesn’t mean it won’t!
Impermanent loss calculators can also be used to help gauge the risk of pools you’re considering investing in. Links to popular calculators for each pool structure can be found below!
Impermanent Loss Calculators
Start earning today
With inflation climbing by the day, DeFi can offer new opportunities for investors seeking yield above high-interest bank accounts. That being said, there are many risks and investors must be fully aware of how the various protocols function and must invest at their own risk.
Stablecoins enable a low-risk digital solution to retain your purchasing power and earn more on your savings. Stably offers a low-cost, user-friendly solution to exchange fiat for stablecoins on the network you’re looking to explore.
In Part 2 of this series, we’ll walk you through how to use Stably Prime to convert fiat to stablecoins, as well as how to move them to your preferred networks.
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