Investment Vehicles
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The principles of investment in DeFi lending are comparable to the investment in short-term bonds. The lenders will earn interest as a return from providing loans. Loan agreements are written and specified in the smart contracts.
Currently, such lending process uses the peer-to-pool method. First, the lenders deposit their digital assets with the lending pool, a decentralized platform for lending. Then, the borrowers will take on loans from the lending pool as digital assets and provide their collateral assets with more than 100% of the loan value (over-collateralization), as shown in the figure below. If the collateral asset value decreases and the collateral asset value to loan ratio decreases below the minimum rate, the platform will liquidate the collateral assets and return loan amounts to the lending pool.
In practice, the lenders will earn interest in the same digital assets of the deposit and will receive interest-bearing tokens to show the total capital and return value. This kind of loaning process uses a management framework called peer-to-pool. Thus, the interest will be distributed proportionally to the loan value. Also, the interest rate is not fixed and will depend on loan demand and supply. Therefore, we can say that such interest can be considered the cost of capital.
In addition to the interest that lenders earn, as mentioned above, some lending platforms will give the investors a return in governance tokens by depositing their interest-bearing token with another platform. This tends to persuade the investors to provide a long-term loan, which makes the lending system more sustainable.
Considering the investment policy, you can see that lending can be a suitable investment. Stablecoin will be the only digital asset that the fund will provide to the decentralized lending platform. Moreover, the fund will choose a lending system that has an over-collateralization requirement. In the unusual market condition with high volatility and probability of asset liquidation, the fund will still receive the total amount of loan back. It might also earn some governance tokens as an additional return from staking the interest-bearing tokens, which is considered a high-risk asset. The fund will then sell these governance tokens and reinvest them with the amount received.
The principle of investment in providing liquidity for DeFi is comparable to the investment in the foreign exchange business. Therefore, liquidity providers will receive some transaction fees as a return on providing liquidity, while the swap contract is written and specified in the smart contract.
The assets, which can be exchanged, must be the digital assets supported by the platform. Stablecoin with dollar-pegged currencies, such as USDT, USDC, BUSD, DAI, UST, usually has the exchange rate with similar currencies at 1:1. This makes providing liquidity for stablecoin exchange less volatile. Therefore, the fund, intending to have stablecoin in its portfolio, can invest in providing liquidity for a decentralized exchange platform per the investment policy.
Liquidity providers will receive the transaction fee as liquidity-providing tokens. In the peer-to-pool system, the transaction fee is around 0.3% of the transaction value, and it will be distributed proportionally to the liquidity providers. Thus, the amount of earned transaction fees will depend on transaction value and the total liquidity supplied.
In addition to the transaction fee, the liquidity providers can also receive governance tokens in some exchange platforms by staking their liquidity providing tokens with the platform. This tends to persuade the investors to provide liquidity in the long term (yield farming), which makes the exchange platform more stabilized. However, the governance token is considered a volatile and high-risk asset. Therefore, based on the investment policy, the fund will sell these governance tokens and reinvest them with the amount received.
