By Sunil Srivatsa, founder and CEO of Storm Labs
DeFi offers exciting possibilities, but beyond the upfront gas fees, there are hidden costs that can significantly impact your potential returns.
Unlike traditional payment processors like Visa V AND MasterCard BUT with fixed fees, smart contract blockchains work differently. On platforms like Ethereum ETH/USD, Solana SOL/USDand EVM-compatible chains, gas rates are dynamic. This means that the cost to process the transaction varies based on network congestion and the priority set for completion. Currently, the average gas fee, or the cost to facilitate a transaction on a smart contract, costs around $4.70 per ETH price.
Beyond gas fees, DeFi hides hidden costs that can have a significant impact on investor returns. Impermanent loss (IL) occurs when the prices of deposited assets diverge in a liquidity pool, potentially leaving you worse off than holding them separately. Traditional AMMs constantly rebalance pools to maintain ratios, but the Loss-Versus-Rebalancing (LVR) ratio ensures that liquidity providers (LPs) do not capture all the potential gains during this process compared to a rebalancing portfolio. Slippage occurs when the final price of the trade differs from the initial price due to market fluctuations, further eroding profits. Finally, Maximal Extractable Value (MEV) allows savvy actors to exploit AMM inefficiencies for profit at the expense of other participants. These potential pitfalls highlight the importance of understanding the DeFi landscape before diving into it.
These hidden costs have a significant impact on LPs deploying their capital into DeFi opportunities. Lower-than-expected returns or even losses can discourage participation, ultimately hindering the growth and stability of the DeFi ecosystem.
There is no silver bullet to eliminate hidden costs in DeFi. Builders need to create protocols that begin to eliminate these complexities and also do a better job of educating users about the risks and additional steps they can take to protect themselves.
Understanding the different AMM models and their tradeoffs is critical. Some newer protocols are helping to mitigate the loss-to-rebalance ratio (LVR) and increase overall returns for investors. Researching platform rebalancing strategies can help you choose the best place for your liquidity. Additionally, hedging an LP position can help mitigate impermanent loss, while setting realistic slippage limits reduces the hassle of price fluctuations during trades.
It is important to always check the price impact when trading; if it is too large, it may be useful to split the single operation into multiple operations. Investors can use conservative slippage settings to prevent the price from moving unfavorably against them after submitting trades. By trading on an aggregator like LlamaSwap, 1inch or Matcha, you can get best execution by accessing liquidity across multiple locations. Finally, sending transactions via an RPC service that protects against maximum extractable value (MEV) such as Flashbots Protect can be another way to mitigate costs.
Some newer Oracle protocols like Pyth use a push-based model instead of the more traditional pull-based model like Chain link LINK/USD. This gives protocols more control over price updates and allows access to near real-time prices on-chain. If there was a way to directly match complementary trades between users of a single protocol, they could settle without impacting prices, slippage or MEV, earning greater returns for liquidity providers.
New protocols with innovative solutions such as onchain wallet management and efficient trade execution are starting to create a fairer environment for liquidity providers. Stay informed on these developments to navigate DeFi with confidence and maximize your returns.