Summary
Decentralized finance (DeFi) protocols offer decentralized financial services through smart contracts and charge fees for those services. When a DeFi project's revenue increases, it attracts more users and liquidity.
Introduction
Choosing between different DeFi protocols can require a lot of time and effort. Many seem similar. So how do we know which one is best for generating passive income from our cryptocurrencies? An essential measure is understanding a platform's revenue and how much of that revenue is shared with its users. You can use that information to make an informed decision about where to invest your assets.
How DeFi protocols work
Decentralized finance (DeFi) protocols offer a variety of financial services that operate through smart contracts. For example, a DeFi protocol could offer decentralized exchange services, lending, and liquidity pools, all executed through smart contracts on a blockchain. In order to access and use these services, you only need to have a wallet and some cryptocurrencies to cover transaction fees.
There is almost no limit to the financial services that DeFi can offer. In the DeFi world, you can access exchange services, money markets, derivatives, and savings products. All of these services are by nature permissionless and without intermediaries.
How DeFi protocols generate income
The operating costs of DeFi services derive from the computing power needed to run the smart contracts. Users normally cover this cost with the gas commissions they pay. However, there are also other additional costs for services such as development and maintenance. DeFi protocols charge fees for their services to cover these costs and generate profits.
Decentralized exchanges (DEX)
Users who swap tokens on a DEX must pay a commission to use the platform's services. For example, a trade may generate a 0.3% commission for the DEX operator's treasury or liquidity reserves.
Loan protocols
Users who borrow from a lending protocol must pay a fee. Part of this will go to paying the liquidity provider (other users who have contributed capital), while the rest will go to the protocol.
Why income is important
Beyond covering the costs of a protocol, increased revenue and profits can also benefit stakers. DeFi projects typically maintain a revenue sharing model through their governance token holders. They can also use the proceeds to increase the APR rates of stakers or liquidity providers operating on their platforms.
In the case of DEXs, higher revenue can attract more users, which in turn improves liquidity. Additionally, more revenue can boost APY for yield aggregators if they benefit from pooling users' staked funds as network validators.
In summary, we can describe the incoming flows and revenues of a project in a cyclical manner:
Popular projects attract liquidity, which in turn attracts more users and a virtuous cycle is formed.
Higher trading traffic and higher liquidity lead to lower slippage and faster trade execution.
More users improve legitimate trading volume, leading to more revenue.
Proceeds are shared with staking users, providing more liquidity.
This cycle also attracts users who want to participate in performance farming. Those looking to invest their money can increase their chances of maximizing profits with compound interest. The more successful a project is, the more liquidity there will be and in turn it will attract more yield farmers. This process generates more revenue that can be used to improve a protocol's offering.
How to know how much DeFi protocols generate
DeFi operates on-chain, meaning that almost all transactional information, depending on the blockchain used, is verifiable. A blockchain explorer is easily accessible to everyone, but that doesn't mean we can understand the scope of a protocol's revenue. There are blockchain data aggregators that simplify the task so you can better understand the revenue of each protocol.
With a Google search and some research on reliable sources, you can find metrics and statistics on the revenue of DeFi protocols. These figures can help you make more informed investment decisions.
Conclusions
If you are looking for the actual performance or basic fundamentals of a project, revenue is an essential metric to study. Thus, by understanding how the protocol generates and shares its income, you will be able to invest intelligently. You can better understand the topic by delving into DeFi 2.0, yield farming, and other general financial topics at Binance Academy.
Further reading
What is Yield Farming in Decentralized Finance (DeFi)? | Binance Academy
What is DeFi 2.0 and why is it important? | Binance Academy
Introduction to DeFi | Binance Academy
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