How to Choose the Best DeFi Protocols for Earning High APYs

Interest rates in the DeFi ecosystem vary greatly. Some projects offer outrageous APYs, such as the up-and-coming Spectra V2, an EVM-centric platform focused on derivatives, where the LP-SW-USUALUSDC pool promises 136,188% base APY and 2.78% in APW rewards. Of course, 30-day averages are dramatically lower since these rates are offered on a promotional basis. However, you can find other options on Solana, SUI, and some other networks offering rates just as high.

The reason why so many protocols on cheaper networks are so popular among contemporary investors is the gas fees optimization making each transaction cost less compared to the flagship DeFi network Ethereum. People who are entering the world of DeFi for the first time are usually impressed with the variety of investment options and the seeming efficiency of capital allocation. Unfortunately, things are not as shiny as they look.

Building a solid DeFi investment strategy

It is hugely important to understand that the decentralized finance sector is still maturing. It is far better than it was a decade ago. We have prominent protocols offering excellent user experience and undeniably useful services. We are reaching billions in TVL and can enjoy an incredible variety of intriguing financial instruments. However, some problems have existed since the first days of the ecosystem’s existence and persist to this day.

Here are some of the issues that should be accounted for in your risk management strategy:

• Regulatory inadequacies of the ecosystem are on full display whenever something tragic happens to investor funds. Victims of fraudulent activity, rug pulls, and other borderline criminal behavior do not have any way to hit back. Even the best lawyers and smartest detectives won’t help you recover funds or receive some form of compensation.
• Smart contract vulnerabilities are, unfortunately, quite common despite the best efforts of the community and developers. The issue here is that catching all the bugs before deploying and battle-testing is a difficult task. A timely smart contract audit can be useful and significantly reduce the risk of hacks. Audits can be lengthy as they require intense testing. For instance, Spectra V2 tested its contracts for two months before releasing.
• Market volatility is another issue often overlooked by newcomers to the industry who often perceive digital assets as similar to stocks and other securities. The issue here is that the vast majority of tokens are speculative in nature. Prices swing up and down dramatically. Bitcoin, one of the most stable coins in the market, can experience significant annual volatility (over 10%). These fluctuations are hard to predict and account for when building a strategy. Portfolio diversification is a good answer to this problem.
• Inadequate premiums. When you are investing in a high-risk venture, you expect to receive appropriate compensation. We call it a “risk premium”. For example, if you are putting money in a lending protocol where all loans are 110% collateralized, the risk level is low so you are fine with a return of 2% or even 1%. However, when it comes to memecoins and other questionable digital assets associated with a risk-reward ratio skewed toward risk, you want a bigger compensation. Thus, investing in something like a SOL-RABBIT pool on Orca (Solana) is rewarded with 10,584% APY in November 2024.
• Impermanent loss is another big issue that can be easily overlooked. It occurs when an investor enters a staking position at a certain price of the principal asset. If the price falls during the staking period, you will incur losses. Since these are not realized until you exit a position, they are called impermanent. Unfortunately, many liquidity providers lose money due to this particular issue.

These risks should be carefully assessed and taken into consideration when trying to create a reliable portfolio that can perform under all circumstances. Many investors are ready to take on higher risks in exchange for juicy premiums. It is possible to achieve a portfolio performance that blows out of the water everything else. However, you should be very cautious and meticulous when searching for proper investment prospects.

How to approach protocol selection

Picking the right destination for capital allocation in the DeFi ecosystem is difficult due to a multitude of reasons. For starters, many protocols are developed by anonymous teams of founders leaving users in the dark about the credibility of people behind any given project. Secondly, many platforms do not have a long history that can be inspected by investors seeking assurance. So, how can you start searching for the best place to get started? 

Yield comparison between high-yield protocols

A nice way to find a good protocol is by comparing their metrics. As an example, look at these three protocols known for their high APYs and relatively low-risk profiles.

What to look for when seeking the best DeFi investment?

You can use several metrics and tips to identify protocols that deserve attention:

• User activity and TVL indicators are hugely important. The latter is the amount of funds locked in pools operated by a protocol. It measures the level of investor confidence and available liquidity. Higher numbers suggest that users think that the project is reliable and will have high adoption rates in the future. The former is harder to judge. You can track operational volumes, asset utilization, collected fees, and other metrics to assess the level of user engagement.
• Insurance options are offered by specialized protocols and cover some types of investments. Multiple decentralized projects are offering insurance options as a complimentary service. Since the ecosystem does not have any regulatory authorities that can offer protection from market risks, investors have to rely on themselves and use insurance coverages. It is not necessary to purchase coverage or for a protocol to offer it. However, using such risk mitigation methods is incredibly useful.
• User experience plays a pivotal role. Up to 40% of all newcomers to the DeFi sector name onboarding the main difficulty preventing them from actively participating in the growing financial market. Learning how to use wallets and dapps efficiently is difficult as interfaces differ from familiar layouts offered by banks and investment firms. Understanding the infrastructure of the DeFi ecosystem is also challenging for people who have not used it extensively prior to investing.
• Accessible digital assets define how well you can build a portfolio that is robust enough to withstand market volatility. Different types of token economics create a complicated system where some assets can perform excellently despite the general bearish trend in the crypto market while others will skyrocket alongside dominant layer 1 tokens like Bitcoin and Ethereum. It is important to have variety! If you are focused only on lending stablecoins, your APYs will be relatively low preventing you from quickly making substantial gains. However, putting too many assets into memecoins will also lead you to financial despair.
• Platform reputation can be a very telling indicator of future success. Since many protocols are quite young, the social sentiment is often hopeful. Trusting the hype generated on Reddit, Discord, X, and Facebook is not the best idea. However, you should be getting information somewhere. We recommend reading user reviews, talking to professionals, and closely analyzing TVL, user engagement, and utilization rates as well as other empirical and easily verifiable data to judge the trustworthiness of a protocol.

These tips will help you find a reliable project that you can invest in. Many of the protocols that check all the boxes will be on the safer side with noticeably lower interest rates. When searching for high-yield options, you should be slightly less inquisitive. Enjoy your risk premiums and limit the exposure to ensure that you are optimizing profitability.

Assessing the earning potential

Various protocols are offering incredibly generous interest rates because they have to. Otherwise, they will quickly lose access to liquidity and the service will be substantially worse due to the lack of user activity and available liquidity in pools. It means that investors are in a unique position as they are catered to by all competitive protocols. Of course, some projects can rely on their reputation, track records, and earned use loyalty to offer lower rewards.

How to identify a good project that will bring you excellent returns? Below are several tips:

1. APY analysis is crucial. Annual percentage yield represents an annual interest rate that accounts for daily compounding frequently offered by decentralized protocols. However, this metric can be misleading:
   • A base APY in two-sided pools is often a combination of rates paid in principal currencies. However, the ratio is more than important. In a typical SOL-PEPU pool offered by multiple Solana-based protocols, you will be paid primarily in PEPU tokens which depreciate rapidly.
   • The vast majority of protocols use variable APYs that may change depending on available rewards, pool utilization, market circumstances, and many other factors. Judging the long-term performance by metrics like the 30-day mean average is a much better way of assessing potential profits.
   • APYs can be artificially boosted by protocols if they are interested in increasing user engagement in particular pools. Interest rates can be raised by adding additional rewards, offering layer 2 tokens, or simply paying slightly more in cheaper tokens.
2. The security assessment should be among the top priorities. You will not receive a penny if the protocol or its smart contracts fail. Always check the protocol and look for specific information:
   • The credibility of founders and their expertise in blockchain technology, fintech, financial markets, and other relevant fields.
   • The frequency of smart contract audits and companies that conduct these audits. It should be easy to find this information.
   • The protocol’s historical performance must be closely analyzed with a strong emphasis on security breaches.

Profitability in raw numbers is easily quantifiable yet it does not represent the whole picture of potential earnings by an investor.

The example of Aerodrome Finance

This decentralized exchange on the Base network is practicing a relatively rare approach of paying its liquidity providers exclusively in native AERO tokens. These are quite valuable even if you don’t sell them on the market for profit. Holders can lock their tokens in for a period of up to 4 years. The efficiency of tokens and their utility is proportionally tied to the length of the lock-in period. These tokens are used for community governance and make people who are locking their tokens in for longer more powerful as voters.

Below are two examples of how it all works:

1. If you lock 100 AERO tokens for 4 years, you will enjoy the 100% efficiency of the tokens. For instance, voting will give you 100 votes and you will be receiving all fees collected by the protocol for your particular stake.
2. Locking for 3 years will unlock 75% of the token’s efficiency. 100 tokens will give you 75 votes. You will get a 75% cut of all fees collected by the protocol.

Here, the benefit of receiving dividends in the form of fees and the power to affect the development of the platform can be far more valuable than the financial gains that you would receive by selling reward tokens.