How Investors Can Protect Themselves From the Hidden DeFi Costs in 2024

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 eat into your potential returns.

Unlike traditional payment processors like Visa V and Mastercard MA with fixed fees, smart contract blockchains operate differently. On platforms like Ethereum ETH/USD, Solana SOL/USD, and EVM-compatible chains, gas fees are dynamic. This means the cost to process your transaction fluctuates based on network congestion and the priority you set for completion. Currently, the average gas fee, which is the cost of facilitating a transaction on a smart contract, costs around $4.70 per ETH’s price. 

Beyond the gas fees, DeFi lurks with hidden costs that can significantly impact investor returns. Impermanent Loss (IL) occurs when deposited asset prices diverge in a liquidity pool, potentially leaving you worse off than holding them separately.  Traditional AMMs constantly rebalance pools to maintain ratios, but Loss-Versus-Rebalancing (LVR) ensures Liquidity Providers (LPs) don't capture all potential gains during this process versus a rebalancing portfolio.  Slippage occurs when the final trade price differs from the initial one due to market fluctuations, further eating into 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 in.

These hidden costs significantly impact LPs who deploy their own 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 for eliminating hidden costs in DeFi.  Builders need to create protocols that start to abstract away these complexities and also do a better job educating users on risks and what additional steps they can take to protect themselves. 

Understanding different AMM models and tradeoffs is key. Some newer protocols are helping to mitigate Loss-Versus-Rebalancing (LVR) and boost 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 sting of price fluctuations during trades. 

It’s important to always check price impact when trading, if it's too large, breaking the single trade up into multiple ones can be helpful.  Investors can use conservative settings for slippage to prevent the price from moving unfavorably against them after submitting trades.  By trading on an aggregator like LlamaSwap, 1inch, or Matcha, one can get the best execution by accessing liquidity across multiple venues. Finally, submitting transactions through an RPC service that protects against maximal extractable value (MEV) like 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 Chainlink LINK/USD. This allows protocols more control over price updates and enables accessing near real-time prices onchain. If there was a way to directly match complementary trades between users of a single protocol, they could settle without price impact, slippage, or MEV - earning more returns for liquidity providers.

New protocols with innovative solutions like onchain portfolio management and efficient trade execution are beginning to create a fairer environment for liquidity providers. Stay informed about these developments to navigate DeFi with confidence and maximize your returns.