ILMs 103: The Power of Auto Compounding and Capital Efficiency
Table of Contents
· Summary/TL;DR
· Introduction
· What is compounding?
· Compounding on the ILM LoopStrategy
· Exposure: Individual vs ILM LoopStrategy
· Conclusion
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Summary/TL;DR
- Compounding is earning on earnings
- Compounding is maximized when done frequently
- ILM LoopStrategy compounds as frequently as possible
- ILM LoopStrategy offers better loan terms than borrowing as an individual (specific-purpose loan vs general purpose loans)
- ILM LoopStrategy is much more capital efficient than individual borrowing due to shared costs
The ILM LoopStrategy offers an automated way for users to achieve the practice of compounding without needing to diligently manage their position. Auto compounding in the context of ILMs, takes staking fee rewards generated by an underlying asset, reinvesting these rewards back into the strategy, effectively growing the base of the initial investment to generate more interest over time.
The impacts of auto compounding add up over time to ultimately benefit the user through reinvestment of staking rewards and distribution of costs to the pool of participants as opposed to any one individual.
Introduction
Continuing the exploration of Integrated Liquidity Markets (ILMs), ILM mechanics offer ways for users to magnify rewards through key features impacting a user’s P/L.
*For a primer to this post, please read Part 1, ILMs 101: Automated growth strategies to magnify your rewards and Part 2, ILMs 102: Key Differentiators and a Leap Forward for Base DeFi to follow along in this series.
The concept of compounding interest is a well known concept to most of those in DeFi; it is the difference between APR and APY, after all. Though seemingly synonymous, APR and APY have different calculations that materially change with respect to interest and rewards. In this article, compounding will be explored in the context of the new ILM LoopStrategy.
What is compounding?
Compounding is the act of earning interest on both the principal investment, and on the interest that was previously earned on that investment. Basically, earning on earnings.
A crucial aspect of compounding is the frequency with which interest is earned and reinvested. For any given investment vehicle, the compounded returns follow the formula:
where R denotes the returns, I the initial investment, APR the interest earned per time period, and N the amount of elapsed time periods. As seen above,
For two investment vehicles which both pay 15% interest per year, vehicle A and vehicle B, with different compounding frequencies, this difference may prove quite large.
Let vehicle A pay interest at the end of the calendar year, whereas vehicle B pays interest at the end of every calendar month. If an amount Y is invested, at the end of the calendar year the yield given by the vehicles is, following the aforementioned compounding formula:
Vehicle A: Y ( 1 + 0.15)1 = Y * 1.150000000
Vehicle B: Y ( 1 + 0.1512)12= Y *1.160754518
Over a single year, vehicle B earns 7.2% more when compared to vehicle A, simply by virtue of the frequency of compounding, in this example 12x per year.
The effect frequency becomes more pronounced as time goes on. The graph below indicates the relative effect of monthly compounding frequency when compared to a simple yearly compounding frequency:
Compounding on the ILM LoopStrategy
The ILM LoopStrategy is a strategy which increases exposure to a desired asset by performing an investment “loop” (read more about it in this blog post and on Seamless’ Github here). The increased exposure is achieved by the following steps:
- Deposit an asset
- Borrow against asset from Seamless pools
- Swap borrowed asset on a DEX for deposited asset
- Repeat 1- 3
The target exposure is achieved by maintaining the ratio between the second, borrowed asset, versus the first, collateralized asset.
The aforementioned ratio of the first to the second asset leads to a multiplier effect — if 2x the initial amount has been borrowed, then the exposure is 3x (the initial amount invested + 2x that amount from borrowing). In equation form, the multiplier is given by:
As an example, let the first asset be wstETH and the second asset be ETH, with a desired multiplier of 3x. Note that wstETH has a 3.4% APR inherently due to the fact it is a Liquid Staking Token that generates staking fee reward. For simplicity, this value will be set to 15%. A user entering the strategy would deposit an amount A of wstETH and be exposed to 3A that amount, via borrowing.
As a result, the user would enjoy 3 x 15% = 45% APR, on the initial amount A.
So where does compounding come into play? The answer is: in maintaining the 3x exposure, as maintaining this desired multiplier is done via rebalancing.
Rebalancing is performing the loop, indicated in the diagram above, to maintain the multiplier. In the `LoopStrategy` this is done automatically via smart contract logic. This means that a user does not need to perform the compounding themselves.
As the wstETH accrues value from the interest received, the ratio between collateralized wstETH and borrowed ETH decreases:
Therefore to maintain the 3x exposure, the LoopStrategy borrows against the interest gained, in the same fashion as above:
- Gain interest on deposited and borrowed assets
- Borrow against interest from Seamless pools
- Swapping the borrowed asset on a DEX for the deposited asset
- Repeat 1- 3
This is not only tedious to do on a daily basis, but it is also unprofitable for small amounts of initial wstETH.
Now, how does rebalancing and compounding frequency relate? In essence, rebalancing is compounding on the interest, so the effect of rebalancing frequency is equivalent to the effect of compounding frequency. The graph below compares rebalancing frequencies (note that all of these are exponential but have been normalized so that yearly rebalancing frequency is a straight line):
It is clear that the most frequent rebalancing is optimal. Additionally, the interest is paid out in tokens which means the `ILM LoopStrategy` offers real yield — a user comes out with more tokens than what they came in with.
From a user perspective, rebalancing is tedious; multiple steps have to be taken, each with associated costs in the form of gas, DEX fees and interest on the borrowed assets. These costs make it unprofitable to rebalance frequently, as an individual.
In contrast the ILM LoopStrategy shares those costs amongst all participants, and as a result can profitably rebalance daily, thereby achieving the highest possible returns.
A caveat: the above examples are greatly simplified. No DEX costs, slippage or interest are taken into account when presenting the graphs. An individual wanting to achieve the same performance as the ILM LoopStrategy would have to be vigilant and deal with these costs thoroughly.
Exposure: Individual vs ILM LoopStrategy
There are some key differences between borrowing as an individual versus borrowing as a deterministic smart contract which materially impact the profitability of increasing the exposure to a given asset multiplicatively.
Seamless pools have no information with what happens to the funds a user borrows. Hence the pools have to be conservative when it comes to risk management and loan parameters such as loan-to-value and interest rate, to protect the lenders.
On the other hand, the Seamless pools can offer better rates to the ILM LoopStrategy contracts as what is done with the funds is predetermined and can be risk-assessed. The deterministic nature of the smart contracts which govern the ILM LoopStrategy allow the Seamless pools to offer better loans, with higher loan-to-value and less interest!
An apt comparison is a specific-purpose loan versus a general loan such as taking out a loan for a house versus taking out a loan to begin an undefined business.
Moreover, for each “loop” performed, the associated fees would burden only an individual, whereas in the case of the ILM LoopStrategy they would be shared amongst participants — as a result, the fixed costs to run the exposure mechanism are far less.
Conclusion
Compounding more frequently is optimal for increasing yield, in ideal scenarios. In practice, compounding is tricky and requires diligence, to account correctly for hidden costs.
Partaking in a ILM strategy divides costs amongst participants, allows borrowing for the specific purpose of the strategy for cheaper and most importantly makes position management non-existent and effortless.
For those bullish on a given token…ILMs are for you!
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