Introduction

The field of decentralized finance, or DeFi, is rapidly transforming the financial landscape. By leveraging blockchain technology, DeFi protocols offer a wide range of financial services traditionally provided by centralized institutions. However, for these protocols to thrive and ensure long-term sustainability, generating revenue is crucial. This article delves into the inner workings of DeFi protocols, exploring the various mechanisms they employ to generate income through specific use cases. We will examine how these revenue models contribute to the overall functionality of the DeFi ecosystem.

Understanding DeFi

DeFi is short for Decentralized Finance. It refers to an ecosystem of financial applications built on the blockchain, notably Ethereum. These applications offer a wide range of traditional financial services but in a peer-to-peer (P2P) manner, taking away the need for centralized institutions. Users interact with DeFi protocols directly through their crypto wallets, removing the reliance on third parties for transactions or approvals.

What are DeFi Protocols?

The last few years have seen tremendous growth in decentralized finance with the release of innovative DeFi protocols. DeFi statistics have estimated the DeFi market to reach $26,170 million by 2024, undoubtedly making it one of the most promising sectors in the financial industry.

DeFi protocols are self-executing computer programs built on blockchains that are designed to address issues related to traditional finance. They use tamper-proof smart contracts that automate financial agreements and transactions based on predefined rules.

Think of a DeFi protocol as your regular bank offering the same services but in a modern, decentralized manner. Users deposit crypto assets and interact with the smart contracts to access services like trading, lending, borrowing, and asset management. They represent traditional finance revamped for the digital age.

How DeFi Protocols Generate Revenue

DeFi protocols generate revenue through the various services they offer. These mechanisms range from direct charges to indirect sources of revenue but they all contribute in one way or the other to keep the platform operational. They include:

Angel Investment

Angel investments form part of the early funding in a DeFi protocol that gets it operational before mainstream adoption. They provide crucial seed funding to start up the DeFi protocol, allowing it to develop features and attract users. Angel investors can also bring valuable expertise and connections to the table, helping the DeFi protocol navigate the DeFi space with ease.

So, while not a direct revenue stream, angel investments play a supportive role in a DeFi protocol’s startup success and sustainability.

Token Presale

Presales are another common way DeFi protocols generate revenue. Protocols create their own token and offer it at a discounted price during the presale. Users who believe in the project’s potential buy these tokens, injecting funds into the protocol. This is carried out through means such as Initial Coin Offerings (ICOs), Initial Exchange Offerings (IEOs), and Initial DEX Offerings (IDOs).

DeFi protocols can leverage ICOs, IEOs, and IDOs as revenue-generating mechanisms, all functioning similarly but with key distinctions:

• ICO (Initial Coin Offering): This is the most common fundraising method in the crypto space. DeFi projects sell their newly created tokens to the public to raise capital. However, ICOs are mostly unregulated, raising concerns about scams and investor protection.
• IEO (Initial Exchange Offering): This is a more regulated version of an ICO. Here, a reputable crypto exchange vets and lists the DeFi project’s token before the offering. This endorsement by the exchange can increase investor confidence.
• IDO (Initial DEX Offering): Leverages Decentralized Exchanges (DEXs) for token sales. Similar to IEOs, but removes the centralized control of a crypto exchange. IDOs are a relatively new concept and regulations are still developing.

Transaction Fees

Just like traditional financial institutions, DeFi protocols often charge a small fee for every transaction. These fees can be a percentage of the transaction value or a flat rate and are usually paid in stablecoins, or the protocol’s native token.

Examples of transaction fee-based revenue generation:

• Decentralized Exchanges (DEXs): Popular DEXs like Uniswap, PancakeSwap, and SushiSwap charge users a small trading fee on each swap.
• Lending/Borrowing Platforms: Lending protocols charge a fee on the difference between borrowing and lending rates. Compound and Aave are leading examples.
• Derivative Projects: These protocols like dYdX, GMX and Drift also charge handling or trading fees on each transaction.

Flash Loans

Flash loans allow users to borrow large amounts of crypto assets instantly without collateral, but only if it is repaid in a single transaction. Protocols charge a fee for facilitating such loans and this forms a source of revenue to the platform. For example, Aave, a popular lending and borrowing protocol charges a fee of 0.09% on every flash loan transaction. So if a user takes a loan of 100 DAI from the platform, the user is expected to repay the sum of 100.09 DAI, which includes transaction fee.

Asset Management Fees

Certain DeFi protocols function as decentralized platforms for asset management, allowing users to allocate their capital to different investments. Management fees are charged by the protocols on these assets, constituting a source of revenue for them.

Yield Farming

DeFi protocols allow users to earn rewards by depositing crypto assets. These platforms use the deposited assets to generate revenue, typically through fees on trades or loans.

For example, Curve Finance (CRV) is a popular DeFi protocol focused on efficient stablecoin trading. Curve itself doesn’t use deposited CRV tokens for profit. CRV is the governance token of Curve, allowing holders to vote on platform improvements.

Convex Finance is a built-on layer that works with Curve. Liquidity providers can deposit their Curve LP tokens (representing their stake in Curve’s liquidity pools) into Convex. Convex then optimizes these tokens to earn boosted CRV rewards for the liquidity providers. This means users get more CRV tokens compared to staking directly on Curve.

Overall, DeFi protocols uses deposited crypto assets to earn revenue and in turn shares a portion to liquidity providers.

Liquidity Provider (LP) Fees

Liquidity providers deposit crypto assets into liquidity pools on decentralized exchanges in return for a share of the trading fees collected by the platform. It’s similar to the model used by the social media platform, X (formerly Twitter), where verified creators are paid a part of the ad revenue generated by the platform based on how much traffic they can generate within a period. Depending on how much each liquidity provider contributes to the pool, these costs are allocated to them proportionately. After that, the platform takes a portion that goes toward platform development and other needs.

Insurance Premiums

Some DeFi protocols provide coverage against hacks or smart contract failures, thus generating revenue through user-paid premiums.

Partnerships and Collaborations

DeFi protocols can integrate with external services or collaborate with other projects, to earn referral fees, or share revenue generated from those collaborations. For example, in November 2023, GMX was allocated 12 million ARB tokens amounting to about $10 million. The agreed utility of these funds involved about 2 million of the tokens going to users as rewards and grant incentives for developers and protocols that advance Arbitrum’s growth by building on GMX V2.

This partnership resulted in a number of achievements for GMX V2 including an unprecedented surge in its Total Value Locked (TVL) from $80 million to a peak of over $400 million and an accumulation of about $29.72B in volume and $27.10M in fees. This was the highest fee generation across all perpetual DEXs within the partnership campaign period.

Why is it Important For DeFi Protocols to Generate Revenue?

Revenue generation is critical to the success of any DeFi protocol. Like any other full-fledged business model, they require a consistent flow of income to cover the costs of operational support. Here are some reasons it is ultimately important that they constantly generate revenue:

Sustainability and Growth

Revenue covers the costs of running the protocol. This includes development costs, maintenance fees for the blockchain it operates on, and periodic security audits to ensure the protocol is safe from hacks. Without a way to generate revenue, DeFi protocols would not be able to sustain its operations.

Attracting and Rewarding Users

DeFi protocols rely on users’ participation to function. For instance, decentralized lending protocols need borrowers and lenders. In generating revenue, they can create mechanisms to reward users. This can entail sharing a portion of the revenue with users who stake tokens on the platform or offering higher interest rates to lenders. When users are rewarded, they are more likely to use the platform more often, which in turn increases the overall value of the protocol.

Essentially, revenue generation allows DeFi protocols to operate sustainably thus creating a healthy and functional DeFi ecosystem.

How to Check the Revenue Generated by DeFi Protocols

Decentralized Finance operates on the blockchain, which means almost all transactional information—depending on the blockchain used—is verifiable. Blockchain explorers can easily be accessed by everyone, but it doesn’t mean the extent of a protocol’s revenue can always be understood.

Essentially, utilizing blockchain explorers and DeFi research tools such as DeFi Llama, Dune Analytics, Messari, DappRadar, etc., enables users to access metrics and statistics on DeFi protocols’ revenues, facilitating more informed investment decisions.

Exploring Revenue Models of Leading DeFi Protocols

Uniswap

Uniswap is a decentralized exchange that allows users to swap cryptocurrencies on its automated liquidity pools. It generates revenue primarily through transaction fees using Uniswap’s governance token, UNI, which allows holders to participate in protocol governance decisions. Also, it has the 0.05%, 0.30%, and 1% tiers, depending on the level of the pair being traded. A portion of the collected fees are used for buybacks and burning of UNI tokens, potentially increasing their value.

Aave

Aave is a decentralized lending protocol that allows users to deposit and borrow a variety of both crypto and real-world assets. Interest rates are determined by supply and demand within the lending pools. However, Aave charges a 0.00001% fee on the difference between borrowing and lending rates. There is also a 0.09% fee on flash loans to be paid by the borrower. Additionally, Aave has its own governance token, AAVE, which grants holders voting rights on protocol developments.

Compound

Similar to Aave, Compound allows users to lend and borrow crypto assets. It makes use of a unique interest rate model that automatically adjusts based on the liquidity pool. Revenue-wise, Compound charges a fee on the difference between borrowing and lending interest rates. Additionally, the COMP token allows holders to participate in governance and potentially offset a portion of the protocol’s fees.

MakerDAO

MakerDAO facilitates the creation and management of DAI, a decentralized stablecoin pegged to the US dollar. It allows users to lock up crypto assets as collateral to mint DAI. MakerDAO charges a stability fee on DAI which helps to maintain its peg to the dollar. MKR, the governance token, allows holders to vote on protocol improvements and also offset a portion of the stability fees.

Synthetix

Synthetix allows users to trade synthetic assets that mirror the price movements of real-world assets like stocks, commodities, and even fiat currencies. This is achieved through the use of a decentralized oracle network and the protocol’s native token, SNX, which serves as collateral for the creation of synthetic assets. The protocol charges fees on the trading volume of these assets, with a portion distributed to SNX stakers.

PancakeSwap

PancakeSwap is a popular Decentralized Exchange (DEX) built on the Binance Smart Chain (BSC). Like many DEXs, PancakeSwap charges a small fee of about 0.2% on every trade that occurs on its platform. This fee is split between a portion going to liquidity providers and another going back to PancakeSwap.

Additionally, it offers users the ability to lend and borrow cryptocurrencies. Borrowers pay an interest rate, and a portion of this interest is collected by PancakeSwap as revenue. PancakeSwap also has its own token, CAKE which is used for governance and liquidity incentives.

Top DeFi Protocols By Revenue

Total value locked (TVL) has been used as the primary metric for measuring DeFi protocol’s success since 2019 when DeFi Pulse popularised it. But while DeFi pushed through a bear market for most of 2023, it was noted that TVL can alter the actual underlying value of a protocol. Some insisted that DeFi should abandon the metric altogether, claiming it’s less meaningful than it’s said to be.

However, a valid alternative metric is revenue generation—the fees collected by protocols minus the rewards paid to liquidity providers. Thus, the revenue discussed below are based on data obtained from DeFi Llama:

Lido — $79.49 Million

Lido is the largest platform for liquid staking with over $28 billion worth of ETH locked. It is also the biggest DeFi protocol, accounting for about a third of the entire sector. Lido made use of Ethereum’s 2022 proof-of-stake transition by allowing users to stake their Ether (ETH) on the platform in return for tokenized staked Ether (stETH), which rewards staking and can be exchanged or put up as collateral. With a market valuation of more than $20 billion, stETH expanded to rank ninth among all cryptocurrencies. A discussion concerning Lido’s concentrated position on the Ethereum network has arisen since it currently manages more than 32% of all staked Ether.

Uniswap (UNI)

In terms of trade volume and total value locked (TVL), Uniswap is the biggest DEX, holding $5 billion worth of cryptocurrencies in its pools. It houses pairings of two tokens, like USDC/ETH, in pools. Stablecoins are present in many pools, which lowers the danger of transient losses. Funds are deposited into these pools by liquidity providers (LPs), who are compensated by traders’ transaction fees.

The most recent version of Uniswap is now accessible on 11 additional chains, including BNB Chain, Polygon, Avalanche, and Arbitrum.

Note: There is no data on its revenue on DeFi Llama but comes second after Lido in the chart.

PancakeSwap (CAKE) — $70.22 Million

The success of PancakeSwap as a top DeFi protocol on the Binance Smart Chain serves as a perfect example of how crucial scalability and affordability are to the DeFi industry. By replicating the well-proven AMM model and enhancing it with reduced fees and faster transactions, PancakeSwap has become a major participant in the rapidly changing DeFi market and successfully drawn a sizable user base thereby boosting its revenue.

Aave (AAVE) — $51.85 Million

Aave competes with Maker as the largest lending platform by TVL. It currently has over $10 billion worth of crypto as collateral. It generates revenue from interest charged on loans and fees associated with borrowing and depositing assets. V3, the latest version, is available on over 10 different blockchains, including Ethereum, which allows users to lend and borrow multiple tokens.

Maker (MKR) — $165.15 Million

The Maker ecosystem consists of a lending platform, a DAO that manages the network, and a decentralized stablecoin called DAI that is backed by US dollar. Users can deposit crypto assets as collateral to borrow DAI on the Ethereum-based platform.

Since 2022, Maker has progressively acquired US Treasury bonds in order to profit from rising interest rates. On 6th August 2023, the yield on a locked version of its DAI stablecoin hit 8%. Since it tokenizes Treasury bonds, savings DAI token, or sDAI, has been proposed as an example of a real-world asset.

Raydium — $16.65 Million

Raydium is a popular DEX built on the Solana blockchain that offers features like Automated Market Making (AMM) and Initial DEX Offerings (IDOs), earning revenue from fees associated with these activities. Solana’s growth has contributed to solidifying Raydium’s position as a top DeFi protocol by revenue.

Here is a quick summary of the top DeFi Protocols by Revenue:

Source: DefiLlama

Risks and Challenges in DeFi

Even with its numerous benefits and functions, DeFi also comes with certain risks and challenges:

• Vulnerabilities of Smart Contracts: DeFi protocols greatly rely on smart contracts. Bugs or other vulnerabilities in these contracts can be exploited by malicious bodies, leading to significant financial losses for users.
• Volatility of Crypto Assets: The underlying crypto assets used in DeFi protocols are often highly volatile. This volatility can lead to unexpected losses for lenders, borrowers, and yield farmers.
• Lack of Regulation: The decentralized nature of DeFi makes it challenging for regulators to oversee and enforce financial regulations. This lack of regulation can increase the risk of fraud and other forms of manipulation.
• Scalability Issues: Blockchain networks, especially Ethereum, currently face scalability challenges. This can potentially lead to higher gas fees and slower processing times for decentralized applications (dApps).

The Future of DeFi Protocols

Despite the current challenges it faces, DeFi holds some real potential for the future of the finance industry. Here are some promising trends to watch out for:

• Layer 2 Scaling Solutions: The development of layer 2 scaling solutions will address the scalability limitations of existing blockchains, allowing faster and cheaper transactions for dApps.
• Interoperability: Efforts are being made to create bridges between different blockchains, allowing DeFi protocols to interact seamlessly.
• Integration with Traditional Finance: As DeFi matures, we may see more integration with traditional financial institutions. This will involve offering DeFi products and services to a wider audience.
• Regulation and Compliance: Regulatory frameworks are expanding to address DeFi concerns. Clear regulations can improve trust and encourage wider adoption of DeFi protocols.
• More Use Cases: The DeFi landscape is constantly evolving, with new use cases for decentralized finance emerging regularly. This includes areas like decentralized insurance, prediction markets, and fractional ownership of assets.

Conclusion

DeFi protocols represent a transformative force in the financial industry, providing a decentralized alternative to traditional financial services. As highlighted throughout this article, the sustainability and growth of DeFi protocols heavily rely on their ability to generate revenue. Through various revenue streams such as transaction fees, flash loans, asset management fees, and partnerships, DeFi protocols ensure their operational viability while attracting and rewarding users.

As the sector continues to evolve, it’s essential for users to stay informed about revenue generation models and the risks involved, while also recognizing the promising trends shaping the future of DeFi, including scalability solutions, interoperability, regulatory developments, and expanding use cases. With this understanding, stakeholders can navigate the DeFi landscape with confidence, contributing to its continued innovation and adoption.