Decentralized Finance (DeFi) utilizes financial applications without a centralized entity. DeFi is not one single application. Rather, it can be considered an entire ecosystem of decentralized applications (DApps) built on various blockchains such as Ethereum, Polkadot, Elrond, etc. These DApps collectively work together in a composable manner and try to replicate the global financial system. Although there is still a long way to go and issues to overcome before we see this, there exist plenty of applications that are providing use cases like payments, lending and borrowing, and insurance, etc. For example, one can keep USDT (a stablecoin pegged to the US dollar) in a DeFi lending and borrowing protocol, Aave, and earn a high annual percentage yield (APY) compared to holding USD in a local bank. In this article, we talk about how decentralized protocols can offer such high yields and what are different ways to gain these APY.
Demystifying DeFi Yields
‘Yield’ or simply put ‘return on capital’ is the bread and butter of DeFi, compelling regular people to get into the ecosystem. Subsequently, ‘Yield Farming’ has cemented its position as the introductory pillar to Decentralized Finance.
The concept of yields and DeFi have transformed the mainstream digital assets industry at large. Until the last cycle (pre-DeFi), crypto-users would hold crypto assets for the sole purpose of price appreciation. Today, people put their assets into DeFi protocols and generate passive returns. As simple as it sounds, these simple mechanisms have lifted digital assets to a whole new level.
With little risk exposure, users can generate double-digit returns on their stablecoins by lending it on DeFi Protocols like Compound or Aave. Also, if you are ready to vary the proportions of risk and opportunity, even 100%-200% APY is not unheard of.
In the current economic regime where banks’ savings rates are <0.5% on US$, people often question the viability of generating such high yields. Are there hidden risks? Are protocols just printing money? Is this…a scam?
Let’s try to make sense of these yields and find the ultimate source of these returns on capital.
DeFi yields come from five major sources:
- Providing Liquidity
- Native Tokens (Liquidity Mining)
- Protocol Activity
- Demand for borrowing
- Leveraged positions
- Flash loans
- Proof of Stake (PoS) rewards
- Providing Liquidity:
One of the most remarkable things about DeFi is the power of liquidity. In traditional markets, only designated professionals or Institutional players can provide liquidity in the form of market-making, selling bonds, capital for insurance covers, or any other financial product. DeFi makes it possible for everyone, including retail investors, to do this in a permissionless and frictionless way.
The simplest way to earn yield in DeFi is to provide liquidity to your favorite protocols. These protocols put your assets to use and pay you back in transaction fees collected from users. For instance, Liquidity Providers in Uniswap (a decentralized exchange) create liquidity pools that enable the exchange of assets.
Downside: Liquidity Providers (LPs) take risks to be eligible for the rewards. These risks can be impermanent loss – in the case of Automated market makers (AMMs), a successful claim – in the case of insurance protocols, and so on. When you are an LP on an AMM like Uniswap, not only are you taking a bet on each asset’s price, you are also taking a bet on their relative pricing.
- Native Tokens (Liquidity Mining)
Liquidity and users are essentially a chicken and egg problem for a DeFi protocol. High liquidity attracts users → more users generate higher fees for LPs → higher fees attract more liquidity → fancy growth numbers
To bootstrap liquidity and users in the early phases of the project, protocols reward early adopters with their native tokens.
Magic money? Not really. Liquidity Mining is DeFi’s version of growth hacking. Learn more about Liquidity Mining here. As an analogy, imagine if instead of raising billions of VC money to give away free rides to bootstrap user growth, Uber could reward its drivers and riders with liquid shares of Uber directly?!
Downside: Yields are majorly dependent on the market price of native tokens which can be volatile in the early life stages of a project. Many times, these yields are unsustainable and dry out before gaining the desired traction.
- Protocol Activity
Protocols collect fees from their users and reward their native token holders with timely claimable rewards. Many times, token holders have to stake their tokens to be eligible for these rewards.
For example, Sushi rewards 16% of trading fees to xSUSHI (SUSHI staked) holders.
These yields are analogous to dividend yield in traditional companies.
Downside: Usually, yields are lower when staking native tokens, hence not an attractive option.
- Natural demand for borrowing
Lending stablecoins is similar to investing in high yield CDs, savings accounts, T-bonds, etc but instead of being controlled by centralized agencies like central banks, government institutions, etc., it is in the hands of the free market (Investors, validators, etc.) and kept in check by immutable smart contracts.
Natural demand for borrowing is the source of yield when all other yields run dry. These yields attract the most capital as it’s relatively a safer way to generate yield (barring smart contract risks).
But ser, who is borrowing at these rates?
The biggest reason: Leverage trading in the Bull Market.
In euphoric times, people expect the prices of their favorite tokens to rise manifold; hence they are not afraid of leverage. Moreover, borrowers use this leverage to also bet on other tokens.
Example of leveraged strategy:
Step1: Set Token balance = 100 ETH (assume 1ETH = 2000 USD)
Step2: Deposit 100 ETH collateral borrow 160,000 USD
Step3: Swap 160,000 USD with 80 ETH
Step4: Deposit 80 ETH as collateral to borrow 128,000 USD (same as step2)
Step5: Swap 128,000 USD with 64 ETH (same as step3)
Repeat the above steps in any order with multiple tokens as long as it’s feasible
At the end of it, at a Loan to Value Ratio (LTV) of 80%, we can effectively take 5X leverage worth our initial capital in any of the tokens we want.
Stablecoins DeFi Composite Rate Index in the above image refers to the average borrowing interest rate for stablecoins in 2021 (Source: Skew)
Although leverage is the biggest motivators for borrowers, there are other ways also which are independent of the bull market:
Flash loans are primitive DeFi loans where borrowers can take out loans without collateral as long as they can pay back in the same transaction. Learn more about flash loans here.
Flash loans account for US$ 4B out of the US$ 13B borrowed out of Aave in the first 5 months of 2021
Traders can bet against the price of an asset by shorting it. Typically to short an asset, you borrow to sell it, and later buy it back at a lower price to return it to your lender.
Traders take short positions in lending/borrowing platforms by following the below steps (Example to show how one can short ETH) –
Step1: Deposit 3750 USDC (stable coin pegged to US$) and borrow 1ETH (At 75% LTV)
Step2: Sell ETH for 3000 USDC (Assuming this to be the price at the time of borrowing)
Step3: Wait for ETH to drop in price, earn yields on USDC meanwhile (Lend it in Aave, Compound or deposit on Yearn)
Step4: In a scenario where ETH drops to 1500 USDC in a month, buyback ETH from the market, and pay back the loan. Depending on the interest rate and duration of the position, shorter can earn up to 1500 USDC
Curve – Generates yield from all four buckets
Curve.fi is a decentralized exchange that allows users to swap between similarly priced assets with minimum slippage (Think USDC-DAI swap). The native token for Curve is CRV.
Why is it worth a mention? If you’re a power Curve user you’d know why. A Curve user can earn all categories of these rewards under one umbrella. How? Let’s walk through it.
Provide liquidity to yPool → Earn from LP tx fees (1) + Auto invest in the highest lending interest from Compound, Aave, dYdX (4) → Claim Liquidity Mining CRV rewards (2) → Stake CRV and claim fees off protocol activity (3)
Curve provides an on-chain liquidity pool where users deposit tokens to become liquidity providers. Once you deposit tokens in a Curve liquidity pool, you start to earn trading fees (1). Users get multiple LP pools to choose from and we select yPool. Assets in yPool are automatically lent to the protocol(s) with the better stablecoin rates (Compound, Aave, and dYdX). (4)
Additionally, all Liquidity Providers can earn Curve’s governance token, CRV. (2)
The CRV earned can be staked in a vote-escrowed time-locked contract to give us veCRV i.e. CRV tokens that are locked for voting and are earning fees. (3)
Note: With multiple sources of yield, you’re exposing yourselves to multiple risks, namely- impermanent loss due to loss of stablecoin peg, smart contract failures, and volatile token prices.
- Proof of Stake (PoS) rewards
For most of its journey so far, DeFi has existed on energy-costly Proof Of Work (POW) blockchains. Ethereum’s transition from PoW to the much anticipated PoS chain and the gradual expansion of DeFi protocols to PoS chains like Terra, Elrond, and Solana have given birth to a new class of DeFi yields. PoS allows users to stake their tokens and delegate to block producing nodes called validators. Staking provides additional security to PoS and in return, stakers are rewarded with tokens from the transaction fees and/or from inflation.
PoS yields are becoming increasingly popular as investors bet on the future of PoS blockchains. Lido, Stafi, and Anchor Protocol are some projects that generate yields from PoS. Many projects also mint liquid staking derivatives that can further generate yield through the above sources.
Downside: Staking rewards do not come without risks. Lazy or dishonest validators can have a portion of their staked funds slashed. Users should do due diligence and have confidence in the validator’s architecture not to get slashed and lose money in the process.
PoS rewards give users an average of 14.95% APY as of the time of writing this article.
Note from the author: Know the risks involved when looking for yields – watch out for impermanent loss, deposit fees, withdrawal fees, vested token distribution, and the risk of your principal being taken away due to protocol mechanics. Avoid protocols that do not acknowledge these risks.
Author – Kratik Lodha
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