A History Lesson In How Yield Works in Finance
In finance, the great majority of end-users and investors don’t actually consider where the yield on their capital comes from – DeFi is no different. With the recent cryptocurrency market downturn, Total Value Locked (TVL) is down, yields are evaporating, and a myriad of risks seem to be spreading, such as stablecoins de-pegging from their 1:1 peg. This begs the question – does legitimate yield even exist? If so, how does one evaluate the risk of placing capital in a yield-bearing product? There are basics worth covering on how to conceptualize the yield opportunities that are marketed to consumers across the financial world and they all apply regardless of CeFi, DeFi or TradFi.
What are interest rates?
An interest rate is a percentage (%) of the principal amount charged by a lender to borrow money over a period of time. Typically, interest rates are denoted annually which is known as the Annual Percentage Rate (APR). In DeFi, protocol success is largely driven by liquidity. Protocols increase their liquidity by incentivizing usage with attractive interest rates for users. Basically, users are paid to put their money to use on the protocol. The smart contract receives the principal investment and the user receives interest in return. Interest rates are important to consider as they underpin the yield on all borrowing and lending activities.
What is yield?
The yield on an investment is the earnings received measured as a percentage (%) figure against the principal amount. In traditional finance, yield is typically calculated annually, with quarterly and monthly computations used less frequently.
Traditional Finance (TradFi) offers a range of yield-bearing products from fixed-income debt securities like bonds, and equity securities like stocks and mutual funds. In TradFi, investors often contribute capital into real estate for the stable yield it provides because few other asset classes bear the same capability to generate income and withstand an economic downturn. There are also higher-risk investment opportunities with the promise of greater yield, like options and futures. Nearly all investors seek more efficient capital, thus the eternal quest for higher yield.
In DeFi, yields reside on a wide spectrum relative to a user’s risk tolerance and are sought in a slightly different manner. Sub-1% APYs offered by banks pale in comparison to the high-digit APYs offered in DeFi for simple actions like depositing assets in a liquidity pool, thus compelling more investors to move their fiat into DeFi. DeFi protocols are also often referred to as “money legos” because users can leverage composability to access liquidity across multiple protocols and earn yield on their assets by taking several actions in succession, essentially stacking protocols together as you would a lego set. Due to the permissionless and composable nature of DeFi, users can get creative to achieve high-digit APRs. For example, a user could deposit SOL on Protocol X and borrow USDC against their deposited SOL, which they can use to open a new position on Protocol Y, and then use that to get a new loan on Protocol Z, and so on. This expands the opportunity for a user to generate yield on their assets by building positions across protocols.
Sustainable vs Unsustainable yield
The proliferation of “yield farming” since “DeFi Summer” of 2020 ignited the trend of protocols offering token rewards via liquidity mining programs and high-digit APRs to attract users and incentivize protocol usage. Unfortunately, the token emissions and high percentage APRs that protocols use to bootstrap liquidity frequently attract “mercenary” yield farmers who remain present only as long as the rewards and high APRs persist and leave once it ends, taking their liquidity with them.
Strategic emissions of tokens as liquidity mining rewards could benefit protocols, but adopting a frequent emissions schedule exposes the protocol and its users to several risks that are worth considering, including;
- Inflation risk: Emissions-based yields depend on inflating token supply to meet demand which introduces market volatility as sell pressure increases.
- Inventory risk: Since liquidity mining rewards are mainly paid out in native protocol tokens, users have significant price exposure to the assets they are farming with and the volatility that these assets are subjected to.
- Liquidity risk: Price volatility impacts liquidity for legitimate users of a protocol. When there is liquidity risk, users have no guarantee that the protocol will be able to meet any redemptions or withdrawals.
- Impermanent loss risk: Liquidity provisioning in liquidity pools can be profitable but the risk of impermanent loss arises as users are exposed to the risk of the assets in the pool. When prices change drastically between the time of deposit and withdrawal, users realize the loss.
“If you cannot explain where your yield is coming from, you’re probably the yield”
The golden rule of DeFi is that if the primary source of yield is token emissions, users are the real yield. Liquidity mining programs that drive inflation-based yields are only sustainable in market conditions where buying pressure offsets selling pressure to stabilize token prices and quickly plummets as market conditions weaken. It is also important to note that interest rates in DeFi fluctuate causing yields to change frequently. The dazzling APR of today, usually a compounding of unspectacular interest rates, does not guarantee profits on investments tomorrow.
DeFi yield is also generated from the following key avenues:
- Demand for borrowing: The natural demand for borrowing persists across all financial markets. Institutions may need to borrow in order to purchase capital goods and fund activities, and individuals may need to borrow non-speculative assets like stablecoins to pay for goods and services. Due to this demand, markets for borrowing and lending are formed. In this case, lenders receive yield for supplying their assets and borrowers pay interest to the lenders. Leverage is also a key stimulator of borrowing demand as investors may need to borrow to take directional bets on speculative assets without selling their holdings.
- Protocol revenue: The fees generated from network activity are one of the main sources of yield for DeFi protocols. Protocol revenue can be generated from the spread between borrowers and lenders and redistributed to users.
Generally, we can conclude that DeFi yield comes from:
- Fees, interest, and premiums paid by demand-side and supply-side users of DeFi platforms
- Token inflation/emission
Sustainable yield implies potential lesser degree risk, which simply does not exist in DeFi as participating in the cryptocurrency market is inherently risky. However, investors can be more cautious and identify too-good-to-be-true yield opportunities to avoid risk exposure beyond their tolerance.
The value of transparency in DeFi and CeFi
Transparency must be upheld as a core value of the platforms that users trust to custody their funds or provide them financial services. Platforms can stay accountable by equipping their user base with the knowledge to weigh the protocol mechanics and capital management strategies against their personal investment goals, capital base, technical knowledge, and risk appetite to make the best decisions and dynamically adjust their allocations. We can examine the value of transparency in modern financial systems through the lens of two events responsible for some of the largest movements in the current cryptocurrency market downturn.
The now-failed algorithmic stablecoin, UST, was able to earn users double-digit APR on Anchor Protocol, a DeFi lending protocol, by relying on the value of its counterweight asset, LUNA. In short, the details of the Terra-Luna mechanics were clearly disclosed in the whitepaper and further made transparent through its on-chain systems. Many analysts and experts had long deduced the risks of the UST-LUNA tokenomics and the unsustainable nature of the Anchor Protocol yield and warned investors about imminent collapse even in exuberant conditions until the eventual death spiral. Centralized Finance (CeFi) platforms like Celsius now facing large liquidation events were previously offering yields with no disclosure on how these yields were composed. In the face of potential insolvency, Celsius paused all withdrawals, swaps, and transfers between accounts. Both of these events, unfortunately, led to large financial losses for investors.
However, the distinct difference between the two worth acknowledging is that centralized lenders were reliant on human discretion that was exercised poorly by taking high-levered bets and deploying capital into compromised systems without adequate risk management eventually causing mass collapse. On the other hand, their decentralized counterparts had transparency and action accountability built in by default through blockchain-based systems that allow users to review data on a real-time basis and impartial smart contracts that automatically liquidate positions to keep the protocol sufficiently collateralized.
The repercussions of the large-scale deleveraging events and platform insolvencies in recent months will be felt for some time but they provide a unique learning opportunity for investors and builders alike. For one, investors can take some of the hard lessons instilled by the market downturn to exercise discretion in future yield-seeking activities with better awareness of the hallmarks of misleading yields reliant on obscure “ponzinomics”. Investors can also better navigate financial services and deploy their capital into yield-bearing products in good faith if clear disclosures and consistent communication about what happens with investor funds becomes an industry-wide standard.
Disclaimer: Views expressed in this article are purely personal opinions and should not form the basis of investment decisions.