Where Do Crypto Yields Come From & What Are The Risks?

The term decentralised finance (DeFi) refers to the growing category of blockchain-based financial software and apps that don’t require the involvement of traditional financial intermediaries such as banks. Decentralised trust requires transactions to be validated through public consensus mechanisms in real time.

Regulators around the world have taken interest in DeFi of late as a consequence of the fallout from the collapse of entities such as 3AC, Terra and Celsius.

Why Should You Pay Attention to DeFi?

Prior to the recent bear market, cryptocurrency holders had deposited around $210 billion into DeFi protocols and apps. Venture capitalists (VCs) have invested heavily in this space as they see the potential future. However, there are risks associated with this space.

Risks

In 2021, roughly $12 billion was lost from DeFi protocol exploits, according to research by Elliptic. Scams and code errors have been the primary causes of theft. Year to date, cross-bridge attacks have also been extremely lucrative for attackers.

It’s important to distinguish the level of centralisation in a DeFi project. The risk of not knowing is to blindly accept hidden centralisation which increases hazards such as rug pulls or poor decision-making. As such, it’s critical to be vigilant with your funds and only risk what you can afford to lose. If you can’t sleep soundly at night, then you need to reduce your allocation.

Read: Managing Risk in Crypto

What Is Yield, APR and APY?

Yield is the earnings that are generated from your initial investment. Annual percentage rate (APR) refers to the interest cost per year that borrowers pay, and annual percentage yield (APY) refers to the income that’s generated for lenders on a yearly basis. Despite the technical differences between these terms, they are often used interchangeably.

These percentages can be useful when you’re assessing the level of risk to reward. For instance, a 10% yield on a top DeFi protocol may be an attractive risk to reward, but a 100% yield on a new and untested protocol may be too high of a risk.

Where Do Crypto Yields Come From?

At the core of DeFi, users can exchange, borrow and lend crypto-assets using smart contracts. There are 4 main ways that produce yield:

1. Carry trade: Traditionally, this strategy requires the borrowing of funds at a low interest rate and investing it in an asset that provides a higher rate of return. For crypto, this occurs when there’s a price premium on the futures (contango) and sophisticated investors can short futures and long spot to lock in the premium.
2. Demand for leverage: Margin loans have been increasingly popular with traders, especially during bull markets. Borrowers pay an APR for the loan in hopes of using leverage to fast-track their returns. (A very risky practice in any asset class, let alone one as volatile as crypto.)
3. Protocol rewards: Users are incentivised to use the DeFi protocol by being rewarded with tokens. In some ways, owning a protocol’s token is similar to owning company shares.
4. Transaction or exchange fee: This is the fee that’s generated from crypto-asset exchange platforms.

Example of Where Users Generate Yield

For simplicity, let’s use USD stablecoin as the mechanism for earning yield.

• Users can provide USD liquidity to automated market makers (AMMs) such as Uniswap. In turn, they are rewarded with yield that’s generated from trading activity.
• Users can utilise DeFi platforms such as Aave to lend their USD. This may also include additional yield from receiving the platform’s token.
• Users can lend USD to institutional borrowers through centralised lenders such as Nexo.
• Users can lend USD to centralised exchanges such as Binance.
• Users can lend USD to investment firms that trade on their behalf.

The same concept applies when you substitute the USD stablecoin with another token such as ether (ETH).

Demand for Leverage

Since leverage can amplify a trader’s performance, it often attracts inexperienced traders who want to get rich quick. During bull markets, many new traders think are geniuses, and willl lever up their positions. This is one reason why there can be sharp drawdowns in bull markets and massive bounces in bear markets.

Traders must close or cover their positions to avoid liquidation. In contrast, some investors prefer generating yield by lending to leveraged traders.

Native Token & Subsidies in DeFi

Native token simply refers to a given protocol’s token. For example, UNI is the native token of Uniswap.

As a mechanism for attracting users, DeFi platforms have provided additional native token yield to incentivise adoption. There is intrinsic value to the token and during a protocol’s growth phase, this value-add can be substantial.

If we observe tokens through the lens of traditional company stocks such as the Bank of America, every time customers deposit into their accounts, the bank generates yield from lending those funds while simultaneously subsidising depositors with some bank stocks.

As the bank grows, the stock price grows so the users’ portfolio increases substantially more than simply earning traditional yield. Whilst this can help drive short-term user growth, it’s unsustainable in the long term.

Protocol Activity

Naturally, DeFi will have winners and losers. After all, creative destruction occurs in all industries. Investors should analyse and monitor activity on the protocols they’re interested in. Total value locked (TVL) is one of many measurements that anyone can utilise on DefiLlama and DeFi Pulse to assess protocol demand levels.

The top-ranking projects are the safer options both in terms of token investment and yield generation as they are more likely to be battle-tested.

Real Yield

The recent focus on real yield has stemmed from factors such as the collapse of centralised finance (CeFi) and the survival of DeFi during the liquidation events. Whilst the concept isn’t new, it does highlight a more sustainable path for DeFi.

In contrast to Terra, who raised cash to bankroll the 20% yields, crypto investors are now seeking a share of revenue from lending and exchange fees. This is more sustainable because the revenues are generated before redistribution. The protocols that can attract users are those that generate the most yield. This reduces the Ponzi-like tokenomics and it redirects the focus towards the value being created in the DeFi ecosystem.

Conclusion

There’s no right or wrong way of participating in DeFi. Some investors simply buy and hold the token of their preferred protocol. Others are willing to take on a little more risk by yield farming. For the true degens, there are a lot more high-risk ways to participate in DeFi.

While DeFi has enormous potential to disrupt traditional finance, it will take time and there will be immense volatility. Whilst traditional investors sometimes argue that diversification is for those who don’t understand what they’re doing, it’s not always an accurate take. During the tech boom, some companies became leaders in their fields. However, post-tech bubble, different tech companies emerged as global giants.

For this reason, it can be argued that for new industries, it’s better to treat investments similar to that of VCs. They invest a small amount of their portfolio into a large number of projects hoping that one or more will become the next unicorn. That said, research is still paramount.

For those wanting to go deeper, see Blockworks seminar on ‘Know Your Yield’.