DeFi Yields 101. DeFi yields are tightly correlated with… | by Marc Arjoon | Sep, 2022


DeFi yields are tightly correlated with on-chain activity and differ by blockchain, protocol and asset type. However, not all yields are alike, as some are associated with increased risk.

  • The average yield across the Decentralised Finance (DeFi) ecosystem was c.4.5%.
  • Yields primarily come from providing liquidity to Decentralised Exchanges (DEXs) and Lending/Borrowing protocols.
  • Yields tend to be a combination of token issuance and a portion of protocol revenue.

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Introduction

In this report, we explore the yields generated by different DeFi. We examine the types and sources of yield in greater detail and look at a group of select protocols for yield income within the DeFi ecosystem.

DeFi can be described as a suite of financial services (lending, borrowing, insurance, trading, derivatives, etc.) that are open to anyone with an internet connection. These services are available without the need for intermediaries like banks or other institutions and therefore have lower transaction times and lower take rates. Eliminating expensive middlemen opens the potential for better yields on both the supply and demand side.

Protocol usage, liquidity, and leverage all increase with crypto-crypto prices due to greater swap fees collected by liquidity providers, rising deposit rates on loan markets, and rising value of token-denominated incentives. This increased utilisation results in the higher yields typically seen within DeFi. These mechanisms incentivise more money to enter DeFi because of the rising rates, but the opposite is also true when prices start to fall. Falling prices lead to falling on-chain activity, decreased liquidity and hence severe yield compression.

DeFi Yields

Similar to traditional finance (TradFi), there are a variety of practices that offer investors some form of yield. Within this report, we will break down the yields by sector, chain, protocol, asset type and risk. Finally, we will construct a model DeFi yielding portfolio that may be used as a benchmark for future constructions. Before diving into the mechanics, below we show the average yields for stablecryptos and other tokens on the leading smart contract platforms.

Polygon and Ethereum offer some of the lowest stablecrypto yields while Binance and Solana offer some of the highest stablecrypto yields. Ethereum and Binance have the highest yields for non-stablecryptos while Polygon once again ranks lowest in this category. In the long term, we expect the yields across the leading ecosystems to head towards parity.

Yield Farming

Yield Farming is a term within DeFi used to describe the actions of earning a yield using DeFi tokens. Yield farming tends to be compared to bond yields, dividend yields or savings accounts. However, the attractiveness of DeFi yields exists because token holders take on elevated levels of risk and these rates can be quite variable in nature.

DeFi yields are also highly reflexive, this is due to the correlation between price action and on-chain activity. The source of these yields can vary by token, protocol and chain, each of which can further vary in yield and riskiness.

Sources of Yield

Within DeFi, there are broadly two sources of yield: i) token issuance and ii) revenues.

i) Token Issuance

A popular technique used by DeFi protocols is to reward contributors with their governance tokens. Protocols can have a limited or unlimited supply of tokens to reward participants with depending on how the smart contract was coded.

ii) Portion of Revenue

When DeFi users interact with protocol, typically two fees are incurred, the gas fee from the underlying blockchain and the protocol fee/ take rate. The protocol may elect to reward a fraction of its fees to token holders and contributors.

It should be noted that yield from a protocol can be derived from both sources (token issuance and protocol fees) and in fact, this is quite common.

Types of Yield

Now that it’s clear where the yields come from, we now discuss the types of yield within DeFi, Liquidity Mining and Staking.

i) Liquidity Mining

Participants seeking yield can provide liquidity to a variety of protocols and receive payments from those who utilise their liquidity. The different types of DeFi sectors where liquidity is needed comprise Lending/Borrowing, Decentralised Exchanges (DEXs), Bridges and Asset Management. While there are other sectors, at the end of Q2 2022, these four represented 70% of all Toal Value Locked (TVL). Below we show the largest sectors by TVL — all of which offer yields for the provision of liquidity.

Yields on Lending protocols are dependent on borrowing activity and open lenders up to credit and default risks. Yields from DEXs and Bridges are dependent on trading volume and expose liquidity providers to impermanent loss risk. Asset management protocol yields depend on the strategy deployed while exposing users to the risk of loss of capital.

Stablecrypto vs Non-stablecrypto Yields

Among these sectors, the assets being utilised can be further grouped into two types — stablecryptos and non-stablecryptos. Stablecryptos are a type of crypto-cryptocurrency that’s pegged to a non-volatile asset (such as the US dollar). These stablecryptos address the issues of inherent volatility risks within the crypto-crypto space and help to facilitate more predictable transactions. The vast majority of stablecryptos (c.80%) are issued by Circle (USDC) and Tether (USDT). These cryptos are mostly backed by US cash & cash equivalents, other short-term deposits and commercial paper held in bank accounts to help maintain trust in the peg1.

Below we show the spread between stablecrypto and non-stablecrypto yields across all legitimate chains and protocols in DeFi, weighted by TVL.

It’s no surprise to see that yields on non-stablecryptos are higher as protocols can create other tokens more easily than stablecryptos.

ii) Staking

The other source of DeFi yields comes from staking, a catch-all term for a wide variety of on-chain actions. Participants seeking yield can choose to “stake” a token with a protocol in return for token rewards. The term “staking” is also used for Proof of Stake blockchains as a means of securing the network, but this is not the case for DeFi staking. In fact, there is no one description for staking as the mechanics and risks differ among protocols. We highlight the most popular forms of staking below.

We highlight a non-exhaustive selection of protocols that reward users based on the type.

Conclusion

DeFi yields come in different shapes and sizes, some have more risks than others, while the sources of the yields vary widely. It is important to understand the underlying yield mechanics of a protocol before assuming the risks associated with it. Most tokens do not directly provide yield, but this trend seems to be changing. As this form of value accrual becomes more popular, it remains to be seen what the regulatory risks will be.

Click here for the full report.



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