One of the most notable features of decentralized finance (DeFi) is the popularity of the concept of “yield.” To attract users, new protocols advertise ridiculously high numbers every day: these tokens have an APR of 97%, these tokens have an APY of 69,420%, and so on. Of course, this feature of DeFi is also what makes newcomers skeptical. How can a new protocol on a blockchain you’ve never heard of earn 1 billion% when the interest rate on a typical savings account is 0.5%?

In this article, we will demystify the concept of DeFi yield. We will list the most common mechanisms by which DeFi protocols provide yield to their customers. In particular, we will make the following arguments:

DeFi yields come from the value of the underlying DeFi protocol , so locking up your funds using a yield-generating DeFi protocol is a bet that the protocol itself has intrinsic value.

Definition of “output”

For the purposes of this article, we define yield as the rate at which a financial position is expected to generate value . This is roughly consistent with the TradFi (traditional finance) definition of a bond's "yield to maturity" (YTM), which is the interest rate a bond will earn at par at its current price. Broadly speaking, if you hold 1.0 units of value and deposit it in an agreement that yields 10%, then after one year you should expect to have 1.1 units of value.

face value

Notice how I used the word “ value ” above. How do you define “ value ”? The truth is, it’s up to you: understanding the denomination of value is key to understanding DeFi benefits .

For example, let’s say a DeFi protocol offers a 1,000% yield for staking its native asset token. The token is currently trading at $2 per coin. You take $100, buy 50 tokens, and stake the entire amount, expecting to receive 50 * 1,000% = 500 tokens at the end of the year.

A year goes by, and you did receive a return on your 500 tokens: you’ve made a 1,000% gain! But now, those tokens are worth just 1 cent each, which means your 500 tokens are worth $5 in total, and in USD terms, you’ve suffered a 95% loss. On the other hand, if the price per token was $20, you now have $10,000 in leverage, a 10,000% gain in USD terms.

The point is: whether you think a 1,000% gain on these tokens is better than a 95% loss in USD value is up to you, and it depends on whether you think the intrinsic value of these tokens is higher than the USD. (In this case, it probably isn’t.)

This example serves to illustrate that to understand the yield of the protocol, you must understand the assets that pay the yields, and potential fluctuations in the value of the yield-paying assets are risks that need to be considered.

Calculate yield

Even with the correct denomination of value, there can be significant differences in how the yield is calculated. Here are some common areas you should look out for when you see an extremely high yield.

APR vs. APY: The Annual Percentage Rate is the amount of added value you accrue each year. The Annual Yield is the amount of added value you accrue each year assuming compounding (i.e., dividends are reinvested). Depending on the specific agreement, assuming compounding may or may not make sense; use a number that is more appropriate for the agreement.

Lookback period: The APY data you see on a DeFi protocol can be based on data from a period in the past: it could be the past day, the past week, the past year, or anything else. Given the variability of market volatility, protocol performance, etc., the expected APY can change dramatically. Therefore, the expected APY may be similar to the actual APY, or it may be different from the actual APY, depending on past and future market conditions. Mitigate this risk by understanding the time frame over which the protocol APY data is calculated.

Explain APR: APR stands for Annual Percentage Rate, which is the actual annual rate of return without considering the effect of compound interest.

Explain APY: APY stands for Annual Percentage Yield, which is the actual annual rate of return that takes into account the effect of compound interest.

Revenue Mechanism

DEX/AMM

Decentralized exchanges (DEX) and automated market makers (AMMs) are classic examples of yield-generating protocols. They are a groundbreaking achievement in financial engineering and have been dubbed the “zero-to-one innovation of DeFi.”

Here’s how they work: Liquidity providers (LPs) deposit pairs of tokens into liquidity pools. The purpose of these pools is to allow traders to exchange one token for another without an intermediary; the exchange rate is determined algorithmically based on formulas such as constant products. In return for depositing these tokens, LPs receive a portion of the fees charged to traders, proportional to the pool liquidity they provide, and are usually charged in the nominal value of the pool token.

For example, in the past 24 hours, the TraderJoe USDC-AVAX pool received $156,000 in trading fees paid to LPs. Given that the total value of the pool is $166 million, this corresponds to an annual interest rate for liquidity providers of $156,000 * 365 / $166 million = 34.2%.

A similar setup in traditional finance (TradFi) would be a centralized order book that tracks the highest bid and lowest ask price for an asset on the market. The biggest difference is that in a TradFi setup, it is the exchanges and brokers that collect the transaction fees, while in DeFi, it is the LPs that collect the same fees. In DeFi, anyone can participate in any aspect of market making, which is a beautiful fact.

LPs are not without risk: if the relative value of tokens changes significantly, LPs may suffer impermanent loss. As with any DeFi protocol, smart contracts are also subject to the risk of hacking and exploitation.

But fundamentally, the source of income for DEX and AMM LPs is clear: they come from trading fees. Traders are willing to pay these fees because DEX and AMM are providing valuable services: liquidity pools and automatic algorithms for exchanging assets. The more popular the trading pair, the greater the trading volume, the higher the fees, and the higher the income of the LP. In other words, the income comes from the value of the underlying protocol.

Lending Pool

Lending pools are similar to DEX/AMM in that they are designed to provide liquidity. The difference is that liquidity is provided in the form of debt rather than sales.

Let's take AAVE as an example. Users can deposit their funds into a lending pool and expect to receive a variable or fixed interest rate from it. On the other hand, borrowers can deposit an asset as collateral and take out a loan from any other asset at a certain percentage (collateral ratio) of the collateral. As long as the value of the collateral relative to the loan does not fall below a certain threshold, the loan remains "healthy" and the borrower has unlimited time to repay the loan, including interest. However, when the value of the collateral falls below the threshold, it is liquidated (i.e. sold) and the debt is cancelled.

For example, a borrower might want to take out a loan in USDC to pay for their groceries. To do this, they deposit ETH, and two things can cause their ETH to be liquidated and close their loan: 1 ) if the price of ETH drops enough, or 2 ) if the loan has accrued enough interest. As long as neither of these events occurs, the loan remains open. Once the loan is repaid, the borrower gets their ETH back.

Again likening this to the TradFi setup: In the centralized world, it’s banks and other institutions (like Fannie Mae and Freddie Mac) that collect the interest rate, passing on often very low rates to depositors. In DeFi, lenders themselves capture this value, and the interest rate is algorithmically set by open source code.

Obviously, this type of service has intrinsic value: the ability to automatically cover, originate, liquidate, and close loans without the need for financial intermediaries is valuable in itself: it removes the possibility of human error, improves capital efficiency, etc. If you lend assets for this, you will be compensated for contributing value to the protocol . After all, if lending assets didn't generate income, you wouldn't lend them, right?

Staking

Many protocols use the term “staking” to refer to any asset locked, but this is incorrect. Staking in its true sense is about risking loss of value in exchange for potential value.

In my opinion, the best example of staking generating income is the Proof of Stake mechanism, which is used by blockchains such as Cardano, Solana, and eventually Ethereum. These algorithms can be esoteric, such as Ouroboros and Last Message Driven Greediest Heaviest Observed SubTree, but the intuition behind them is simple.

Proof of Stake is about ensuring that transactions on the blockchain have integrity — no double spending, false accounting, etc. To ensure the integrity of a series of transactions, validator nodes check that each transaction is valid according to the rules of the blockchain.

How can we trust that validators will work honestly? This is where Proof-of-Stake comes in. At a high level, it works like this:

1. The user pledges part of his assets to the validator.

a. Once staked, there is usually a minimum lock-up period, ranging from a few weeks to a few months. Eventually, users can redeem their assets.

2. For every honest work that validators do (such as calculating transaction integrity, voting on the correct block, etc.), they will be rewarded.

b. Rewards will be paid to stakers, which is the yield.

3. For every dishonest work done by the validator (such as breaking the rules, cheating, going offline, etc.), they will be slashed (i.e. a portion of the funds are taken away).

c. The penalty is taken in proportion to the stakes.

4. Validators verify and vote on each other’s work to decide honesty/dishonesty.

The security of a Proof-of-Stake network comes from the fact that the amount of money required to control enough validators to render the entire network dishonest is intractable.

As the de facto successor to proof of work, proof of stake is a landmark achievement in the field of distributed consensus. By locking your assets with validators, you earn returns by contributing to the security of the underlying network , which is inherently valuable, and you are at risk of losing if the validator is dishonest or compromised.

Good income generator

If you don’t want to think too much about how to generate yield, then optimizers might be for you. These are brainteaser mechanisms that take your assets, perform a bunch of DeFi operations behind the scenes, and ultimately return more assets to you. The best analogy for this type of operation might be a mutual fund or a hedge fund: you don’t actually invest, you outsource it to an algorithm.

Yearn Finance’s vaults are probably the most famous example of this. They accept a ton of different assets and employ a variety of strategies to earn a yield on your assets. For example, the LINK vault has the following description:

CREAM Lender Optimizer

Provide LINK to CREAM to generate income.

Vesper Finance Reinvestment

Provide LINK to Vesper Finance to earn VSP. Earned tokens are harvested, sold for more LINK, which are deposited back into the strategy.

loan

Provide LINK to AAVE to generate interest and receive staked AAVE tokens. Once unlocked, the earned tokens are harvested and sold for more LINK, which are deposited back into the strategy. The strategy also borrows tokens against LINK. The borrowed tokens are then deposited into the corresponding yVault to generate yield.

MakerDAO Representative

Stake LINK and mint DAI in the MakerDAO vault, then deposit this newly minted DAI into the DAI yVault to generate yield.

League DAO Reinvestment

Provide LINK to League Dao to earn LEAG. Earned tokens are harvested, sold for more LINK, which are deposited back into the strategy.

Another great example of a yield optimizer is Gro Protocol. [Full disclosure: I am a member of G-Force, the decentralized marketing arm of Gro Protocol, and am not awarded GRO.] Gro is a risk-tranched stablecoin yield optimizer, so it accepts assets like USDC, USDT, and DAI. It deposits these downstream into many different protocols to generate trading fees (i.e. from DEXes), lending income (i.e. from lending pools), and protocol incentives (i.e. governance tokens), and liquidates them back into the original stablecoin.

Capital Allocation of Gro Protocol

Yield optimizers are attractive because they blend multiple strategies, so if any one strategy fails, you may still end up making money with the others. They also save you the time of researching how any single protocol works. That said, you take the risk of trusting the author of the optimization strategy - the returns you will receive depend on how good the optimization strategy is .

Derivatives

Financial derivatives are an increasingly popular area in DeFi, with increasingly sophisticated products becoming available. In our last article, we introduced Dopex - a decentralized options exchange that allows users to earn yield on a single collateralized options vault. Another great example is Ribbon Finance, which provides users with a mechanism to write covered call options and sell put options on DeFi assets. In these cases, the yield generated comes from taking on the risk of certain price behavior of the underlying asset.

Derivatives are a double-edged sword. On one hand, the ingenuity of these protocols is filling a niche that will undoubtedly become more valuable as DeFi matures as an industry. On the other hand, these are fairly complex financial technologies that the average DeFi participant cannot be expected to understand. If you are going to earn a return from a derivatives-based protocol, it is important to understand how the structure of the derivatives directly relates to your returns!

Governance

Governance tokens are one of the largest sources of ad revenue, but they are also arguably the most difficult to understand. As the name implies, these tokens give holders the right to participate in the governance of the underlying DeFi protocol through proposals and on-chain voting. These changes can include the smallest parameter changes (such as "increase the interest rate on this vault by 0.1%) to overhauls of the entire ecosystem (such as MIM and Wonderland merging).

When DeFi protocols are first starting out, they often reward liquidity providers and other early participants with their protocol’s governance tokens, a process known as “liquidity mining.” They will also launch liquidity pools for their governance tokens on DEXs so that these tokens can be exchanged for common assets like USDC and ETH. This leads to a market price for the tokens.

The question then becomes: why are governance tokens valuable? A standard answer is that governance tokens are similar to equity in a company. In theory, you are entitled to a portion of the future cash flows of the protocol, and you also have partial decision-making power over it. However, in practice, this may or may not be the case: depending on the structure of the protocol, the revenue may flow primarily to the treasury, rather than to the governance token holders. Due to the limits of the coin, the decision-making power you have will only be proportional to the number of tokens you hold.

Governance tokens become particularly difficult to reason about when they exhibit a recursive structure — i.e., holding tokens results in the right to control or participate in future distributions of such tokens. This dynamic was covered extensively in our article covering the CRV Wars .

The moral of the story here is that if a DeFi protocol derives the majority of its returns in the form of its native governance token, you should apply additional scrutiny to it because in this case, your returns are actually coming from the underlying protocol.

Rebasing Tokens

As detailed in our post on [redacted], the redeemable token, or sometimes referred to as a “reserve currency”, refers to OHM and its forks.

Rebase explanation: Rebase is to apply a series of commits to another branch in the original order, while merge is to combine the final results together.

Rebase tokens are fundamentally defined by the eponymous rebase mechanism, which simply means that if you lock your coins into a staking contract, the amount of coins you hold will increase by a certain percentage over a fixed period of time. For example, 8 hours, this frequency of compounding leads to astronomically high APYs. For example, currently, OlympusDAO offers 0.3265% rewards per epoch (8 hours) on staked OHM, resulting in an APY of 3,450%.

Of course, if you’ve been reading this carefully, you’ll easily see that an increase in the amount of base currency doesn’t necessarily mean an increase in value. That is, if the number representing the amount of currency doesn’t have a meaningful correspondence to something intrinsically valuable — like software that facilitates financial transactions, or a real-world asset like the dollar, or a share of a protocol’s future revenue — then a rising amount of currency doesn’t necessarily mean you have more value.

Recently, there has been a reckoning for rebased tokens as more and more participants realize that their high APYs do not actually mean they have more value. Here is a chart of the market caps of OHM, TIME (Wonderland), and BTRFLY ([redacted]):

OHM's market value fell 85% in 3 months.

TIME's market value has been volatile, falling 52% in the past three months.

BTRFLY's market value has fallen 48% in 3 months.

“Reserve Currency” demonstrates how DeFi can quickly lose its grip on reality. When new participants see extremely high numbers, they get excited and buy in. This drives the price up, causing more participants to buy and stake, creating a flywheel effect. If people had stopped at any point to consider why the numbers were going up, they might have realized that their high APY was not based on value , but on an inflationary monetary instrument .

TIME, in particular, has seen quite a bit of drama recently, with accusations that TIME’s Treasury Secretary 0xSifu is a convicted financial felon:

Twitter from zachxbt.eth

To be fair, some in the Rebasing Token community have discussed changing the dynamics, which may have been triggered by the recent price crash. In addition, these tokens are backed by treasuries and revenue streams, such as OlympusDAO’s protocol-owned liquidity-as-a-service.

However, if the currency does not even attempt to have its “volume” meaningfully reflect the underlying source of value, then they should not be considered a reliable deliverer of DeFi returns.

in conclusion

There are many ways to earn yield through DeFi, some are low risk, some are high risk, but in all cases, you should understand where your yield is coming from. The more the value of the underlying protocol is tied to the yield paid to you, the more certain you can be that you won’t lose money. Since DeFi yields come from the value of the underlying protocol, your key job is to determine the value of the DeFi protocol, and I’m here to help you do that.