Where does the high yield of DeFi, which beats traditional finance, come from?

In recent years, traditional banking has become less and less popular. The annual interest rate for savings accounts in some US banks can even be as low as a ridiculous 0.1% (considering that the current inflation in the United States is close to 5%, saving accounts = throwing money away); during the same period, the annual interest rate for deposits in Anchor Protocol is 20% (Note: Anchor Protocol is based on the stable asset protocol Terra Money. It is a new type of savings protocol that aims to balance interest rates by coordinating block rewards from multiple different PoS consensus blockchains, and ultimately achieve a storage rate with a stable yield). I think everyone knows which one to choose next.

Defi’s yields often seem unrealistically high, which makes one wonder how these yields are generated? Are they really sustainable, or are they just a Ponzi scheme?

Compared to other markets such as traditional finance, the yield of cryptocurrencies is very high, which is also the point criticized by many skeptics. Abnormally high yield = Ponzi scheme, which seems to be logically correct. But we still have to study and understand it ourselves, and doing due diligence is more important than anything else.

DeFi’s high returns are not only earned by Degen

DeFi may be known for its extremely high yields, even using relatively safe assets such as USDC, USDT, DAI, and BUSD. You can also get quite good returns:

• Stablecoin lending on platforms like Aave and Compound: 6-8% annual yield

• Staking: 4-20% annual yield

• Liquidity Mining: 50-200% annual yield

• Degen Mine's Return: 200-30M% Annual Return

Obviously, risk and return are also positively correlated in the crypto market. For example, lending your stablecoins to relatively safe protocols (Aave and Compound) can give you at least 4% return per year. The following figure shows the annual rate of return of Aave:

The yield on lending comes from borrowers borrowing funds from the protocol and paying a higher interest. The protocol makes a spread between lending and borrowing, similar to what banks do today. If the demand for lending rises, the yield on lending will also rise.

The yields of different stablecoins will also be different. For example, the yield of USDT is often higher, because many investors are beginning to avoid USDT due to various regulatory and shady issues. Therefore, it is only natural that one point of risk is exchanged for one point of return.

The risks involved in participating in this type of investment are:

1. Protocol becomes target of hacker attacks

2. Insufficient collateral

All of these may cause investors to lose their principal. Cream Finance, which has been attacked one after another, is a very good example. Bitpush has previously reported on this project many times, [DeFi protocol Cream Finance was attacked by flash loans again, with losses exceeding 130 million US dollars] , [Cream Finance was attacked by flash loans due to a reentrancy vulnerability in the AMP token contract], [Cream website DNS was attacked, and the team reminded users not to submit private keys and other information to the website].

Cream Finance's liquidity pool was eventually completely emptied, and the product's users became victims.

Liquidity Mining

Being a lender is not the only way to earn Defi dividends, you can also choose to earn income by providing liquidity in the liquidity pool, that is, liquidity mining. This means that you can collect transaction fees as a market maker, and sometimes you can also receive transaction fees as rewards in the form of governance tokens.

But providing liquidity is not a risk-free thing. First, as a liquidity provider, you must hold at least two currencies, which means you will have at least two cryptocurrency exposures. Second, you may face impermanent loss. In this case, holding tokens is a better choice.

Topaz Blue, a crypto financial consulting company, recently released a market analysis report, which mentioned that 49.5% of liquidity providers on Uniswap V3 have experienced negative returns due to impermanent loss (but even so, the transaction fees provided by Uniswap can still make up for the uncompensated losses in most cases, which is why there are still a large number of investors willing to invest and provide liquidity). In fact, uncompensated losses are more like an opportunity cost. You don’t really lose anything, but the way you choose does not have another possibility (simply holding coins) to earn more.

Illustration of gratuitous loss

Lending protocols can offer relatively high yields, which are often driven by the need for leverage. Part of this potential demand for leverage comes from traders who are good at using information. When they get some inside information, they prefer to invest in a desperate way.

Assuming that a trader knows in advance that a project will have great good news, the trader may borrow a large amount of USDC from the market at an annual interest rate of 8% (about 0.02% per day) and use it to accumulate a large number of tokens. As long as the daily price fluctuation of the purchased token is greater than 0.02%, the trader can profit from the loan. However, relying on insider information to carry out large-scale order operations is not a wise choice in the Defi field. Such large orders will be recorded on the blockchain and eventually monitored by various detection tools (for example, Whale Alert), thus becoming a "well-known secret."

Another major incentive for the surge in leverage demand is to adopt a market-neutral strategy (a market-neutral strategy refers to an investment strategy that builds long and short positions at the same time to hedge market risks and obtain stable returns regardless of whether the market is rising or falling. The market-neutral strategy is mainly based on quantitative analysis of statistical arbitrage). For example, traders can go long on spot and short on perpetual/futures and receive a funding premium from the exchange. Regardless of the price trend, whether it is rising or falling, the trader's losses on one position will be offset by the gains on the other position.

Assuming a 5x leverage on the trading position, with a 4% annual return on a delta neutral position, the trader would ultimately be able to earn a 20% return, which is much safer than simply using a one-way risk exposure, but the return is still considerable.

In addition to traders, investors participating in liquidity mining also need leverage

For example, borrowing stablecoins at an annual interest rate of 10%, and then using the borrowed money to charge a pool with an annual return of 30%, this creates a perfect arbitrage opportunity. While earning a 20% arbitrage space, you can also obtain the risk exposure income of the original mortgage tokens (used to exchange for the collateral of stablecoins). As long as there are such arbitrage opportunities, there will always be demand for high-interest loans in the market. This is the principle of supply and demand creating high returns.

Since many new protocols currently offer an annual interest rate of 30%-50% or even higher to attract liquidity providers, this will usually push up the coin price again (high yields attract more people to mine, and more people need to buy the protocol’s native tokens to participate in mining, thereby pushing up the coin price), creating higher yields.

Risk Premium

Risk premium is inherently present in all risky assets and it is defined as the premium for bearing risk, above the risk-free rate.

In DeFi, risk premiums can exist in multiple aspects, from market risk to counterparty risk and illiquidity risk and volatility risk. The more risk an investor takes, the higher the risk premium, and the higher the risk compensation return. Any transaction in the crypto market is inherently risky, and the market requires a risk premium to compensate for the risk it takes.

Market risk is the risk of the entire process of investing in cryptocurrency, which includes the market volatility of cryptocurrency itself, hacker attacks, private key management costs/risks, leverage, etc. Compared with traditional financial instruments such as stocks, cryptocurrencies are usually riskier, so investors require higher returns for the risks they take. DeFi can be seen as a derivative of the crypto market, which contains greater risks. Various smart contracts face risks brought by bugs, hackers, and project parties every minute and every second, so high returns are not surprising.

Counterparty risk also increases returns. For example, you would expect to be compensated for the risk that your counterparty goes bankrupt or disappears with your funds. If you trade futures on dYdX, dYdX is your counterparty. If dYdX gets hacked, so does your funds. Therefore, there is a risk premium for trading futures on dYdX.

Therefore, DeFi also follows the most basic financial rules, that is, the greater the risk taken, the higher the rate of return.

Agreement income

Another source of revenue is from protocol revenue. For example, lending protocols like Aave use protocol revenue from lenders and borrowers and distribute it to stkAave holders.

Many DEXs, such as PancakeSwap, use protocol revenue to repurchase and destroy their governance tokens, which creates a deflationary effect on the tokens, thereby increasing the price of the tokens. By distributing value to token holders, a unique revenue model is created, whereby the protocol can distribute governance tokens as revenue, because those who invest in governance tokens contribute to the development of the protocol, and they can share the future cash flow of the protocol, similar to holding a company's stock, but stocks do not allow holders to participate in corporate governance.

This aligns incentives between depositors and token holders, as they are now incentivized to deposit liquidity, accumulate governance tokens and stake them for yield, or sell them to others who want access to that yield.

Are high returns sustainable (years or even decades)?

In a bull market, the demand for leverage is often shockingly high, because most investors want to invest more money to earn higher returns. New projects have also sprung up, which has led to the emergence of a large number of high-yield mining pools, which has brought in new capital and once again increased the market's demand for leveraged capital.

In theory, the protocol revenue will also increase significantly, because the bull market will generate more transactions, and more transactions mean more transaction fees. It is a virtuous circle that allows the protocol to maintain a high rate of return to attract users.

But in a bear market, the situation is completely different. In a bear market, the prices of a large number of tokens plummeted, and there were fewer and fewer buyers. The tightening of funds led to a comprehensive decline in yields, and the demand for leverage also plummeted. This further led to a decline in trading volume and protocol revenue, forming a vicious cycle.

DeFi has been in a bull market since the beginning of last year. This means that the market demand for leverage remains high. As long as innovation in this field continues, the asset class will continue to grow and the yield will remain high. But even in the wildest fields, innovation and development will eventually encounter bottlenecks, so the high yield of DeFi is likely to be just a temporary phenomenon.

In the long run, the decline in yields is an inevitable trend. To compare, just like the history created by the US dollar in the field of legal currency, the yield on savings in the US dollar in the 1980s was 20%, but with the Federal Reserve printing a large amount of money, the yield has now dropped to 0%. This is a natural economic cycle, so the Defi market that follows economic principles will eventually not escape this cycle.

Market cycles will affect the demand for leverage, but the most important reference factor for whether the income can be sustained is still whether the protocol income is sustainable, that is, the value created by the protocol itself, the problems solved, and the impact produced, which will exist for a long time. The iron must be hard to forge, and this principle applies everywhere.

Image source: Internet

Author: Chen Zou, Bitpush exclusive