Where does the high income from DeFi mining come from? Is it sustainable?

Original title: "Analysis | Where does the high income of DeFi mining come from? Is it sustainable? "

Original author: Julian Koh, founder of Ribbon Finance, a DeFi protocol that provides structured products

Original translation: Perry Wang, Lianwen

One of the main narratives of decentralized finance (DeFi) is that ordinary people will have to move their fiat currency to the DeFi space given the high returns of DeFi. Empirically, this is true - the lending rate for stablecoins on the Compound protocol is now over 10% APY, and there are many mining opportunities in the DeFi space with APYs of 50% to 200%. You have to know that in the real world, most banks offer deposit rates to customers of no more than 1%.

But when ordinary people first hear these yield numbers, most are wary rather than confident. “This must be a scam!” The yield must reflect some hidden risk that we, the crypto-enthusiasts, don’t take into account. This is a reasonable assumption—smart contract risk is difficult to quantify, so loan providers may require borrowers to provide high interest rates to compensate for this risk.

Historical lending rates for USDC in Compound

Looking at the historical lending rates for USDC in the Compound protocol, we can see that over the years, lending rates have soared from -1% to over 10%. The smart contract risk in this protocol has not changed in any substantial way, which suggests that high interest rates may be driven more by demand than supply.

Now that we have figured it out, why are borrowers willing to pay such high interest rates to borrow crypto assets?

Going a little deeper, lending assets is just one of the ways people earn yield. To really understand where yield comes from, we first need to think carefully about how money grows and why you can get paid to put money into something. I believe that yield comes from four categories: borrowing demand, risk exchange, service provision, and equity growth.

This article will analyze each in detail to truly understand the benefits of DeFi.

Natural borrowing needs

The most obvious source of benefits is the natural need to borrow. Businesses need to borrow assets to purchase capital goods, banks need short-term loans to finance their activities (the repo market), and individuals may need loans to pay for college. Because of this natural need to borrow, markets for borrowers and lenders begin to form, and these loans are priced - one person's need to borrow is another person's benefit.

Looking ahead, precisely because this natural demand for borrowing remains at very basic levels, it is almost unlikely that this yield will ever dry up.

Another reason there is a natural need to borrow is that people crave leverage. As some people say, “leverage is a ****.”

Investors who are extremely bullish on an asset may want to borrow cash to buy more of it, especially if they expect the asset to grow faster than the interest rate they pay to borrow it. This is very clear in the DeFi space. Platforms like dYdX and Alpha Homora offer some of the highest lending rates of all DeFi protocols because they create very simple ways for borrowers to use these borrowed assets for leveraged positions.

To create high-yield products, a large amount of borrowing demand needs to be stimulated, and investment leverage is one of the best ways to stimulate lending in the current market environment.

Risk Exchange

Another source of returns is through risk exchange, which intersects with borrowing demand. The simplest example here is insurance.

If Alice wants financial protection, that is, compensation if she is involved in an accident, she is willing to pay Bob a certain fee for this. In essence, Alice and Bob are exchanging risk with each other, and Bob receives a certain benefit for taking that risk.

Another prominent example of risk exchange is through options contracts. Option buyers are willing to pay a premium to protect themselves from large swings in asset prices, while option sellers receive some benefit for being on the other side of the trade.

One of the new ways to exchange risk in the DeFi space is through risk tranching. Protocols such as Saffron Finance take cash flows and divide them into different parts - the Junior part (i.e. the highest risk) receives a larger share of the returns from the cash flow, but must bear the risk of cash flow losses, while the Senior part receives a lower cash return, but its investment in the cash flow is guaranteed.

Essentially, Junior and Senior class assets are swapping risk, and they are ultimately income opportunities with different risks.

These risk swap contracts are a huge market in traditional finance because there is always an inherent demand for risk swaps, driven by the fact that different individuals/institutions inherently have different risk profiles.

Therefore, in the long run, I guess this will also become one of the main sources of DeFi income.

Service provision

A less intuitive source of revenue is that you can earn money by using your assets to provide services. For example, a money changer can charge fees because they use their assets to provide services. In the case of a money changer, the reason for the revenue is that they facilitate the exchange of two currencies.

Another example is an ATM – a machine that holds cash and allows customers to instantly withdraw funds from their bank accounts to purchase goods and pay for services. The ATM is a service that customers are willing to pay for.

In the DeFi context, providing liquidity to automated market makers (AMMs) can fall into this category of earning income. By providing assets to AMMs, services can be effectively provided to users who want to exchange assets. Taking the Uniswap protocol as an example, for each transaction, the liquidity provider LP receives 0.3% compensation.

As long as we expect the demand for these services to persist over time, we can also expect their respective benefits to persist.

However, providing such services has its own risks, specifically the potential for "impermanent loss" in providing assets to AMMs. In the long run, if the cost of hedging these risks is sufficiently lower than the benefits gained from providing the service, providing liquidity to AMM assets will be a positive income move.

Equity Growth

Another source of “return” comes from the value of equity growth. If you lent money to Uber in exchange for equity in the business during the seed phase, the return on that investment would be staggering, driven primarily by the growth in equity value.

Most of the high yields in DeFi today are driven by the growth of equity (crypto assets). For example, when you mine on Compound, you are actually lending money to the protocol and getting free equity (free COMP tokens). So you get the base yield on the loaned assets (from natural borrowing demand), plus the "yield" of the appreciation of COMP tokens.

Since DeFi assets are currently in a hypergrowth phase, most of the crazy earnings numbers you see come from equity growth.

Many DeFi protocols see this approach as a short-term method to attract users to their protocols. They hope to win a large number of users by offering equity for free. Therefore, the main strategy of asset owners at present is "yield farming", that is, taking these equity incentives for free and praying that the value of these assets will rise, so that their overall income will soar.

It’s unclear whether this revenue stream will be sustainable in the long term. Once the protocol realizes that the equity incentives it pays out for user acquisition are not worth the cost, it may shut them down.

DeFi’s primary strategy for earning yield in the future will likely be driven by one of the other three factors, rather than equity growth.

in conclusion

As the DeFi ecosystem matures and moves along the S-curve, we may see yields drop from ridiculous 1000% APY to more “normal” levels.
Over time, equity incentives may decrease and assets will move out of their high-growth phase. In the future, I expect to see more sophisticated product design in the risk exchange space as people design more complex financial products that can increase yields.