How yield is generated in DeFi

1. Introduction

In today’s low-yield environment investors are facing a dilemma: traditional asset classes like bonds, equities or real estate offer only dire yield opportunities but are subject to considerable macro and interest rate risks. High inflation (7.5% in the Eurozone per April 2022¹) makes the situation even worse. 

Given these circumstances, it does not come as a surprise that investors’ interest in DeFi yields, which are quite high by comparison, is growing fast. Actual adoption of DeFi investments is lacking, though, especially among institutional investors. We see several main reasons for this: A lack of regulatory clarity, a still very limited (but growing) number of service and data providers, and finally the urgent need for education in the field of blockchain technology in general and DeFi in particular, which the latter would help the professional investors to price in the volatility of the underlying assets and to understand the disruptive character and the convincing promises of the technology.

In this article, we will assess the three major sources of income generation in DeFi: Lending, Staking and Liquidity Provision. 

2. Lending

Lending emerged in the Roman empire around the year 300 BC. So, it is certainly not a DeFi innovation. But DeFi makes lending a lot more efficient, not only when compared to banking practices in the Roman emipre², but also in comparison to the current (traditional) financial system. 

There are two forms of DeFi lending: Centralized and decentralized lending. Centralized lending means, there is an intermediary offering to pay interest in return for lending out assets. This is very similar to a bank, with the notable difference that the assets to be lent/borrowed are cryptoassets. Some well-known providers in this market are Celcius (celcius.network) and BlockFi (blockfi.com).

Decentralized lending is different: Firstly, it is trustless: Lender and borrower do not know each other and there is no written credit agreement which both parties must sign. In fact, there is no counterparty as such. Instead, all lending conditions (notional amount, interest rate, collateral, etc.) are put into and executed by a smart contract. In other words: the middleman – usually a bank – is taken out of the equation. 

Secondly, DeFi lending is a lot quicker than traditional lending. Since all transaction are executed on a blockchain, payments and settlements are made (almost) instantly. 

Currently, the main chunk of (decentralized) lending occurs via the platforms AAVE or Compound. On these platforms, borrowers have to provide collateral exceeding the value of the loan they would like to take out. This “over-collateralization” is a mechanism to protect the lenders from counterparty risk as there is no reliable credit scoring method out there (yet). In other words: you can only lend out money if you have enough collateral. In traditional finance this would be called a lombard credit. 

DeFi loans are used by traders who want to leverage their positions, mainly in bull markets, in which they assume the interest payments will be lower than the resulting profit from the funds borrowed. Furthermore, as governance tokens of smart contract-protocols can sometimes be borrowed as well, the borrower can gain more voting power for the time of borrow. Good examples of this are Curve Finance (CRV) and Yearn Finance (YFI). 

Another innovative form of lending that is specific to DeFi are so-called flash loans. These loans are fully automized transactions, which lend out money and receive repayment within seconds. Ethereum based flash loans for example are paid out and repaid with the same block. Due to their nature, flash loans do not have specific collateral requirements at all. If they are not repaid within the (so called) block time, they will be reversed, i.e. the transaction did not happen at all. This is possible due to the fact that the blockchain is discrete in adding blocks, and only transactions based on blocks that have been verified and accepted by a majority of nodes in the network, have actually happened. For flash loans, the borrower has to pay a tiny fee, but they make it possible to exploit arbitrage opportunities between different marketplaces.

Other forms of lending – without the need for over-collateralization – start to emerge. Platforms like Maple Finance³ are successfully implementing new methods to assess credit risk and can in turn offer credit to a wider range of borrowers. Finally it is worth mentioning Goldfinch, a recently emerged decentralized platform that brings crypto-backed loans to the “real world”. These are logical evolutions of DeFi lending. We are convinced that the further development of the space will have to move into this direction: by solving real world problems – i.e. making existing lending markets more efficient or extending credit to otherwise unbanked areas – DeFi lending will grow and become widely adopted.

3. Staking

When assessing the underlying economics of staking, it becomes obvious that this form of yield is indeed new.

Before diving into the details, it is necessary to have a brief look at the difference between the two main blockchain consensus mechanisms: Proof of Work (PoW) and Proof of Stake (PoS). PoW basically is a race of market participants (so-called „miners“) to compute the next block of a blockchain and to reap a reward for doing so. Although this is a tried-and-tested mechanism, it has a big downside: very high energy consumption. That is where PoS shines. Instead of having all market participants „race“ to create the next block, under a PoS consensus mechanism, an algorithm determines who is given the right to „mint“ or „forge“ the new block. A key factor that is taken into account in this selection process is the amount of collateral (the „stake“) in the form of native tokens, a participant (often called a node operator in PoS) has posted. This collateral or a part thereof can be taken away (called “slashing”) if the participant shows undesirable behavior, like being offline, or attempts of fraud.

The reward a node operator generates for minting can be expressed as a percentage – the native staking yield or APY. The chart below depicts the staking APY development for ETH vs. the amount of staked ETH tokens in 2022. Ethereum has modeled its APY as a supply-and-demand function, i.e. the rate declines as more tokens are being staked. Since staked tokens are locked until the transition to ETH 2.0 is completed, the number of staked tokens can only stay constant or increase, while the APY can remain constant or decrease. For other chains / protocols different rules may apply. 

Figure 1: ETH – Native staking APY vs. tokens staked
(Source: Kasuria)

Meanwhile it is possible for all investors holding a PoS native token to invest into staking. Many platforms and most major crypto exchanges offer investors access to staking pools – without the need to run their own nodes. Needless to say, that this service offering comes at a cost to be paid as commission to the operator of the pool. But unlike in traditional financial products, the fee a staking pool provider asks is easily visible: it is simply the native staking yield minus the yield offered by the pool. 

What are the risks of staking? When assets are being staked, they are committed for a certain period of time and cannot be withdrawn. The time period varies across the blockchain networks from a few days to several weeks, and can even be, as in the prime example of Ethereum, indefinite (until the merge from Ethereum’s PoW to the new PoS consensus mechanism has taken place). In traditional finance this is called liquidity risk. Furthermore, the yield rate on staking is not fixed, but depends mainly on the number of transactions to be verified in the network (as the originators of transactions also pay the fees). This translates into a certain “interest rate risk”.

Apart from the proof-of-stake in validation of transactions, there is the possibility to stake tokens in smart contracts. This is called “layer 2-staking” and has nothing to do with the validation of transactions, but rather provides “trust” to the protocol itself. Besides having governance voting power, staking “investors” usually benefit from a share of the protocol fees, which is the staking reward in this scenario.

4. Liquidity Provision

One major source for income generation in the DeFi world are so-called Decentralized Exchanges (DEXs). In contrast to Centralized exchanges, such as the NYSE, LSE or Binance, a DEX is a trading platform running on a blockchain. The most prominent examples include Uniswap, PancakeSwap and Curve Finance, which make up c. 50% of the market when this article was written (see figure 1 below).

Figure 2: Top 3 DEXs by 24h Trading Volume as per 05 July, 2022 
(Source: https://www.coingecko.com/en/dex)

The above comparison already suggests that the economics of Liquidity Provision cannot be new. Centralized exchanges have existed at least since the foundation of the Amsterdam Stock Exchange in 16024.

At centralized exchanges there are order books that provide transparency about bids and asks on the one hand and „market makers“ on the other hand. Market makers are bringing trading parties and trading interests together and also facilitate trading through providing liquidity from time to time.

With DEXs however market participants are always trading against a pool of liquidity that is made available by users. Prices are determined on the basis of the volume of the asset tokens in relation to each other inside the pool. In this setting DEXs now provide the opportunity to engage in Liquidity Provision to anyone and to participate in earning trading fees.

To profitably do this, one needs to consider some points that are unique to this „business“:

  • It is usually necessary to deposit the assets into a given trading pool at a predefined ratio.
  • The earnings potential rises with the risks of the asset pair provided. There are two main risk: 
    1. Market risk: The risk of holding the assets provided and their price depreciating. 
    2. The risk of Impermanent Loss5: The risk of the two assets‘ prices moving relative to each other.
  • When providing liquidity to a pool, investors receive Liquidity Provider (LP) tokens. The tokens represent a claim on a share of the pool and they can often be used for staking in other protocols, effectively providing an additional layer of return. The fees paid by “customers” of the pool who access its liquidity (=swap tokens), are usually paid into the pool growing its value. As the share which the liquidity provider owns, remains constant, he benefits in absolute terms.

The real innovation of DEXs are the above mentioned “Automated Market Maker“ (AMM) and the pricing mechanism which substituted the common orderbook model of traditional exchanges. In the example of a pool with two assets, the core of the AMM is the constant product formula x*y=k, where x (resp. y) is the price of the first (resp. second) asset and k is the constant of the specific pool. It follows that whenever there is a shortage of the first asset, the price for it, x, will increase, whereas the price for the second asset, y, has to decrease to maintain the constant k. With this mechanism the demand and supply is modeled and clearly laid out to anyone, without  the need for a  third party (the market maker) or someone who governs the order book.  The theoretical model has been initially discussed between Vitalik Buterin and Hayden Adams, who subsequently founded Uniswap, bringing the model to life. 

In summary, Liquidity Provision is a yield opportunity best suited for seasoned crypto investors, who have a clear view on the associated risk and opportunities in this field. Technical knowledge and access to reliable market data are hard pre-conditions for engaging in Liquidity Provision, let alone multi-step yield harvesting strategies. 

5. Aggregator Protocols

The savvy reader might have thought about the ultimate DeFi yield generation opportunity already while reading the above sections of this article: a strategy combining all or some of the sources of yield. This can range from a rather simple „two-hop“ to highly complex multi-hop strategies. Two main routes to invest in yield generation strategies exist: Building it yourself or use an aggregator protocol like Yearn Finance. While a detailed explanation of a self-built strategy is beyond the scope of this paper, let us have a brief look at the functioning of a YFI vault, in this example the ibEUR/sEUR vault:

Let us assume that an investor holding ETH tokens deposits into this vault, receiving share tokens of the vault. The ETH will be converted into the right number of ibEUR and sEUR and added to the respective Curve Finance liquidity pool (LP). In exchange, the vault receives LP tokens of this pool, which it automatically deposits into Convex, thus generating additional yield. All yields will be harvested and reinvested by YFI, ie automatically compounded from the investor’s perspective.

6. Conclusion

DeFi offers a variety of yield generation opportunities. While Lending is the most traditional form of yield, Liquidity Provision is a form of yield generation new to a broad investor base. In essence this “business” is shared entirely between exchanges and brokers in traditional finance. Staking on the other hand is a completely new yield opportunity, derived from the underlying mechanics of PoS blockchains. Even combinations of these yield opportunities are possible and already common among the more sophisticated DeFi investors, who either run their own strategy or invest though an aggregator protocol.   

These are still the early days of this technology and similar to the rise of the internet, financial markets are amongst the first players to adopt web3. We are convinced that the further development of the DeFi space will have to move into the direction of solving real world problems, like bringing financial services to the un- and underbanked parts of the world. Amid recurring financial and inflation crises all around the world financial sovereignty can also be seen as such. Improvements in the technical and data infrastructure, supportive and clear regulation and finally education of investors and users are all to be tackled on this journey.  

Sources:

1: https://ec.europa.eu/eurostat/documents/2995521/14442438/2-01042022-AP-EN.pdf/ba153bc6-c1aa-f6e5-785b-21c83f5319e5#:~:text=Euro%20area%20annual%20inflation%20is,office%20of%20the%20European%20Union.

2: https://en.wikipedia.org/wiki/Roman_finance

3: https://www.maple.finance/

4: https://www.investopedia.com/terms/a/aex.asp 

5: https://arxiv.org/ftp/arxiv/papers/2106/2106.14404.pdf