Where is the sustainable yield in DeFi?
This question remained unanswered in the back of investor’s minds during the two year bull run, where it was sidelined in favor of unprecedented APYs. As market conditions have worsened, the importance of understanding the sources of crypto yield has only grown. In this research report, we seek to identify these baseline rates, investigate how they flow through to investors, and evaluate future sustainability of yield relative to traditional finance.
10-Year US treasury rates are the highest they’ve been since 2018, when they last crossed the 3% threshold. An upward rates environment is largely detrimental for the digital asset ecosystem. Crypto is fundamentally a bet on systemically lower global rates and a hedge against inflation. As the relative value (yield) for storing dollars on-chain falls compared to the rates available in the real world, the relative yield production of digital currencies decreases. This is especially important given current risk premiums necessary for crypto incentivization, given the risk on principal capital. In contractionary markets, understanding the sustainability of asset yields is crucial.
Unsustainable vs. Sustainable Yield:
To start, it’s helpful to understand what unsustainable yield generation looks like in DeFi. At its core, protocol success is driven by liquidity. During the bootstrapping phase, liquidity is especially important, and sourcing it particularly difficult. To solve this, protocols issue their native token at highly inflationary rates as compensation for third party liquidity provision. While sometimes effective when used tactically, opting into an aggressive emissions schedule often has a number of destructive effects.
The general timeline for the liquidity farm looks something like this-
Bootstrapping protocol liquidity remains a largely unsolved problem. Organizations are caught in the middle of a Catch-22. On one hand, they can incentivize liquidity using the only asset they have, their native protocol token, and risk price pressure and falling liquidity for legitimate users. On the other hand, not developing sufficient initial liquidity for your token leaves a project dead in the water before it even has a chance to get off the ground.
So, what makes other sources of yield sustainable? Once stratified, most returns in DeFi stem from a few core opportunities:
- Proof of Stake Inflation
- Real World Interest Rates
- Borrowing / Lending
- Non-Incentivized Liquidity Provision
Staking for validation helps secure the blockchain while actually producing an effect on efficiency of the chain, rather than just rewarding stakers for removing secondary market liquidity, aligning investor incentives with long-term protocol view, and boosting token price. Secondly, investors are much more likely to denominate portfolio success in an ETH, BTC, or USD than any other format. For investors who use a cost basis in ETH, farming in-kind yield is acceptable and doesn’t necessarily require additional hedging.
Layer One blockchain inflation is the most basic source of yield in crypto. The most heavily traded chain, Ethereum, offers compensation for validation in the form of native tokens. While this structure is similar to DeFi token staking, it has a few important differences.
As such, while it’s certainly not a ‘risk free rate’, blockchain inflation represents a baseline rate for the borrowing and lending of assets within an ecosystem. Theoretically, the stable (non-variable) rate paid on ETH borrows should always remain above the rate that users can earn from staking (baseline yield). A lender would almost always choose to stake, a lower risk option, than to take on default risk.
So, what’s in future for Ether yield? Staking rewards have been steadily trending down as total supply increases, and as the number of the staked ETH increases. At the start of 2021, there was 2.1mn ETH staked (10.8% APR), compared to 8.8mn ETH Staked (5.3% APR) at the start of 2022. The merge, when it goes live, will push these numbers upward initially as fees paid from miners are instead passed through to validators. Initial forecasts put the starting PoS rate at 9%+, with expectations that it consolidates as users begin staking ETH to claim low-risk cashflow.
Non-Incentivized Yield Farming:
Historical yields of non-incentivized pools are another way to get a sense of ‘true’ yield in the ecosystem. At the lowest risk level (Baseline Rate, for Yield Farming/LP), pools where assets are pegged to the same value, think USDC/DAI at $1, and have little impermanent loss. Additionally, looking at highly trafficked non-pegged pools like WETH/USDC signals for the state of general non-incentivized volumes.
The USDC/DAI pool on Uniswap v3 has seen yield steadily compressing over the past 6 months. Deposit APR has decreased from 12% (the high, in January ’22) down to sub ~2% APR in fees generated, with no impermanent loss. Generally speaking, the average day represents an annualized fee rate of sub-1%, with a few heavily traded days helping bias total rewards upward (think USDC trading day after UST de-peg, which caused a major spike in volumes).
The WETH/USDC pair on Uniswap has averaged significantly higher rates of return at an average total return of 16% Deposit APR over the past 6 months. However, unlike the USDC/DAI pool, the WETH/USDC pair has been subject to impermanent loss of over 7%, reducing the total tokens gained by nearly 50%. Additionally, when removing the UST outlier event from the volume traded, only a handful of days have averaged annualized fees generated over 15%.
Assuming a more stable WETH/USDC rate of 14%, net yield on the pool, relative to the baseline ETH staking rate of 5% and IL of 7%, is about 2%. Yield for liquidity providers is slim picking- such low margins are unlikely to incentivize taking on LP risk. It will be very interesting to see how use of liquid staked Ether, like Lido’s stETH, will proliferate into liquidity provision. By pairing stETH (or an alternative) against USDC, LPers would simultaneously be able to earn staking rewards and earn liquidity fees.
Borrowing / Lending:
On the investor level, demand for additional asset exposure is an important upward force for funding rates. This demand is most readily seen in DeFi through the existence of Collateralized Lending Protocols (CLPs), such as Aave, Compound, and Balancer.
Yields can stay high as long as there remains extreme demand for capital, relative to the amount of cash in the space. As TVL grows, protocol-level demand for assets will decrease, lowering the rates that they will pay for deposits. In a bull market, new protocols will likely emerge, fueling demand for excess capital and keeping rates high. In a bear market, forces conflict. On the one hand, fewer new protocols will be growing quickly, creating excess demand for liquidity. On the other, project TVL will generally consolidate, which could force them to look outside to source money. Additionally, depending on the credit-worthiness of the assets, protocols may have to offer higher-than-normal rates for riskier assets that investors are now less likely to hold.
Rates on Aave for ETH are currently 0.58% For Supply APY, and 5.35% for Stable Borrow APY. Theoretically, Borrow APY (stable) should always remain above the rate that protocols can earn from staking (risk free yield). As yield for Layer One assets declines at the staking level over time, borrow rates should come down, which will in turn cause supply rates to drop on heavily trafficked assets.
Rates on both USDC deposit and borrowing are trending down to historical lows. On a 6 month time frame, deposit rates are down from 3%+ on 12/31 to 0.91% now. Borrow rates have decreased from almost 4% at the end of the year to just over 2% now.
Here lies an important question for crypto investors to face- Why lend stablecoins for a 2% annualized rate of return, with stablecoin and protocol tail risks, when a money market fund or 10Y is yielding the same, with a guarantee of safety?
Perpetual Swap Positioning:
Non-zero funding rates also create yield opportunities – a market maker is able to sell swaps to investors with bullish sentiment, go short the spot token to hedge beta exposure, and pocket yield.
Using a real example – one of the biggest questions into the merge was whether investors were positioned long or short. While there were a number of signs that pointed toward net long positioning, the biggest flag was in funding rates on Ether pairs. By September 13th, two days before the merge, funding rates on many exchanges were -50%, annualized, or lower. On the day of the merge, funding rates on many exchanges hit lows of -300%, annualized, with some exchanges clearing lows of -500%+.
Non-zero funding rates also create yield opportunities – a market maker is able to sell swaps to investors with bullish sentiment, go short the spot token to hedge beta exposure, and pocket yield. As an example, ETH annualized funding (currently, on 11/9) on dYdX is ~-57%, meaning that shorts are paying longs 57% annually for the right to have ETH token-margined positions.
As investors want increasing positive exposure to assets, they’re more willing to pay higher rates on borrows (as potential for gain far outweighs funding). Conversely, in bear markets, investors will pay higher rates to take short positions on token, which we’re seeing as macro volatility sends rates lower.
Active vs. Passive Yield:
The relationship between active and passive yield leads to additional effects on lending yield. The average investor is perfectly content to use set-and-forget strategies, which always creates opportunity for those willing to be more active.
Borrowing rates can be increased by arbitrage opportunities, such as the former bLUNA / LUNA arbitrage on Astroport. Investors could borrow LUNA, exchange it for bLUNA when it was trading cheap on secondary markets, then burn bLUNA over 21 days on Anchor and pocket the profit. This strategy yielded ~20-30% APY, causing LUNA borrowing rates to increase. In turn, this kept supply APY more resilient to decreases in staking yield.
Market making / arbitrage opportunities are most lucrative in high volatility, high volume markets. Their cost of doing business is directly related to their cost of borrowing. When times are good for the business, markets are buzzing with activity and rates have bottomed, allowing market makers to borrow assets cheaply and trade frequently. On the other hand, low liquidity and rising rates is a tough setup for these active traders. Their expenses grow, while the amount of opportunity they’re able to extract from the market falls substantially.
The current market state is certainly categorized by falling liquidity and rising interest rates. Demand from Market Makers will remain present, but likely at a lower rate as their margins compress. This will cause the spread between active and passive investing yields to tighten as well, as taking on increased risk is disincentivized by market conditions.
Admittedly, this positioning takes a highly US-centric view. Retail investor access to the domestic securities, digital, and legal infrastructure is incredibly strong, but the same doesn’t necessarily hold true outside of America. Even if the current rates environment remains fixed, there are factors that could positively influence the continued uptake of digital debt. During our chat, Sam Eyob, CIO of Goldfinch.Finance, highlighted the following fundamental themes in the non-US market:
- Cost Reduction– Use of smart contracts allows removal of administrative costs for moving capital (e.g. no 3rd party provider is needed to figure out the payment waterfall, then dole out cash to participants). Removing this expense could return between 50bps-150bps on deals.
- Structured Products– This is a common example stemming from smart contract flexibility. As a practical example, on-chain structure gives uninhibited access to create Risk Weighted Assets (RWAs – Effectively ETFs), defined by industry, country, or any other scope. Smart Contract composability can also drive uptake, through its ability to create DeFi primitives not possible in traditional finance.
- Access to opportunities: Double digit yields are now more accessible through DeFi protocols, which package up opportunities around the world for investors to see. Generally speaking, quality RWA yields are common, managers just don’t yet have the capacity, time, and network needed to find and assess them.
Such factors could help keep demand for digital products, despite falling American demand for digitally denominated debt.
Effect on post-merge ETH Staking Rate:
The last point worth noting remains theoretical, but may present as a great trade in the near future. If basis trade rates remain low (1.5-3%) after the merge, there will likely be little to no incentive to lend to protocols. If one can ‘risk-free’ stake ETH for 4+% APR, why would you take on counterparty risk?
This can be corrected under two scenarios:
- ETH staking rate grows extremely quickly because of its relative value proposition, causing staking rates to compress down to basis yields.
- Basis rates for ETH rise after the merge, as demand for staking liquidity raises rates.
- Greater capital efficiency allows for more leverage, and subsequent demand, driven by existing assets in the space.
- Demand for leverage in DeFi returns, causing demand for borrows, and subsequent rates offered for lending, to increase.
This report is not investment or trading advice. Please conduct your own research before making any investment decisions. Past performance of an asset is not indicative of future results. The Author may be holding the cryptocurrencies or using the strategies mentioned in this report.