How Are Crypto Yields Generated?

The first decade in crypto (2009-19) saw people primarily speculate or invest in different crypto assets. The second witnessed the emergence of Centralized and Decentralized Finance platforms that enable people to earn yield on their crypto assets. Consumers flocked to these platforms to grow their existing crypto portfolio and at times as an alternative to their traditional banking accounts.

However, the implosions in the crypto ecosystem that started with the collapse Luna ecosystem and grew to multiple Centralized Finance players such as Celsius Network and Voyager filing for bankruptcy has shaken consumer confidence. What happened over the last few months is unfortunate. But, it also highlights the need for a better understanding of how these yields are generated and the risks they entail.

There are primarily three activities that lead to yield generation

1. Lending and Borrowing
2. Providing capital protections against financial risks
3. Providing capital to enable a service

Lending and Borrowing

People borrow to acquire an asset (home mortgages), fund an upskilling activity (education loans), or finance a consumer purchase (smartphone financing). Businesses borrow to meet short-term capital requirements such as payroll or expand their business activities such as setting up a new factory. Traders, both retail and institutions, borrow to get leverage.

The reasons people borrow crypto are similar in nature to that in real-world economy albeit a lot of borrowing activity is co-related with the current market sentiments in crypto. Crypto Miners and Validators use their crypto assets to take out loans in stablecoins to fund the expansion of their computational infrastructure. Individuals have used their crypto assets as collateral to fund unexpected short-term expenses. However, borrowing crypto assets as leverage remains one of the largest use cases of crypto lending.

What kind of trades have demand for leverage

Asymmetric Directional Bets

An asymmetric bet is a trade where the potential upside is significantly higher than the downside. Let's say there is an asset with the current price of $1000. There is a 10% probability that in a year it can go to $100K and a 90% probability of slipping to $500. The risk-adjusted potential upside for a unit of the asset is $9K of profit vs $450 loss.

Market Neutral Strategies

These are trading strategies where the returns are independent of the market's direction. It involves opening a long and a short position simultaneously to take advantage of inefficient pricing.

Basis trading is a common market-neutral strategy used in crypto. In this, a trader takes a long position in a crypto token and a short position in its derivatives such as futures or perpetual swaps. For instance, the current price of a token on June 30, 2022 is $20K. The futures for the token to be settled in September 2022 is $25K. A trader can purchase the token and then short sell the equivalent amount on the futures for September locking the $5K profit. Of course the trade doesn’t work if the spot price of the token goes higher than $25K.

Arbitrage

Arbitrage is buying a security in one market and simultaneously selling it in another at a higher price, profiting from the temporary difference in prices. As compared to traditional financial markets, crypto is still nascent and evolving. This presents multiple arbitrage opportunities in the ecosystem. For instance, up until a couple of months back before the Luna Crash, it was possible to borrow USDC, DAI, or USDT from a protocol like Compound for sub-5 % APR, swap it for US Terra and lend it on Anchor Protocol to earn 20% APR.

How Lending is Facilitated

To lend money, you need a counterparty who is interested in borrowing from you. This requires match-making between lenders and borrowers. The first attempts at enabling lending in DeFi took an approach of Peer-2-peer matchmaking. Peer-to-peer matchmaking is a hard problem to solve. You need both parties to agree on multiple parameters such as duration, interest, and the time when somebody wants to lend and another entity wants to borrow. The pre-cursor to Aave called ETHLend took this approach.

The next generation took Peer-to-pool-to-peer Lending approach. Depositors’ funds were put into a pool through smart contracts and on the other end borrowers would take out loans. This is the prevalent mode of lending and borrowing in crypto today. CeFi has systems and processes to enable different safety constructs whereas in DeFi aspects such as how much liquidity should be maintained in a pool and what should be the interest rate is managed through smart contracts.

Providing Protection Against Risks

Insurance is one of the most common forms of such activity. An entity promises to pay you an amount X in case an event A happens in exchange for you paying a premium of amount Y at regular intervals. e.g. Life Insurance, Luggage Loss Insurance etc. The insurance provider calculates the probability of the event happening across a population and then arrives at a premium. For instance, a life insurance provider is unlikely to be in a situation where the majority of its customers face the insured event at the same time. Of course, this doesn’t necessarily remain true in all circumstances.

Insurance in DeFi

AAVE Safety Module is the primary way through which a mitigation action is to be taken in event of a shortfall. This module acts as insurance for the depositors in case short fall event where a pool becomes imbalanced due to a crash in the market and the prices of collaterals going below the total deposits.AAVE token holders are incentivized to lock in their tokens into the pool in exchange for receiving rewards for doing so.

Thus, AAVE token holders are rewarded for providing protection against the risk of bad loans.

Writing Options

An options contract is is an agreement between two parties to buy or sell an asset at a predetermined future date for a specific price where the buyer side of the contract has an option but not necessarily an obligation to execute the contract.

For e.g. Let’s say you hold an asset A and expect the price to go up. But you would like to hedge your risk in case markets start crashing. You can buy a Put Option (an option to sell the stock) expiring on a certain date. If the market doesn’t crash, you can skip exercising the option. But if it does, you would have been able to limit your losses.

DeFi Protocols such as Ribbon Finance make it simpler to earn yield from structured products such as Options.

Providing Capital to Enable a Service

This is when your capital enables a service that otherwise would not have been possible. For instance, Decentralized Exchanges are built on two constructs - Liquidity Pools and Automated Market Makers. A liquidity pool is a set of digital tokens locked by users into a smart contract that enables trading on a decentralized exchange. Automated Market Maker algorithms decide the price at which a trade should execute on the DEX based on the ratio of the two assets in the pool.

Liquidity Providers earn a portion of the trading fees in return for providing liquidity that enables the operation of trading on the exchange.

Similarly, blockchain networks that follow a Proof-of-Stake consensus mechanism require validators or block creators to explicitly stake capital which can be penalized if they behave maliciously or lazily. Hence, in such scenarios users provide capital to ensure the safety of the blockchain network, and in return for that, they earn a percentage of the transaction fees generated on the network.

Crypto Yield Instruments will continue to proliferate. However, a deeper look should be able to unveil how these opportunities are generating yield. An understanding of the source of the yield will also shed more light on the sustainability of the yield and the risks it entails.

References

• Where does yield come from, anyway? - By Julian Koh
• Where does yield in crypto come from? - By Ming Zhao
• Where do the yields come from in crypto? - By Su Zhu and Hasu