Yields Existence
Over the centuries, many theories and stories have advanced to explain the existence of 'yield' ('interest') and its role in coordinating capital allocation within financial markets according to preferences for risk. Still, a near-infinite variety of definitions and assumptions continues to perpetuate financial and economic theory with projections including a "reward for abstinence" or, as Bastiat noted, "time had value." In contrast, financial historian William Goetzmann described the emergence of interest as "the most significant of all innovations in the history of finance." Conventional wisdom holds that the most encompassing view of yield is "the price of time" or the 'reward for idleness.'
Moreover, yields are a pertinent metric for investors when channeling for risk. Generally, the ability to generate greater than market returns (benchmark dependent) is a function of taking more risk (beta) or exuding a superiority in identifying mis-priced assets relative to their intrinsic value (alpha).
Put more concretely, yield is the percentage return derived from deploying particular investment strategies and can be represented via the following succinct formula;
Total return = Net gain/Loss in principle value + realized Yield
Precedent suggests that "yields" are essential. This piece will endeavor to describe the first iteration of yield within decentralized finance (DeFi), the problems of perpetual inflation and incentive misalignment regarding the most prevalent source of yield within DeFi (aka Liquidity Mining), and the notion of "real yield."
Conceptualising Liquidity Mining
In crypto-economic systems, mechanism design and the distribution of tokens are used to compensate agents who commit different kinds of capital and behavior to a protocol: to block producers for their 'work' or to investors for their capital and liquidity over time. Liquidity mining (LM) is associated with the latter.
LM is a bootstrapping mechanism and incentive strategy in which rewards are denominated in the protocol's native token and paid out to liquidity providers to augment/subsidize their costs and generate organic' network effects' of liquidity and volume in the long term beyond the product's utility. As proposed by Gauntlet, the incentive design must:
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Increase liquidity equilibrium once incentives are removed. Liquidity can be lower once the reward structure is removed, but liquidity and fees must be higher than prior.
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Steepen Lps elasticity or "stickiness": the efficacy of the program is dependent on whether Lps stay around following token distribution and do not respond to alternative protocol incentives
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Sybil resistant: the incentives program must be difficult/impossible to exploit
Although some of the assumptions hold in particular cases, the overwhelming analysis concluded that the first iteration of LM was ineffective at creating long-term flywheels and incentive alignment, which bore more similarities to the perpetual money printing of the federal bank. This outcome is essentially a function of unacceptable incentive designs:
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Incentive misalignment between the natural users who contribute to the growth of the protocol and financially optimizing mercenaries: As the circulating supply increases due to inflationary issuance, the value claim on each additional token is diluted. Governance also comes into play as these sophisticated entities presumably have a more significant token consideration (whale characteristics) and thus can exude more concentrated voting power over future token distribution (plutocratic governance)
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Yield realization is dependent on the sale of the native token: Accordingly, selling pressure is a pre-committed and programmatic economic forcing function. From a mechanism design perspective, LPs enter the Prisoner's dilemma, whereby the welfare of the participants can be better off by not selling yet they reach an inferior economic outcome. Still, it is locally rational (self-interest) to sell before the next LP such that → supply capital → receive rewards → sell.
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LM participants are profit maximizers and lack "stickiness": The direction of emissions is more akin to renting liquidity and activity over time rather than a long term creation of economic growth. Mercenary, non-loyal LPs will rotate to other yield-bearing opportunities.
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Reflexivity bound system: As the value of the emitted token depreciates, incentives become less valuable (when denominated in USD) and less effective at siphoning liquidity. Note this has the opposite effect when the token price is increasing.
Onchain capital movements and historical implosions (e.g., OHM) suggest a weak statistical relationship between liquidity mining and the retention of liquidity over the long term. For instance, Nansen reported that the majority of farmers exit within 5 days of entering a farm. Seemingly, Buying growth with dilution is only sustainable when the equity value outpaces the issuance rate.
Real Yield: Meme or movement? Vanity or value?
Born out of the ashes of LM, 'real yield' is an emissions design philosophy such that APR outlayed to those committing capital is a function of the protocol's revenue (fee generation) rather than a fixed emission schedule and is typically denominated in Eth or USDC. In this realm, there is a measurable nexus between sustainable economic growth and the costs to acquire said growth.
However, the 'real yield' thesis is flawed in isolation when not coupled with sophisticated constraints addressing the token supply, levers for demand, and designing the incentive itself. Inspired by its predecessors, including OHM and GMX, TapiocaDAO's time-weighted average magnitude lock ($twAML) is the next canonical and sound representation of 'real yield' in an incentive-compatible economic model. The reader can dive into the granularities here.
Whether real yield is objectively 'better' is a nuanced point of discussion. What can be said with relative conviction is that its reliance on defensible product market fit and value capture means there is no free lunch - "to get something, you to give something" -and the net positive of the stimulus should always exceed the costs.
Though not all 'real yield' is created equal, with reflexivity still bound to the effectiveness of the incentives, ‘real yield’ has become a vanity metric to justify the multiple used in valuation. Instead, we should be asking whether the protocol's defensible revenue flow supports the distributions of free cash flow at this nascent stage.
Compound, one of the most entrenched DeFi protocols with staying power, plunges further into unprofitability upon further issuance.. It is highly uncommon to distribute earnings for early-stage businesses, and surprisingly, EVERYTHING in crypto is venture stage with shaky product market fit. Thus, the value of tokens not conforming to the real yield narrative is based on the probability of future claims on protocol earnings once they have exhausted ALL internal ROI opportunities locally within the protocol. Although we are in crypto, we do not depart from the bounds of financial physics. Founders and developers of early-stage protocols should be optimizing for market share, not P/E ratios, for our friend Mr Buffet.
Questions remain:
What collective summoning of actions/behavior deserves to be incentivized?
What defines a token's value or discounted Future value if it does not share in generated fees? Timing: when to distribute based on measurable data points?
Perhaps, this forms the basis of future pieces. As discussed above, the definition of what constitutes "real yield" is a consideration theorized over discourse dating back centuries.
Perhaps the new substrate of programmatic yields mathematically defined by code better demonstrates the "true rate" as opposed to the perpetual inflation of a nation's currency based on electioneering decisions by central banks. Still, there remain open design questions within our realm of "real yield" that we must confront. If you are building a DeFi application that is experimenting with variations in the scalar of yield design and distribution, please comment or reach out!