Why Does Crypto Offer Such High Yields: A Comprehensive Guide Pt.1
The second installment in our new series, “DeFi in Perspective”, by Banditx0x
Why Does Crypto Offer Such High Yields?
DeFi offers interest rates far greater than those found in traditional finance or banks. We will mainly discuss USD yields because they are what most newer DeFi participants or skeptics would be interested in. Defi also offers high yields on crypto tokens and, with the help of decentralized oracles, offers interest on real world assets such as foreign currencies and commodities.
In traditional markets, one would suspect that these “too good to be true” returns have to be scams or be counterbalanced by some hidden blowup risk. This article proposes that these high yields are generally the result of positive-sum, rather than zero-sum, interactions. However, we also acknowledge that ponzi-like economics do exist and have to be considered.
In crypto, there is a massive demand for liquid capital which isn’t adequately met by supply. Capital can be used to supply lending, liquidity and leverage. The crypto market is extremely inefficient, and yields vary dramatically depending on which strategies are being employed and which platforms are being used. The farming strategies that will be discussed are not the “best” yield farming strategies, but are simple examples to illustrate concepts that apply to the broader DeFi ecosystem. Knowing the source of crypto yields can help us earn interest on our capital and help us understand why these high yields will eventually come to an end.
The 5 sources of high yield proposed by this article are:
- High demand for USD
- Facilitating Leverage
- Liquidity Provision
- Early User incentives
- Farm and Dump schemes
High Demand For USD
The yields on USD stablecoins are extremely lucrative, but it is not enough to attract sufficient DeFi capital. Many DeFi users who know about the highest yields are also extremely passionate and optimistic about crypto, and find the prospect of earning two digit returns on fiat unsatisfying relative to the gains they expect from holding crypto assets.
An example of the extraordinary demand to borrow is that Binance customers are paying 0.06% per day to borrow USD, which translates to 124% per year.
Generally, crypto participants cannot lend out their own capital for as high returns as centralized exchanges. However, decentralized borrowing and lending platforms offer better interest than banks. They also allow funds to be used as collateral to borrow other assets.
The interest rate for borrowing and lending USD-based stablecoins is higher than other assets. This reflects the high demand to borrow USD, and the low demand to borrow crypto assets, as borrowing a crypto asset is implicitly shorting it.
Leverage
Futures contracts on exchanges such as FTX, Binance and DyDx allow extreme leverage for longing and shorting crypto assets, with some exchanges offering up to 125x leverage. The high demand to leverage long ETH and BTC causes the futures contract for ETH-USD and BTC-USD to trade at a premium to the spot price. Similarly, the perpetual futures contract for most tokens have positive funding rates, which means buyers of the futures contract constantly have to pay short-sellers a funding fee. Therefore, arbitrageurs can earn yield by holding an asset and then shorting an equivalent amount of the futures contract. In traditional finance, this is called a basis trade, with “basis” referring to the difference between the spot price and the price of a futures contract for that same commodity.
From one perspective, this is an arbitrage which takes advantage of the mispricing of two equivalent assets. Another perspective is that these traders are providing a service to people who want to leverage long crypto assets. Long positions, which are in high demand, must be matched with a short position, and basis traders step in to meet this demand.
Liquidity Provision
In liquidity pools, multiple tokens can be staked in order to allow people to swap between them. For example, the atricrypto pool in Curve requires liquidity providers to stake three stablecoins (DAI, USDC and USDT) and allows users to swap their stablecoins against your pool. Liquidity providers are paid a small fee for each transaction. The ability to swap stablecoins is useful because even though they are equivalent in value, protocols offer different yields on different stablecoins. In the Aave example above, USDC and USDT offer higher yields than DAI, so DAI holders may want to swap to a different stablecoin. Thus, your yield as a liquidity provider comes from providing a useful service to others.
Early User Incentives
Technology startups often aim to create a network which becomes more valuable the more people participate in them. They rely on venture capital to bootstrap their initial operating costs and offer services for free or at a heavily discounted cost to start the network. These networks such as Uber, Airbnb and Facebook are not useful without a wide user base, but once they are established, the same difficulty serves as a moat against competing businesses. Most DeFi protocols share the same network effects but have a different funding model.
DeFi projects takes the early user subsidization model to an extreme — instead of offering free or discounted services, crypto offers early users a token which represents a share of the protocol. This achieves two things:
- Attract initial users and liquidity to start the network
- Distributes ownership of the protocol to make it more community owned and decentralized
Some of these tokens are owned by the founding team which they can use to fund the project development and marketing.
Polygon, an Ethereum sidechain, is an example of early user incentives done well.
Polygon released their liquidity mining program which rewarded established protocols such as Aave and Curve with $5 million worth of Matic tokens to bring their projects to Polygon. These protocols distributed the Matic tokens to users, which meant that they temporarily offered far higher yields on the Matic chain than Ethereum.
DeFi users who were skeptical of sidechains because of security and centralization concerns bridged over to access the high yields. After bridging over, they experienced the benefits of low gas fees and fast transactions and, thus, some became permanent users.
Polygon’s liquidity program worked well because they had a useful product which could retain a permanent user base out of some early customers. Early user incentives can backfire when a product offers no lasting value proposition to users. In this case, the incentives attract users who deposit their funds to extract high yields and immediately leave when the incentive program ends.
Farm and Dump Schemes
Early user incentives taken to an extreme, combined with an absence of long term value, creates a zero-sum ponzi scheme. These are characterized by:
- Lack of innovation, such as forking a project without adding any new features.
- Lack of vesting (token lock-up) for founders. Most legitimate projects lock up the token supply for founders and investors to align their incentives with the long term value of the project or token. Without a lock up period, the founding team can sell their tokens for an early profit and abandon the project
- Hyperinflationary tokens, sometimes with unlimited supply cap. Inflation of token supply siphons away value from all holders of that token. Extremely inflationary tokens are “designed to go to zero”.
- No long term plan. Without long term development and support, protocols will eventually die out and the associated token will be worthless.
These projects can still be a source of yield as they are propped up by users that buy into misleading marketing and are unaware of the underlying mechanisms. It is a zero sum game, and the losers are those who hold or provide liquidity for the token. These participants are sometimes referred to as “exit liquidity” as yield farmers convert the tokens they earn from farming into assets with more sustainable long term value such as USDC or ETH. In some other schemes, early participants make profit by selling to later participants.
These tokens are “designed to go to zero” in the sense that the founding team makes no effort to create long term value for token holders and tries to extract value from the believers in a project in a zero-sum way. The tokens allocated to the founding team are often “dumped” onto the market. These protocols put extreme incentives to provide liquidity for the protocol’s native token, and users who naively provide this liquidity are often referred to as “exit liquidity”, as they allow users to swap their “worthless” farm tokens for assets with more sustainable value such as USDC or ETH.
These forks rarely have the network effects or continual innovation which will allow them to retain any long term intrinsic value. Participants can still profit from these farms by supplying assets such as ETH or USDC and being rewarded the farm token. It is best to sell the farm tokens immediately as they will be devalued by extreme inflation.
Are these high yields sustainable?
A common thread between all these sources of yield is that all of them depend on the crypto optimism. When people believe that crypto assets will go up in the future, yields generally increase. Let’s examine what happens to yields if this belief in crypto declines:
What happens to these yield sources when crypto enters a bear market?
Demand to borrow USD — Lower demand and greater supply as crypto is converted into fiat assets.
Leverage — Low demand for leverage as participants become more risk-off
Liquidity — If fewer exchanges between tokens and stablecoins occur, fees given to liquidity providers drop.
Early User Incentives — These incentives are generally rewarded in the protocol’s native token. If there is low demand for these tokens, their price drops, resulting in low returns.
Farm and Dump Ponzis — These low effort forks can thrive in a bull market but generally fail to attract capital in a bear market.
Conclusion
The current main sources of yield in DeFi will likely eventually decline. As DeFi becomes viewed as a legitimate industry, more conservative players with higher capital bases will eventually come in and dilute the yields. Fortunately, the space is rapidly innovating and constantly inventing more use cases of capital. In 2020, DeFi summer was declared to be over, yet we have seen high yields in DeFi re-emerge with more protocols, alternate chains and mainstream adoption. Currently, simple allocation strategies in DeFi offer better returns than any opportunities in the traditional world. Learning yield farming early will allow you to earn interest on your capital and prepare you to implement more sophisticated strategies as DeFi evolves and becomes more complex.
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