[Part 1] 4 sources of DeFi Yield
How the hell can you have 100% APY, a Bank of America analogy, and why there is no such thing as a free lunch
This is the first post of a two-part series on DeFi yields. Part 1 covers tactically where yield comes from and Part 2 talks about my thoughts on what underpins DeFi as a whole!
Introduction
You may not know much about crypto, but you probably do know someone YOLO’ing into “edible tokens”, “yield farming to make 1000% APY”, and/or rethinking their career trajectory to include crypto trading at Jane Street.
At the same time, we’re also starting to see legitimate crypto “neobanks” and pseudo-Wealthfront products like Eco, Dharma, BlockFi popping up that are literally a 10x better product because they have 10x yields that of premier saving accounts like Goldman’s Marcus. When you can get 5-10% rates vs paltry 0.01% rates, it piques a lot of people’s curiosities.
So what gives? Where are these yields coming from, are they sustainable, and is this all just an elaborate Ponzi Scheme?
Four Sources of Yield
There are four places where yield is coming from (in no particular order) -
Staking Rewards - Yield from securing a blockchain
Lending - Yield from people borrowing
Platform Fees - Yield for providing a service
Native Token Rewards (most interesting) - Yield for participating
Let’s go through each one.
Staking Rewards - Yield from securing a blockchain
The technology behind blockchain is one of distributed consensus - how do we get multiple, independent parties to agree on what the current state of the ledger is. These parties are doing work to “secure” the blockchain and stop frauds from changing the state. Rightly so, they want to be compensated for it.
The new consensus mechanism that many chains (including Ethereum) are adopting is called Proof-Of-Stake. Here, you’re “validating” the current state and putting up money as collateral, called staking. It’s kind of like betting - if you’re right about the current state (and right being that everyone else agrees with the state you propose) then you get a small reward. If you’re wrong (or lie/cheat and get caught) then you lose that amount.
Thus the first yield is coming from the reward being generated for staking and securing. For example, in an upcoming version of Ethereum (and live on a testnet already), the yield for staking and securing is currently 6.2%, and will follow a predictable pattern depending on the total amount staked.
Lending - Yield from people borrowing
If I lend money out, I expect to get it back along with some interest to compensate for not having it right now (time value of money). This is how banks work - they take deposits from people, lend it out, and then split the interest generated between themselves and the depositor.
Similarly in crypto, there are many people who would want to borrow your crypto right now and are willing to pay you a high interest rate for it. Examples of these lending protocols include Aave and Compound.
Okay you might ask, who is borrowing crypto and why are they willing to pay high rates? Well as you can imagine a lot of it is from speculators/traders - people want to lever up and believe the returns they can get from trading and investing is > borrowing rate.
A second source of borrowers are crypto holders who don’t want to spend their BTC/ETH (whether for ideological reasons, or because they think it could continue to go up) and thus are borrowing against it to maintain their exposure. So for example, you’ll see people borrow DAI (a stablecoin) with ETH as a collateral, and then go use that stablecoin for trading, real world spending, experimentation, etc.
Thus the second source of yield in DeFi is coming from the natural demand of borrowing. And for now, it turns out people are quite willing to pay for the privilege with Compound and Aave showing >2% for lending out DAI.
Platform Fees - Yield for providing a service
Typically when you use a service you pay a fee - for example, Coinbase (fee per trade), laser tag (fee per game), Barry’s Bootcamp (fee per class), AWS EC2 (fee per GB) etc. Typically that fee goes to the company as revenue and is used to pay suppliers for providing that service (“cost of goods sold”), employees for creating it, shareholders for providing capital, etc.
Similarly in crypto these “platform fees” are paid to those who helped provide the service. For example, the Coinbase equivalent in DeFi are decentralized exchanges (DEXs) like Uniswap that charge 0.3% for every trade made. The fees are then shared (albeit indirectly) with all the participants who help support the exchange, in proportion to how much and how they specifically supported. For DEXs, the support is often in the form of locking up your crypto, also known as being a liquidity provider. In the future, protocols like Uniswap can even turn on an additional 0.05% fee that goes to token holders directly (See my post on Uniswap & AMMs if you want to learn more!)
Thus the third form of yield is getting a portion of a platform fee for helping maintain a service. For a DEX like Uniswap, there were 1.18M in trading fees generated the day this piece was written, all of which eventually goes to the service providers.
Native Token Rewards - Yield for participating
This type of yield is in my opinion the most interesting. When I was at Uber we often used discounts and free rides as a way to encourage people to use the platform. Similarly when you start a company, founders often give equity to advisors to encourage them to help get customers, tweet, evangelize etc.
In crypto, many protocols are now giving rewards to users for using the platform in the form of a governance token. For example, if you borrow or lend on Compound/Aave, you get COMP and AAVE as a reward. These governance tokens are kind of like shares and give you the right to vote on changes to the protocol.
The real world equivalent would be if you get Bank of America (BoA) stock every time you took out a mortgage or made a deposit in a BoA savings account. Or if you got Starbucks stock after the 15th Pumpkin Spice Latte you purchased this week. Sure beats punch cards right?
There is a natural supply/demand for these governance tokens as well, and a big source of yield (especially the ridiculous ones you hear about) comes from equity growth in these tokens.
Thus the fourth type of yield is getting a reward for using these platforms in the form of a token, which then increases in value. Note this is different from the platform fee above - the yield is coming from participating and not necessarily running the service (more on this below).
Putting it all together
Often when you see crazy yields, it is a result of combining multiple sources of yield. So for example, you could lend on Aave and get yield there (#2) AND get yield in the form of AAVE tokens for for participating in the protocol (#4). Or you could help run a service like Uniswap and get trading fees (#3) AND get rewards for providing liquidity to certain trading pairs (#4).
Using our Bank of America example, the real world equivalent of the second example would be getting BoA stock for being a bank teller at BoA AND getting additional BoA/AAPL stock for using a new BoA supported Apple branded credit card.
Risks & Criticisms
You’re often told there is no such thing as a free lunch so it makes sense why people are suspicious. Hopefully by now you see there is logic behind the rates, but it’s worth looking into the risks and criticisms -
Rates are often shown as APY or APR - i.e. they’re annualized. However, crypto is such a volatile market that rates fluctuate all the time and aren’t the same for a few days let alone a year. Though note, there is a lot of work being done in making these rates more stable - like my friend Kenton with Sense!
Yields can have hidden losses - When you trade on AMMs you can have impermanent loss, where the underlying assets’ prices move more than the yield it generates. This can make providing liquidity (aka yield from participating/servicing) a bad overall strategy.
High gas fees - To use these DeFi projects you often have to pay gas fees (which goes to the miners for securing the blockchain - aka more yummy yield on top of the staking rewards we already discussed!). Oftentimes by the time you account for gas fees to use a protocol, redeem tokens, etc. the net returns are minimal. This too is changing rapidly as gas fees get lower with new scaling solutions.
Smart contract security risk - Remember that everything in crypto is just code that holds money which then talks with other code. This means if there is a bug, hackers can drain contracts and you can lose all your money very quickly. And because it’s all decentralized, there is no one you can go complain to.
Self custody - building on the third point, currently in most projects you’re responsible for everything and truly control the flow of money. This is great until it isn’t, and given most projects have UIs designed in 1999 Microsoft Paint, you’re inherently taking on this self custody risk. In fact, I personally believe one reason yields are so high is because you’re not paying someone else for protection (ex. Account recovery).
What’s Next
So are these rates sustainable? Is DeFi all one big scam? We’ll save that for the next post 🙂
Sources [1] [2] [3] [4] and countless conversations
Special thanks to Rob, Kenton, Rahul, and Vishnu for reviewing the post and providing their feedback! If you have comments/feedback/want to chat more, feel free to DM me on twitter or shoot me an email (parthchopra28@gmail.com) - would love to hear from you :)