Down the DeFi Yield Rabbit Hole



Disclaimer

Our content is intended to be educational and must be used for information and education purposes only. It is very important to do your own analysis before making any investment based on your own personal circumstances. You should take independent financial advice from a professional in connection with any information that you find on our page and wish to rely upon, whether for the purpose of making an investment decision or otherwise. Crypto is risky, constantly changing and complex, all information provided in this article is publicly available and subject to change by developers at any time.


Introduction

"An investment in knowledge pays the best interest." — Benjamin Franklin

Last week, the largest collapse in crypto history occurred — the collapse of an entire stablecoin. $60 billion dollars evaporated out of the Luna ecosystem (between UST and Luna) sending shock waves across the broader crypto markets.


Though many experienced crypto personnel and economists within the industry addressed and warned about the vulnerabilities of the Terra’s algorithmic stablecoin before its collapse, most investors turned a blind eye to pocket the high, stable yields (19.5%) from Anchor protocol.


For most individuals, under-indexing the death spiral mechanic in the Luna/UST proved disastrous.


Whilst generating an attractive passive income is one of the key value propositions of DeFi, it is important to understand how these yields are generated and the risks associated in each strategy.


In this article, we aim to take the reader through some of the popular passive income-generating DeFi strategies in the market and their potential risks that investors should consider when investing in them.


1. Lending

In decentralised or DeFi lending, investors can interact directly with the borrowers through pre-programmed smart contracts. In other words, DeFi lending platforms allow investors to enlist their crypto tokens, which can be loaned by borrowers and repaid within a set duration with interest. Investors can also use their crypto tokens as collateral and borrow against it (similar to pawning).


Popular DeFi lending platforms

Aave: Total crypto deposits as of 18/05/22 $10.85 billion

Total crypto borrowing as of 18/05/22 $3.40 billion

Compound: Total crypto deposits as of 18/05/22 $5.56 billion

Total crypto borrowing as of 18/05/22 $1.48 billion


Potential risks

Most lending applications do not require background checks that are essential to mitigate credit and fraud risks.

There could be bugs/vulnerabilities in smart contracts that will result in breaches/hacks draining investor funds/tokens.


2. Staking

Staking has gained a significant amount of attention over the past couple years. The easiest way to think about staking rewards, is as a dividends paid in the native token, where a token owner is incentivised to hold and lock up their tokens.


Proof of Stake

Staking was initially used to incentivise economic security for the consensus mechanism of a distributed network. Examples like Ethereum’s Beacon Chain or alternative Layer 1's like Solana or Avalanche — most often, these chains are referred to as Proof of Stake (PoS) chains.


PoS yields are typically on the low end by crypto standards, but low token emissions also means a more stable token supply. As PoS chains require their tokens to have value in order to economically secure the network, the balance of token supply and token price is very important to network health.


A list of PoS networks & their estimated staking rewards can be found here.


Popular PoS networks

Ethereum 2.0: Total Value Locked as of 20/05/22 $24.65 billion

Solana: Total Value Locked as of 20/05/22 $20.03 billion

Avalanche: Total Value Locked as of 20/05/22 $7.14 billion


Potential risks

During the Luna death spiral last week, the price of Luna fell so much that the cost of owning the network was only ~$2m — this led to the chain being halted multiple times. Fully understanding the token economic design of a protocol is required to understand when risk assumptions change. Example of PoS Pros and Cons can be found here.


dApp Staking

The other form of staking has nothing to do with network security, I call this dApp staking.

dApps are applications built on top of Layer 1 networks, 99% of new token projects that come to market are dApps. A simple analogy is Layer 1 networks are like iOS or Android, dApps are the applications you build on top like Spotify or Netflix.


dApp developers have realised that incentivised staking of their tokens creates a short term supply sink. Less circulating supply on the market often leads to higher token prices in the short-medium term.


Popular Staking dApps

MakerDAO: Total Value Locked as of 20/05/22 $10.37 billion

Curve: Total Value Locked as of 20/05/22 $8.83 billion

OlympusDAO: Total Value Locked as of 20/05/22 $357 million


Potential risks

Unfortunately, all staked tokens eventually unlock and enter the circulating supply at some point — likely significantly affecting the token price as unlocked supply floods the market. It’s extremely important to fully understanding the supply dynamics of a token, here’s a good article by Cobie looking at ApeCoin’s proposed staking mechanisms and dApp staking more generally.


3. Yeild Farming / Liquidity Mining

In the most simple sense — Liquidity Pools exist on Decentralised Exchanges (DEX) & Automated Market Makers (AMM) for token pairs to trade against one another. Liquidity Providers (makers) are people or institutions who provide liquidity to a token pair, and users (takers) swap those token pairs on platforms such as Curve or Uniswap for a small fee.


That fee is given to the Liquidity Provider, minus a cut to the platform. In addition to the swap fee, dApps will often provide additional incentives to people providing liquidity to their pools — as liquidity is essential to enable a healthy, active market.


Yield Farming is where Liquidity Providers actively search out high-yield opportunities, provide liquidity to those pools to reap the rewards, then move their liquidity elsewhere once it becomes sufficiently profitable to do so.


Popular Automated Market Makers

Uniswap: Total Value Locked as of 20/05/22 $5.84 billion

Curve: Total Value Locked as of 20/05/22 $8.83 billion

Sushiswap: Total Value Locked as of 20/05/22 $2.16 billion


Potential risks

Yield Farming takes a lot of active management and familiarity with dApps you’re interacting with. The risks are high, as new tokens often offer the higher APY %’s, but are typically more prone to hacks, exploits or rug pulls compared to more established names.

Impermanent Loss is also a big consideration when providing liquidity to both sides of a swap. This video from Finematics is a good introduction to IL.


Conclusion

This has been a high-level overview into the types of yield available in DeFi — it’s a fascinating industry that iterates quickly. Stay safe, always do your own research and manage your risks.


If you’d like to learn more or ask any questions, please reach out, we’re always happy to educate.


Authors

Cam is a Tokenomics Advisor & a Contributor to Australian DeFi Association. He owns ETH, CVX, USDC & USDT among smaller investments at the time of writing.

  • Follow camx on Twitter

  • Chat to camx on Discord


P.D. is the Co-Founder of Geminio & a Contributor to ausbiz, startup daily & Australian DeFi Association.

He owns BTC, ETH, AVAX, CRV, ANT, COMP, MATIC & various stablecoins at the time of the writing.


Further Reading:

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