Where does yield come from, anyway?
One of the dominant narratives in DeFi is that regular people will be compelled to move their fiat into DeFi because of high yields. Empirically, this is true — lending rates for stablecoins on Compound today are >10% APY, and there are multiple “yield farming” opportunities with anywhere from 50% to 200% APY. In the real world, most banks give their customers sub 1% rates per year on their money.
However, when regular people hear these yield numbers for the first time, most express skepticism instead of confidence. This must be a scam! The yields must reflect some hidden risk that us crypto degenerates are not taking into consideration. This is a fair hypothesis — smart contract risks are difficult to quantify, so maybe lenders demand high rates from borrowers to compensate them for that risk.
Looking at Compound’s historical lending rates for USDC, we can see that rates have fluctuated between sub-1% all the way to 10%+ over the years. The smart contract risk has not changed meaningfully here, hinting that high rates are probably more demand-driven versus supply-constrained. Now that we have figured that out, why are borrowers willing to pay such high rates to borrow cryptoassets?
Zooming out slightly, lending out assets is only one of the ways people can earn yield. To truly understand where yield comes from, we need to think hard about how money grows in the first place, and why you can get paid for putting your money into something. I posit that there are four categories of where yield comes from: Demand for Borrowing, Exchanging Risk, Service Provisioning, and Equity Growth. This essay will examine each one in detail to try to understand DeFi yields.
Natural Demand for Borrowing
The most obvious source of yield comes from the fact that there exists some natural demand for borrowing. Businesses need to borrow assets to purchase capital goods, banks need short-term loans to finance their activities (repo markets), and individuals may need to borrow to pay for college tuition. Because this natural demand for borrowing exists, markets for borrowers and lenders start to form, and these loans get priced — one man’s demand for borrowing assets is another man’s yield. Looking out into the future, it is also highly unlikely that these yields will eventually dry up because this natural demand for borrowing persists at a very fundamental level.
Another reason why there exists natural demand for borrowing assets is because people desire leverage. As some people say, “leverage is a helluva drug”.
Investors who are extremely bullish on an asset may want to borrow cash to buy more of that asset, especially if they expect that the asset growth will be greater than the interest rate they are paying to borrow. This is extremely clear in the context of DeFi. Interest rates on platforms like dYdX and Alpha Homora are amongst the highest in all of DeFi, because those platforms have created very simple ways for borrowers to use those assets for leveraged positions. To create high yield products you need to stimulate high demand for borrowing, and leverage is one of the best ways to stimulate borrowing in the current market environment.
Another source of yield that is orthogonal to the demand for borrowing is through exchanging risk. The simplest example here is insurance. Alice may want financial protection in the case that she is involved in an accident and is willing to pay Bob for this. In essence, Alice and Bob are exchanging risk with each other, and Bob gets paid some yield for taking on that risk.
Another prominent example of exchanging risk is through options contracts. Options buyers are willing to pay a premium for protect themselves against large moves in asset prices, and options sellers earn some yield for being on the opposite side of the trade.
One of the newer ways of exchanging risk in DeFi is through tranching risk. Protocols like Saffron Finance take a stream of cash flow and split it into different tranches — a junior tranche which has a larger share of the cash flows but has to bear the risk of the cash flow diminishing, and a senior tranche which gets paid a smaller, but guaranteed, share of the cash flow. In essence, the junior and senior tranche are exchanging risks with each other, and they both end up being yield opportunities with different risks.
These risk-exchange contracts are a huge market in traditional finance, because there is always intrinsic demand for risk exchange, driven by the fact that different individuals/institutions have inherently different risk profiles. Because of this, I suspect that this will also become one of the primary sources of yield in DeFi in the long term.
One of the less intuitive ways that one can earn yields is by providing a service using your assets. For example, a money changer can charge a fee because they are using their assets to provide a service, in this case, the convenience of swapping between two currencies. Another example is an ATM — by having cash in the machine, it allows customers to withdraw money from their bank accounts immediately to pay for goods and services. This is a service, and customers are willing to pay for it.
In the case of DeFi, providing liquidity into an AMM falls into this category of yield-generation. By supplying your assets into this AMM-machine, you are effectively providing a service to users who want to swap assets. And in the case of Uniswap, you are rightfully compensated 0.3% for each trade that occurs.
As long as we expect demand for these services to persist over time, we can also expect that their respective yields will persist. However, providing this service comes with its own risks, namely the Impermanent Loss that arises from providing assets to AMMs. Over the long term, if the costs of hedging against these risks are sufficiently less than the fees they earn from providing the service, AMM asset provisioning will remain a yield-positive endeavour.
Lastly, another source of “yield” comes from the value of equity growing. For example, if you lent money to Uber at the seed stage in exchange for equity in the business, your yields on that investment would be phenomenal, primarily driven by the growth of the equity.
Much of the high yields in DeFi today is driven by this growth in the equity (the cryptoasset). For example, when you “Yield Farm” on Compound, you are effectively lending money to the protocol PLUS getting free equity (free $COMP). Because of this, you are earning the base yield from lending assets (natural demand for borrowing), plus the “yield” from $COMP tokens appreciating in value. Because DeFi assets are currently in a hypergrowth phase, most of the insane yield numbers that you see come from this equity growth.
Many DeFi protocols see this endeavour as a short-term way to acquire users onto their protocols. By giving out free equity, they hope to win over a large group of users. Because of this, the current dominant strategy for asset owners is to “yield farm”, a.k.a collect these equity incentives for free, and pray that the equity value of these assets goes up, skyrocketing their overall yield.
It is unclear if this source of yield will continue to persist over the long-term. Once protocols realize that the equity incentives they are distributing for user acquisition may not be worth it, they may shut off these incentives. In this future, the primary strategies for earning yield in DeFi will likely be driven by one of the other 3 factors instead of equity growth.
As the DeFi ecosystem matures and progresses along the S-curve, we will likely see yields collapse from the ridiculous 1000% APYs to something more “normal”. Equity incentives will likely diminish over time, and the assets will fall out of their hypergrowth phase. In this future, I expect to see more sophistication on the Risk Exchange front, as people engineer more complex financial products that can boost yields.
Ribbon Finance is creating a protocol for the construction of these complex financial products, and aims to simplify them so that they will be highly accessible to a large retail audience.
Special thanks to Dave White for helping me think through this and organize my thoughts around this topic.