Subverting traditional finance, how did DeFi's high yield come about?

Image source: Internet

Image source: Internet

Author: Bitui exclusive Chen Zou

In recent years, traditional banking business has become less and less popular, and the annual interest rate of savings accounts in some banks in the United States can even be as low as 0.1% (considering that the current inflation in the United States is close to 5%, savings accounts = coins ); while in the same period, the annual interest rate of deposits in Anchor Protocol is 20% (Note: Anchor Protocol was created based on the stable asset agreement Terra Money, which is a new type of savings agreement, which aims to coordinate blocks from multiple different PoS consensus Chain’s block reward to balance the interest rate, and finally achieve a stable yield storage rate) I think anyone knows which one to choose next.

Compared with other markets such as traditional finance, the rate of return of cryptocurrencies is very high, which is also the place that many skeptics attack. Abnormally high rate of return = Ponzi scheme, which seems to be logically correct. But we still have to research and understand by ourselves, and doing due diligence is more important than anything else.

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The high returns of DeFi are not only earned by Degen

• DeFi is probably known for its extremely high yields, even with relatively safe assets like USDC, USDT, DAI, and BUSD. You can also get pretty good returns:

• Stablecoin lending on platforms like Aave and Compound: 6-8% annualized yield

• Staking: 4-20% annual yield

• Liquidity mining: 50-200% annual rate of return

Yield of Degen flush earth mine: 200-30M% annual rate of return

Obviously, risk and return are also positively correlated in the crypto market. For example, lending your stablecoins to relatively safe protocols (Aave and Compound) can give you at least 4% per annum. The following chart shows Aave's annual rate of return:

The rate of return on lending comes from borrowers borrowing funds from the protocol and paying higher interest. The agreement made the spread between borrowing and lending, similar to what banks do today. If the demand for borrowing goes up, the rate of return on borrowing goes up as well.

The rate of return between different stablecoins will also be different. For example, the rate of return of USDT is often higher, because many investors have begun to shy away from USDT, which is currently plagued by various regulatory and shady issues.

• The risks involved in participating in this investment are:

• Protocols targeted by hackers

Insufficient collateralAll of these may cause investors to lose their principal. Cream Finance, which has been attacked one after another, is a good example. Bitui has made many reports on the project before,

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Liquidity mining

Liquidity mining

Becoming a lender is not the only way to earn Defi dividends, you can also choose to earn income by providing liquidity in the liquidity pool, that is, liquidity mining. This means that you can collect transaction fees as a market maker, and sometimes receive transaction fees as rewards in the form of governance tokens.

Encrypted financial consulting company Topaz Blue recently released a market analysis report, which mentioned that 49.5% of the liquidity providers on Uniswap V3 have had negative returns due to impermanent losses (but even so, the transaction fees provided by Uniswap are in In most cases, unpaid losses can still be compensated, which is why there are still a large number of investors willing to invest and provide liquidity) In fact, unpaid losses are more like an opportunity cost. You are not really losing, but the way you choose There is no other possibility (simply holding currency) to earn more.

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Illustration of gratuitous loss

Lending protocols can offer relatively high yields, often driven by the need for leverage. Part of this potential leverage demand comes from traders who make good use of the information. Often when they get some inside information, they prefer to invest in a desperate investment behavior.

Assuming that a trader knows in advance that the project will have huge positive news, the trader may borrow a large amount of USDC from the market at an annual interest rate of 8% (about 0.02% per day) and use it to accumulate a large amount of tokens . As long as the price of the purchased token fluctuates by more than 0.02% per day, the trader can profit from the loan. However, relying on insider information to operate huge orders is not a wise choice in the DeFi field. Such large orders will be recorded on the blockchain and eventually monitored by various detection tools (for example, Whale Alert ), thus becoming a "well known secret".

Assuming a 5 times leverage operation on the trading position, a trader can finally obtain 20% return, which is much safer than simply using one-way exposure, but at the same time the return is still considerable.

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In addition to traders, investors participating in liquidity mining also need leverage

Since many new protocols currently offer 30%-50% or even higher annual interest rates to attract liquidity providers, this usually drives up the currency price again (high yields attract more people to mine, and more people need to buy The protocol's native tokens participate in mining, thereby increasing the currency price) and creating higher yields.

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risk premium

Essentially present in all risky assets, a risk premium is defined as the premium for taking risk above the risk-free rate.

In DeFi, risk premiums can exist in multiple ways, from market risk to counterparty risk as well as illiquidity and volatility risk. The more risk an investor takes, the higher the risk premium, and the higher the risk compensation return. Trading in any crypto market is inherently risky, and the market demands a risk premium to compensate it for the risk it takes.

Market risk is the risk of the entire process of investing in cryptocurrency, which includes market volatility of the cryptocurrency itself, hacker attacks, private key management costs/risks, leverage, etc. Cryptocurrencies are often riskier than traditional financial instruments such as stocks, so investors demand a higher return for the risk they take. And DeFi can be regarded as a derivative of the encrypted market, which contains greater risks. All kinds of smart contracts will face risks brought by bugs, hackers, and project parties every minute, and it is not surprising that high returns are naturally .

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Agreement income

Agreement income

Another source of revenue is from agreement revenue. For example, a lending protocol like Aave uses revenue from the agreement between lenders and borrowers and distributes it to stkAave holders.

This aligns incentives between depositors and token holders, as they are now incentivized to deposit liquidity, accumulate governance tokens and stake them in yield, or sell them to others who want to capture that yield way people.

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Are high yields sustainable? (years or even decades)

In a bull market, the demand for leverage is often frighteningly high, as most investors want to invest more money to earn higher returns. And new projects have sprung up like mushrooms after the spring rain, which has created a large number of high-yield mining pools. While bringing in new capital, it has once again increased the market's demand for leveraged capital.

Theoretically, the income of the agreement will also increase significantly, because the bull market will generate more transactions, and more transactions means more transaction fees. It is a virtuous circle for the protocol to maintain a high rate of return and attract users from scratch.

But in a bear market, the situation is completely different. In a bear market, the prices of a large number of tokens plummeted, and there were fewer and fewer takers. The tightening of funds led to an overall decline in yields, and the demand for leverage also plummeted. This further leads to a decline in transaction volume and protocol revenue, creating a vicious cycle.

Since the beginning of last year, DeFi has been in a bull market. This means that the market demand for leverage is still high. And as long as innovation in this space continues, the asset class will continue to grow and yields will remain high. But even in a wild field, innovation and development will eventually encounter bottlenecks, so the high rate of return of DeFi is likely to be only a temporary phenomenon.

The market cycle will affect the demand for leverage, but the most important reference factor to know whether the income can be sustained is still whether the income of the agreement is sustainable, that is, the value created by the agreement itself, the problems it solves, and the impact these will have something that exists for a long time. You need to be hard to strike iron, and this principle applies everywhere.

This article is from Bitpush.News, reproduced with authorization.