Original compilation: Block unicorn

Original compilation: Block unicorn

One of the most notable features of decentralized finance (DeFi) is the popularity of the concept of "yield". To attract users, new protocols are touting ridiculously high numbers every day: 97% APR for these tokens, 69,420% APY for these tokens, etc. Of course, this feature of DeFi also makes newcomers suspicious. How is it possible for a new protocol on the blockchain you've never heard of to earn 1 billion percent when the interest rate on a typical savings account is 0.5 percent?

This article will demystify the concept of DeFi yield. We will list the most common mechanisms by which DeFi protocols provide yield to their customers. In particular, we will make the following arguments:

DeFi income comes from the value of the underlying DeFi protocolfirst level title

1. The definition of "production"

For the purpose of this article,We define yield as the rate at which financial conditions are expected to yield value.This is roughly in line with TradFi's (traditional finance) definition of a bond's "Yield to Maturity" (YTM), the rate at which a bond reaches par at current prices. Broadly speaking, if you hold 1.0 units of value and deposit it into an agreement that yields 10%, you should expect to own 1.1 units of value after a year.

2. Face value

valuevaluevaluevalue”? The truth is, it’s up to you:Understanding denominations of value is key to understanding DeFi returns.

For example, suppose a DeFi protocol offers a 1,000% yield on staking its native asset token. The token is currently trading at $2 per coin. You take $100, buy 50 tokens, stake the entire amount, and expect to receive 50 * 1,000% = 500 tokens at the end of the year.

A year has passed and you have indeed received 500 tokens in return: you have earned 1,000%! But now, these tokens are only 1 cent each, which means that your total value of 500 tokens is 5 dollars, and you have suffered a 95% loss in USD terms. On the other hand, if each token is priced at $20, you now have $10,000 in chips for a yield of 10,000% in dollars.

The point is: whether you think the 1,000% gain in these tokens is higher than the 95% loss in USD value is up to you, depending on whether you think the intrinsic value of these tokens is higher than USD. (In this case, it probably won't.)

This example is used to illustrate that to understand the benefits of the agreement,You must understand the assets paying the proceeds, the potential fluctuation in the value of the yield-paying asset is a risk that needs to be considered.

3. Calculate output

Even with the correct denomination of value, the way yields are calculated can vary widely. Here are some common things you should be aware of when you see extremely high yields.

1. APR and APY:The annual percentage rate is the amount of added value you accrue each year. Annual yield is the amount of added value you accumulate each year, assuming compounding (i.e. reinvestment of dividends). Depending on the specific protocol, it may or may not make sense to assume compound interest; use a number that is more appropriate for the protocol.

2. Lookback period:The APY data you see on DeFi protocols can be based on data from some time period in the past: it could be the past day, the past week, the past year, or anything else. Given the variability in market volatility, protocol performance, etc., APY can be expected to vary significantly. Accordingly, projected APY may or may not be similar to actual APY, depending on past and future market conditions. Mitigate this risk by understanding the time frame over which the agreement's APY data is calculated.

Explain APR: APR stands for Annual Percentage Rate, which is the actual annual rate of return, without considering the impact of compound interest.

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DEX / AMM

Decentralized exchanges (DEXs) and automated market makers (AMMs) are typical examples of yield-generating protocols. They are a seminal achievement in financial engineering, dubbed "the zero-to-one innovation of DeFi".

Here's how they work: Liquidity Providers (LPs) deposit pairs of tokens into a liquidity pool. The purpose of these pools is to allow traders to exchange one token for another without an intermediary; the exchange rate is determined algorithmically based on formulas such as constant product. In return for depositing these tokens, LPs receive a portion of the fees charged to traders proportional to the liquidity they provide to the pool, usually in the denomination of pool tokens.

For example, in the past 24 hours, the TraderJoe USDC-AVAX pool received $156,000 in transaction fees paid to LPs. Given that the pool has a total value of $166 million, this corresponds to an annual interest rate for liquidity providers of $156,000 * 365 / $166 million = 34.2%.

A similar setup in traditional finance (TradFi) would be a centralized order book that tracks the highest bid and lowest ask prices for an asset in the market. The big difference is that in a TradFi setup, it is exchanges and brokers who charge transaction fees, while in DeFi it is LPs who charge the same fees. In DeFi, anyone can participate in any aspect of market making, which is a beautiful fact.

LPs are not without risk: LPs may suffer impermanent losses if the relative value of tokens changes significantly. As with any DeFi protocol, smart contracts are also at risk of hacking and exploits.

But fundamentally, the source of income for DEXs and AMM LPs is clear: they come from transaction fees. Traders are willing to pay these fees because DEXs and AMMs are providing valuable services: liquidity pools and automated algorithms for swapping assets. The more popular the trading pair, the larger the trading volume, the higher the fee, and the higher the LP's income. in other words,The income comes from the value of the underlying protocol.

5. Lending pool

Lending pools are similar to DEX/AMM in order to provide liquidity. The difference is that liquidity is provided in the form of debt rather than sales.

Let's take AAVE as an example. Users can deposit their funds into a lending pool and expect to earn a variable or fixed rate from it. On the other hand, a borrower can deposit an asset as collateral and take out a loan against any other asset at the value of a certain percentage (collateralization rate) of the collateral. As long as the value of the collateral does not fall below a certain threshold relative to the loan, the loan remains "healthy" and the borrower has unlimited time to repay the loan, including interest. However, when the value of the collateral falls below a threshold, it is liquidated (i.e. sold off) and the debt is canceled.

For example, a borrower might want to take out a loan in USDC to pay for their groceries. To do this, they deposit ETH, and two scenarios will result in their ETH being liquidated and their loan closed: 1) if the price of ETH falls enough, or 2) if the loan accrues enough interest. As long as neither of these events occurs, the loan will remain open. After the loan is repaid, the borrower gets their ETH back.

Again, liken it to a TradFi setup: In a centralized world, it's the banks and other institutions (like Fannie and Freddie) who charge interest rates, passing the often very low rates on to savers. In DeFi, lenders themselves can capture this value, and the interest rate is algorithmically set by open-source code.

Clearly, this type of service has intrinsic value: the ability to automatically cover, originate, liquidate, and close loans without a financial intermediary is valuable in itself: it removes the possibility of human error, improves capital efficiency, etc. If you Lend assets for this purpose,You will be compensated for contributing value to the protocolfirst level title

6. Pledge

Many protocols use the term "staking" to refer to any asset lock, but this is incorrect. Staking in the true sense is risking value loss in order to gain potential value.

In my opinion, the best example of staking generating yield is the proof-of-stake mechanism, which is adopted by blockchains such as Cardano, Solana, and eventually Ethereum. These algorithms may be esoteric, such as Ouroboros and Last Message Driven Greediest Heaviest Observed SubTree, but the intuition behind them is simple.

Proof of Stake is about ensuring that transactions on the blockchain have integrity - no double spending, false accounting, etc. To ensure that a series of transactions has integrity, validator nodes check that each transaction is valid against blockchain rules.

How can we trust validators to work honestly? This is where Proof-of-Stake comes in. At a high level, it works like this:

1. The user mortgages some assets to the verifier.

a. Once staked, there is usually a minimum lock-up period, ranging from a few weeks to a few months. Eventually, users can redeem their assets.

2. For every honest work done by validators (such as computing transaction integrity, voting on correct blocks, etc.), they will be rewarded.

b. Rewards will be paid to stakers, this is the yield.

3. For every dishonest work done by a validator (such as breaking the rules, cheating, going offline, etc.), they will be slashed (i.e. a portion of the funds are taken away).

c. Penalties are earned proportionally from stakes.

4. Validators verify and vote on each other's work to decide honesty/dishonesty.

The security of a Proof-of-Stake network comes from the fact that the amount of funds required to control enough validators to make the entire network dishonest is intractable.

The de facto successor to Proof of Work, Proof of Stake is a landmark achievement in the field of distributed consensus. By locking your assets to validators, you earn income by contributing to the security of the underlying network, which is inherently valuable, and you run the risk of losing money if validators are dishonest or compromised.

7. Good benefit device

If you don't want to think too much about how to generate returns, an optimizer might be for you. These are brain teaser mechanisms that take your assets, perform a bunch of DeFi operations behind the scenes, and eventually return more assets to you. Probably the best analogy for this kind of operation is a mutual fund or a hedge fund: you don't actually make the investment, you outsource it to an algorithm.

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1. CREAM Lender Optimizer

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2. Vesper Finance reinvestment

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3. Borrowing

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4. Representative of MakerDAO

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5. League DAO reinvestment

Give LINK to League Dao to get LEAG. Earned tokens are harvested, sold for more LINK, which is deposited back into the strategy.

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Gro Protocol Capital Allocation

Yield optimizers are attractive because they blend multiple strategies, so if any one fails, you may still end up making money with the others. They also save you time researching how any individual protocol works. That is, you take the risk of trusting the author of the optimization strategy --How much you will earn depends on how good your optimization strategy is。

8. Derivatives

Financial derivatives are an increasingly popular area of ​​DeFi, with increasingly complex products becoming available. In our last article, we introduced Dopex - a decentralized options exchange that allows users to earn yield with a single-collateral options vault. Another great example is Ribbon Finance, which provides users with the mechanism to write covered calls and sell puts on DeFi assets. In these cases, the resulting yield comes from taking the risk of some price action of the underlying asset.

Derivatives are a double-edged sword. On the one hand, the ingenuity of these protocols is filling a niche that will no doubt become more valuable as DeFi matures as an industry. On the other hand, these are fairly complex financial technologies that the average DeFi participant cannot be expected to understand. If you want to benefit from a derivatives-based agreement,Then it's important to understand how the structure of derivatives directly relates to your returns!

9. Governance

Governance tokens are one of the largest sources of advertising revenue, but they are also arguably the most difficult to understand. As the name suggests, these tokens give holders the right to participate in the governance of the underlying DeFi protocol through proposals and on-chain voting. These changes can range from minimal parameter changes (eg "increase this vault's interest rate by 0.1%") to entire ecosystem overhauls (eg MIM and Wonderland merger).

When DeFi protocols first started, they typically rewarded liquidity providers and other early participants with their protocol’s governance tokens, a process known as “liquidity mining.” They will also launch liquidity pools for their governance tokens on the DEX so that these tokens can be exchanged for common assets like USDC and ETH. This results in the market price of the token.

The question then becomes: why are governance tokens valuable? A standard answer is that governance tokens are similar to equity in a company. In theory, you are entitled to a portion of the future cash flows of the agreement, and you also have some decision-making power over it. In practice, however, this may or may not be the case: Depending on the structure of the protocol, revenue may go primarily to the treasury rather than governance token holders. Due to coin constraints, the decision-making power you have is only proportional to the number of tokens you hold.

It becomes particularly difficult to reason about when governance tokens exhibit a recursive structure - i.e. holding tokens leads to the right to control or participate in future distributions of such tokens. This dynamic is covered extensively in our article covering The War on CRV.

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10. Rebase Tokens

As detailed in our post on [redacted], the redacted token, or sometimes calling itself a "reserve currency", refers to OHM and its forks.

Rebase explained:Rebasing is to apply a series of commits to another branch in the original order, while merging is to combine the final results.

Rebase tokens are fundamentally defined by the rebase mechanism of the same name, which simply means that if you lock your currency in a staking contract, the amount of currency you hold increases by a certain percentage over a fixed period of time. Say 8 hours, this compounded frequency results in an astronomically high APY. For example, currently, OlympusDAO offers a reward of 0.3265% per epoch (8 hours) on staked OHM, resulting in an APY of 3,450%.

Of course, if you have been reading this article carefully, you will easily see that an increase in the amount of the base currency does not necessarily mean an increase in value. That is, if the number representing the quantity of money doesn't meaningfully correspond to something intrinsically valuable -- like software that facilitates financial transactions, or a real-world asset like the U.S. dollar, or a share of a protocol's future revenue -- then the currency A higher amount doesn't necessarily mean you have more value.

Recently, there has been a reckoning for rebasing tokens as more players realize that their high APYs don't actually mean they hold more value. Below is a chart of market caps for OHM, TIME (Wonderland) and BTRFLY ([redacted]):

OHM's market value has fallen by 85% in 3 months.

TIME's market capitalization has been volatile and has lost 52% over the past 3 months.

BTRFLY's market cap fell 48% in 3 months.

valuevalue，rather an inflation based monetary tool。

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Twitter from zachxbt.eth

To be fair, some of the Rebasing Token community has discussed changing the dynamics, possibly triggered by the recent price crash. Additionally, these tokens are backed by treasuries and revenue streams, such as OlympusDAO’s protocol-owned Liquidity-as-a-Service.

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11. Conclusion

There are many ways to earn income through DeFi, some low-risk and some high-risk, but in all cases, you should understand where the income is coming from. The more the underlying agreement is worth and pays you, the more certain you can be that you won't lose money. Since DeFi revenue comes from the value of the underlying protocol, your key job is to determine the value of the DeFi protocol, and I'm here to help you do that.