In recent years, traditional banking business has become less and less popular. The annual interest rate of some bank savings accounts in the United States can even be as low as a ridiculous 0.1% (considering that the current inflation in the United States is close to 5%, savings accounts = throw money ); In the same period, the annual interest rate of deposits in the Anchor Protocol was 20% (Note: Anchor Protocol was created based on the stable asset protocol Terra Money. It is a new type of savings protocol designed to coordinate blocks from multiple different PoS consensus Block rewards of the chain are used to balance interest rates and finally achieve a storage interest rate with a stable yield) I think anyone knows which one to choose next.
Defi’s rate of return seems to be high and unrealistic in many cases. This makes people have to be curious. How do these rates of return come about? Are they really sustainable, or are they just Ponzi schemes?
Compared with other markets such as traditional finance, the rate of return of cryptocurrencies is very high. This is where many skeptics criticize. The abnormally high rate of return = Ponzi scheme, which seems to be logically correct. But we still have to research and understand by ourselves, doing due diligence is more important than anything else.
The high income of DeFi is not only Degen can earn
DeFi may be known for its extremely high yield, even with relatively safe assets such as USDC , USDT, DAI and BUSD. Can also get quite good income:
- Stable currency lending on platforms such as Aave and Compound: 6-8% annual yield
- Pledge: 4-20% annual rate of return
- Liquidity mining: 50-200% annual rate of return
- Return rate of Degen flushing earth mine: 200-30M% annual rate of return
Obviously, risks and returns are also positively correlated in the crypto market. For example, lending your stablecoins to relatively secure protocols (Aave and Compound), they can give you at least 4% of income per year. The picture below shows Aave’s annual return:
The rate of return on borrowing comes from the borrower borrowing funds from the agreement and paying higher interest. The agreement makes the spread between lending and borrowing similar to what banks do today. If the demand for borrowing rises, so will the rate of return on borrowing.
And the rate of return between different stablecoins will also be different. For example, the yield of USDT tends to be relatively high, because USDT, which is surrounded by various supervision and shady problems, has caused many investors to avoid it. Therefore, it is only natural that one point of risk can be exchanged for one point of income.
The risks of participating in this investment are:
- Protocol becomes the target of hacker attacks
- Insufficient collateral
This may cause investors to lose their principal. Cream Finance, which has been attacked one after another, is a good example.
Cream Finance’s liquidity pool was eventually completely emptied, and users of the product became victims.
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 you can also collect transaction fees as a reward in the form of governance tokens.
But providing liquidity is not a matter of zero risk. First of all, as a liquidity provider, you must hold at least two currencies, which means that you have at least two cryptocurrency exposures. Second, you may face impermanent loss. In this case, holding tokens is a better choice.
Crypto-financial consulting firm Topaz Blue recently released a market analysis report, which mentioned that 49.5% of 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, gratuitous losses can still be made up, which is why there are still a large number of investors willing to invest and provide liquidity.) In fact, gratuitous losses are more like an opportunity cost. You are not a real loss, just the way you choose. There is no other possibility (just holding money) to earn more.
Diagram of Free Loss
Loan agreements can provide relatively high yields, which are usually driven by the need for leverage. Part of this potential leverage demand comes from traders who make good use of the news. Often when they get some inside information, they prefer desperate investment behavior.
Assuming that a trader knows in advance that the project will have huge good news, the trader may borrow a large amount of USDC from the market at an annual interest rate of 8% (approximately 0.02% per day) and use it to accumulate a large amount of tokens . As long as the daily price fluctuation of the purchased token is greater than 0.02%, the trader can profit from the loan. However, relying on inside information to carry out large order operations 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”.
Another major incentive for the surge in demand for leverage is to carry out a market-neutral strategy (market-neutral strategy refers to the simultaneous establishment of long and short positions to hedge market risks, an investment that can obtain stable returns regardless of whether the market is rising or falling. Strategy, market neutral strategy is mainly based on quantitative analysis of statistical arbitrage) For example, traders can go long spot, short perpetual/futures, and collect capital premium from the exchange. Regardless of the price trend, whether it is up or down, a trader’s loss in one position will be offset by the gain in another position.
Assuming that the trading position is leveraged by 5 times, on a delta-neutral (meaning that a trading strategy is not affected by small price fluctuations of the underlying asset) position with a 4% annual return rate, the trader can finally get A 20% return is much safer than simply using one-way risk exposure, but at the same time the return is still considerable.
In addition to traders, investors who participate in liquidity mining also need leverage
For example, borrowing stablecoins at an annual interest rate of 10%, and then using the borrowed money to flush a pool of 30% of the annual income, this creates a perfect arbitrage opportunity. While earning 20% of the arbitrage space, you can also obtain The risk exposure income of the original mortgage token (used to exchange for the collateral of the stable currency). As long as there is such an arbitrage opportunity, there will always be a demand for high-interest loans in the market. This is the principle that the relationship between supply and demand creates high returns.
Since many new agreements currently offer 30%-50% or even higher annual interest rates to attract liquidity providers, this usually raises the price of the currency again (high yields attract more people to mine, and more people need to buy The original tokens of the agreement participate in mining, thereby increasing the price of the currency), creating a higher rate of return.
The risk premium essentially exists in all risky assets. It is defined as the premium for taking risks, which is higher than the risk-free interest rate.
In DeFi, risk premiums can exist in many aspects, from market risk to counterparty risk as well as illiquidity risk and volatility risk. The more risks an investor takes, the higher the risk premium, and the higher the risk compensation returns. Any transaction on the encrypted market is inherently risky, and the market requires a risk premium to compensate for the risk it takes.
Market risk is the risk of the entire process of investing in cryptocurrency, which includes the market volatility of the cryptocurrency itself, hacker attacks, private key management costs/risks, leverage, etc. Compared with traditional financial instruments such as stocks, cryptocurrencies are usually riskier, so investors require higher returns for the risks they take. And DeFi can be regarded as a derivative of the encrypted market, which contains greater risks. Various smart contracts face risks caused by bugs, hackers, and project parties every second, and it is not surprising that high returns are naturally. .
Counterparty risks also increase returns. For example, you would expect to be compensated for the risk of your counterparty going bankrupt or disappearing with your funds. If you trade futures on dYdX , dYdX is your counterparty. If dYdX is hacked, so will your funds. Therefore, trading futures on dYdX has a risk premium.
Therefore, DeFi also complies with the most basic financial rules, that is, the greater the risk taken, the higher the rate of return.
Another source of income is from agreement income. For example, a lending agreement like Aave uses the income from the agreement between the lender and the borrower and distributes it to stkAave holders.
Many DEXs such as PancakeSwap use protocol revenue to buy back and destroy their governance tokens, which has a certain deflationary effect on the tokens, thereby increasing the price of the tokens. Then by distributing value to token holders, a unique income model is created, that is, the agreement can distribute governance tokens as income. Because the person who invests in governance tokens has contributed to the development of the agreement, he will Being able to share the future cash flow of the agreement is similar to holding a company’s stock, but the stock cannot allow the holder to participate in corporate governance.
This aligns the incentives between depositors and token holders, because they are now incentivized to deposit liquidity, accumulate governance tokens and invest them in income, or sell them to others who want to obtain that income Way of people.
Is the high yield sustainable? (Years or even decades)
In a bull market, the demand for leverage is often appalling, because most investors want to invest more money to earn higher returns. New projects have also sprung up like bamboo shoots after a rain, which has created a large number of high-yield mining pools, which, while bringing in new capital, once again increase the market’s demand for leveraged capital.
In theory, agreement revenue will also increase substantially, because the bull market will generate more transactions, and more transactions mean more transaction fees. It is a virtuous circle to allow the agreement to maintain a high rate of return to attract users from scratch.
But in a bear market, the situation is completely different. In the bear market, the price 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 led to a decline in transaction volume and agreement revenue, forming a vicious circle.
Since the beginning of last year, DeFi has been in a bull market. This means that the market’s demand for leverage is still high. As long as innovation in this area continues, asset classes 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 yield of DeFi is likely to be a temporary phenomenon.
From a long-term perspective, the decline in yield is an inevitable trend. Comparing with a sword, just like the history created by the U.S. dollar in the field of legal tender, the rate of return on saving U.S. dollars in the 1980s was 20%, but with the Fed printing a lot of money, the rate of return has now fallen to 0%. This is a natural phenomenon. Therefore, the Defi market that follows economic principles will not escape this cycle after all.
The market cycle will affect the demand for leverage, but the most important reference factor to know whether the income can be sustained is whether the income of the agreement is sustainable, that is, the value created by the agreement itself, the problems it solves, and the impact that these will have Something that has existed for a long time. You need to hard yourself to strike iron, and this principle applies everywhere.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/where-does-the-high-yield-of-defi-that-slap-traditional-finance-come-from/
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