Defi Yields in (4) Minutes
Where does your APY come from? It’s simpler than you might realize
Inflation has sat in the purview of nearly everyone in light of Covid-19 stimulus. In the case of the US economy at least, Americans have debated whether or not using our currency as an economic crutch is worth it.
The important thing to realize is that inflation is generally a good thing in moderation. Money is subject to supply and demand like any ‘thing’, such as a designer handbag, milk, or stock in a company. It’s just that we don’t see rapid changes in the value of a dollar since there’s so many of them and the Fed works to stabilize its value. In other words, for the value of the dollar to change noticeably for people like us, a major world event would have to happen, such as a pandemic, or a war that shuts down the trade of a necessary commodity.
When the value of a currency increases rapidly, people are incentivized to acquire and hold more of it. This can cause problems for the economy because if people aren’t spending money, then businesses can’t operate and pay their employees, and so on and so forth. It’s better then to have slight inflation where the value of the dollar slowly falls in order to incentivize spending. (This is somewhat of a simplification. If you want to know more about this specifically then search “the velocity of money”).
You can view the economy as a giant pie, and each dollar is a tiny slice. The growth of the pie with the same number of dollars floating around represents deflation. Since everyone would have the same fraction of the whole thing, their true amount of ‘pie’, or wealth, increases. Alternatively, if the Fed prints about the same amount of new dollars as there is economic growth, then people’s share of the pie decreases, but their true amount of pie remains about the same. This concept of share-of-supply versus real wealth is important to understand because nearly every token in existence — even Bitcoin and Ethereum — adheres to these rules.
In the case of Ethereum, for example, money printing occurs as a security subsidy to the miners (soon to be stakers). An investor who simply buys Ether and does nothing with it is being diluted; their share of the Ethereum ‘pie’ shrinks as more tokens are mined and put into circulation. However, the dollar value of their portfolio may still increase if more money is invested into Ethereum than the value of tokens sold + the value of tokens created. These factors are ultimately influenced by the opinion of investors.
In the summer of 2020, Compound Finance, a money lending platform built on Ethereum, popularized a system of money printing that miraculously both increased the supply of their platform’s token, but also increased the price of an individual COMP token — for a short time at least.
Lol it’s not that simple, of course, but that description isn’t that far off. What occurred is that Compound used a system of token creation and distribution called ‘liquidity mining’. Like how miners are paid for their services, Compound would pay people who simply used the platform: either lending or borrowing. The payment would come from the spontaneous creation of the Compound governance crypto, COMP. Think of it like earning loyalty points or airline miles but turned to the extreme.
This liquidity mining system had a handful of resulting effects that benefitted Compound as a whole. The first effect of this type of token distribution was that it gave many of the people who used Compound a stake in the platform itself: COMP is a cryptocurrency that can be bought and sold, but it also represents voting rights for any changes to the Compound platform. In a sense, COMP is a crypto-stock.
The second thing that happened was that it influenced a whole ton of people to use the platform. Since everyone who lent or borrowed essentially got free crypto on top of earning interest, it became very beneficial to use Compound as a way of earning a little extra on your investments. You would achieve what you needed to normally on the app, then sell the COMP that you received for additional profit.
Of course, this system of money printing isn’t sustainable. When the number of slices to the pie keeps increasing, there will always be someone who’s short-changed. In this case, the people who got the worse end of the deal were those who simply bought COMP on the open market and held: mostly investors on places like Coinbase. As time went on, the rate at which COMP was being printed grew faster than the project could handle. The dollar value of these investors’ COMP holdings decreased even though Compound itself was still growing and seeing more usage.
And that’s one of the many unsavory truths about Defi: builders and long-time investors have no issue with making a profit at the expense of less aware investors. Even if everyone profits today, those on the better side of the knowledge gap will simply extract returns on their investment from less experienced users.
There are ways to protect yourself from being diluted in this way such as staking or minimizing holding periods. However, every Defi project is different and there’s no single strategy that’s optimal to use when investing across all of them. That’s why you should always understand the tokenomics behind a given project. No matter how much the next hot dapp might grow, it won’t mean much if you don’t actually position yourself to benefit from that growth. Like always, DYOR.