Yields and Interests, Demystified…
Over the last two years, DeFi has exploded from a niche sector within an even more niche industry to drawing in billions of dollars of volume into its borrowing and lending platforms. Much of the hype surrounding DeFi is in its seemingly absurd interest rates, with double and triple-digit APYs dotted around the space. However, jumping into the world of decentralized finance without fully understanding how these platforms work can be confusing and lead to needless losses.
Decentralized lending and borrowing platforms work similar to how things function on centralized financial services, except instead of having a trusted intermediary like a bank, users interact with a smart contract. Lenders deposit capital into the smart contract to generate interest, while borrowers deposit collateral to loan those assets and return them with interest.
Lenders want higher interest rates, and borrowers look to reduce the cost of borrowing. Interest rates may be high, but in the cryptocurrency space, they are often variable, meaning they change alongside the volatile crypto market cycles. But how are these rates calculated? And are they as profitable as they seem?
Interesting Yield
Cryptocurrencies are bought and sold on exchanges, which are usually centralized parties that stand between buyers and sellers and ensure successful trades by charging a trading fee. Decentralized exchanges require users to trade with a smart contract while lenders supply capital to liquidity pools. By providing assets to the DEX pool, lenders earn rewards as a cut of trading fees, enabling much greater liquidity in decentralized markets.
This also eradicates counterparty risk since the rules are coded into the platform’s lending smart contract. However, DeFi isn’t risk-free, and these platforms can suffer from impermanent loss. This is where liquidity providers experience losses from asset devaluation due to volatility spikes in the market. While they can be recovered from if the asset recovers in price, this can lead to crippling losses if managed incorrectly.
“What is Impermanent Loss?” — Finematics✨
Further, not all of these platforms run on audited code, and they are susceptible to attacks from users with malicious intent. That being said, most popular platforms have been vetted for these risks. As long as you do your research and invest in projects valuable to the space’s growth, volatility spikes will recover in the long run.
Additionally, DeFi insurance is slowly becoming a more secure sub-industry of the blockchain space, helping investors hedge against thefts by bearing the risk for a periodic fee. Decentralized insurance also enables investors to fully protect their DeFi deposits against cryptocurrency volatility spikes and offers trustless claim and risk assessments.
Lending is probably the safest way to earn yield on cryptocurrency assets, and because loans are mostly over-collateralized, lenders are almost guaranteed to make no losses. Users can also generate yield through staking, which is how networks using the Proof-of-Stake consensus mechanism (and its variants) secure themselves.
Staking involves locking up tokens in return for staking rewards, and stakers can reinvest these rewards to compound their earnings. Staking does not have a comparable model in the traditional financial services space and dramatically benefits the blockchain ecosystem by ensuring markets have sufficient liquidity for applications to perform their desired functions.
Method to the Madness
Last summer, DeFi was all anyone could talk about, and this wave of hype has fueled a plethora of projects to enter the space. However, not all of them are worth checking out. The cryptocurrency space is notorious for its scams, and understanding how the technology works and brings value to its users is paramount to spotting a scam when you see one. As a rule of thumb, if it seems like a multi-level marketing scheme, it probably is.
It’s also essential to understand the difference between APR (Annual Percentage Rate) and APY (Annual Percentage Yield). In DeFi, for example, APR is the interest paid by borrowers on loans, while APY is the interest lenders earn for loaning out their capital. While this may seem like an insignificant difference, APR interest rates are not compounded.
Instead, it is calculated by multiplying the periodic interest rate by the number of periods where the rate is applied without indicating how many times the rate is applied to the existing balance. APY, however, does take into account the frequency of interest application — intra-year compounding — and is calculated using the formula APY = (1+R)^n -1, where R is the periodic rate and n is the number of periods.
This seemingly minor difference can have multiplied effects over time. For instance, a credit company could charge a 1% interest rate every month, which amounts to 12% APR, whereas the APY for a 1% interest rate compounded monthly could be 12.68% over the year. Borrowers are always looking for the lowest rates, and this can be confusing, especially for less experienced investors.
Some loans use this slight terminology difference to disguise a lower interest rate. When looking for a housing loan, for example, even a slightly higher interest rate can be devastating to borrowers in the long term. Some platforms also apply this logic to lenders, attracting liquidity providers by quoting the APY while disguising a lower APR rate of return.
Peaks and Valleys
Liquidity mining and yield farming are powerful tools for any investor in the DeFi space, but they can be confusing to newer users and can lead to preventable losses, especially during periods of high volatility. In addition, liquidity and collateral tokens can devalue just as fast (if not faster) than they appreciate.
“What is Yields Farming?” & “Is Yield Farming dead?” — Finematics✨
DeFi also suffers from sudden and destructive interest rate volatility spikes, which can lead to capital inefficiency. As many protocols continue to shift to Layer-2 solutions due to the current inadequacies of the underlying blockchain technology, capital will continue to become increasingly dispersed across these chains. This will make it progressively more challenging for individuals to track interest rates to manually transfer collateral between platforms to maximize profits.
With Fuji, loans are always offered at the lowest market rates, and to refinance loans, the platform automatically rebalances its pools, ensuring loans are always financed at the optimal rate and lowering interest rate volatility. Fuji also makes it much easier to manage debt positions, with the ability to manage every loan from the dashboard. In addition, using its FlashClose feature, the platform allows users to close positions without needing the borrowed assets. This is done by selling the collateral and repaying the outstanding debt in the same transaction.
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In the decentralized ecosystem, interest rates are derived algorithmically using the ratio of tokens between supplied and borrowed assets. Rates tend to rise with borrower demand, which varies based on the market performance and sentiment. The more assets in the pool, the more borrowers are incentivized to use the available liquidity. The more assets are borrowed, the higher the rate climbs.
For decentralized finance platforms, interest rates are generally a function of its utilization ratio, which is the ratio of assets in the pool that have been lent out. A balanced utilization ratio is a sign of a healthy lending market — under-utilization means too little interest is generated, while over-utilization cannot meet borrower demands.
Additionally, on platforms with a high utilization ratio, a surge in lenders withdrawing funds can cause a delay in their payouts until outstanding loans are paid back. The ideal interest rate model helps determine the equilibrium interest rate, where the total demand for borrowing matches the total lending supply. Algorithmic interest rate models are some of the most popular solutions today for a reason — they find this equilibrium efficiently in a way that’s easy to implement on-chain.
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