Understanding DeFi: how does DeFi pay such high yields?

Decentralised finance has created a world of new possibilities for digital assets. Ethereum’s DeFi ecosystem lets users lend, borrow, swap and stake their assets in a permissionless and trustless manner, acting as a new Internet-native alternative to the traditional finance system. Of all the advantages DeFi offers over TradFi, the ability to earn high yields might be the most significant. Though interest rates vary, it’s common to earn between 5% and 15% APY on your crypto holdings, and sometimes the rates can be much higher. In this feature, we answer three questions: What is yield farming? How does DeFi pay such high yields? And is it all a ponzi, or is this truly a revolution in Internet finance?

An introduction to yield farming

DeFi exploded in 2020, thanks mainly to the emergence of an innovation called yield farming.

Without a doubt the biggest catalyst for DeFi’s growth has been the emergence of yield farming.

In its simplest terms, yield farming refers to the process of earning on your crypto assets.

Earning interest on your savings is not a new concept. In the traditional banking system, people store their funds in banks, and they get paid a small interest rate in return for lending out their assets. Through the 1980s and 1990s, banks would typically pay anywhere between 5% and 10%, whereas today the rates are closer to 0.5%.

DeFi creates an alternative way to earn on your assets: rather than locking your fiat money away in a bank account, you can now lock up your crypto assets in smart contracts in exchange for yield.

Yield farming is associated with lending, and it’s made possible through liquidity pools. Users can lock their assets in a smart contract to earn yield on their holdings. In some instances, it’s even possible to earn yield for borrowing assets.

Yield farming is usually associated with stablecoins, but it’s also possible to earn yield on volatile assets.

The most advanced yield farmers leverage Ethereum’s composability to develop strategies across multiple liquidity pools to maximize their returns. For example, farmers may borrow DAI by depositing collateral to Aave, then lend out the DAI in another protocol to earn yield.

Important note: it’s worth noting that yield farming requires trusting stablecoins or other types of crypto asset, which carries an element of risk. Many stablecoins depend on a centralised issuer, and they could lose their peg. Moreover, the yields paid in DeFi are not guaranteed or as secure as banks because there is no deposit guarantee or state backing. Therefore, DeFi users should take caution and be aware of the risks.

Demand for leverage

DeFi opens up the possibilities of finance and presents users with many opportunities to profit.

This creates demand for leverage — DeFi users borrow assets with the expectation that they will be able to make profits that exceed the interest payable.

Yields are typically measured in APR (annual percentage rate) or APY (annual percentage yield), and the borrowing rates tend to be higher than the lending rates paid for the same assets.

The demand tends to be highest for stablecoins like DAI and USDT as they are not as prone to price fluctuations.

This creates an environment where it’s possible to earn high returns for lending out assets — often far exceeding the rates paid by banks.

Earning native tokens

One of the biggest challenges DeFi protocols face is attracting liquidity. DeFi needs deep liquidity for liquidity pools to work, which is why the landscape can be so competitive.

Many DeFi projects offer token rewards as a strategy to attract liquidity. For example, when SushiSwap launched as a fork of Uniswap at the height of DeFi summer, it carried out a “vampire attack” by offering SUSHI rewards specifically to Uniswap liquidity providers. This drained liquidity from Uniswap and likely set the stage for the launch of UNI — Uniswap’s native token.

Another reason DeFi projects launch tokens is to give ownership of the protocol to users — after all, this is decentralised finance. Token holders often have a say in the governance of protocols and can vote on key decisions. Issuing tokens is one important way for DeFi protocols to establish that they are truly decentralised, which can also be important from a regulatory perspective. While regulators may not be fond of tokenized stocks on centralised exchanges like Binance, there’s little they can do to shut down sTSLA on Synthetix.

In many cases, DeFi users can earn a protocol’s native token by providing liquidity to a pool. For example, SushiSwap users can earn double rewards in both SUSHI and another asset by providing liquidity to the protocol.

The process of earning a protocol’s native token by providing liquidity is known as liquidity mining — a turbocharged take on yield farming that grew in popularity after Compound launched its COMP token in May 2020. Users found that they could profit by borrowing assets to farm COMP, leading to a 1,400% price increase in the space of a few days.

DeFi users can also earn native token rewards through staking, which involves locking up assets in the protocol. For example, Synthetix users earn SNX rewards weekly in return for staking SNX. Like yield farming and liquidity mining, the rewards for staking vary depending on the protocol.

Earning protocol fees

DeFi protocols charge small fees for activities such as borrowing and swapping assets. Many DeFi projects distribute a portion of the fees they earn to other users in exchange for providing liquidity. This allows liquidity providers to earn on their assets, with rates varying depending on the amount of activity the protocol attracts.

Data from cryptofees.info shows the fees various protocols earn — Ethereum staples like Uniswap, Aave, SushiSwap and Compound are among the highest earners today. Uniswap, for example, charges a 0.3% fee that gets distributed to liquidity providers.

Many DeFi governance tokens have been dubbed “productive assets” as they earn a portion of the protocol fees. SushiSwap, for example, charges a 0.3% fee: 0.25% gets distributed to liquidity providers, but the remaining 0.05% is allocated to SUSHI token holders.

Yield optimisation tools

As DeFi expands at such a rapid pace, and the level of liquidity in pools constantly changes, it can be challenging to chase the best yields. The problem of finding out where to put DeFi assets to work has led to the emergence of yield optimisation tools, which aim to find the best rate across the DeFi ecosystem for users. They often pay higher rates than those offered in regular lending and borrowing protocols. By far the most popular yield optimisation tool in the Ethereum ecosystem is Yearn.Finance. Launched by cult DeFi builder Andre Cronje, the protocol lets users deposit their assets — both stablecoins and volatile assets — which are then deposited to liquidity pools across DeFi to provide the best rates of returns for users. Yearn’s popular Vaults product borrows stablecoins to farm yield, but the farmed tokens get exchanged to the user’s deposited asset and paid back as yield. Yearn.Finance offers DeFi users a way to take advantage of complex strategies they may not otherwise be able to use themselves, and it eliminates the need for spending excess gas moving assets across DeFi’s various liquidity pools.

Conclusion

In conclusion, DeFi is already proving to be a revolutionary innovation with limitless potential. Without a doubt one of the biggest attractions to DeFi is yield farming, which creates opportunities to earn attractive returns for putting assets to work in the ecosystem. DeFi users can earn high yields due to the high demand for leverage, as well as through native tokens and protocol fees. As the DeFi ecosystem matures and adoption grows, many users are becoming aware of the abundance of opportunities to earn on their crypto assets. We’re doubling down on the opportunity too: our token.com product is designed to capture DeFi’s outsized returns and make it easy for anyone to grow their money.

However, it’s worth noting that there are many risks associated with using DeFi, so caution is advised. In general, the less established liquidity pools offering outsized returns to the rest of the ecosystem are more risky than the so-called DeFi blue chips. Moreover, should DeFi hit mass adoption, it’s likely that yields will decrease over time. In the meantime, today’s DeFi natives are earning lucrative rewards for pioneering the technology.

Credit: Thanks to Uncommon Core hosts Su Zhu and Hasu, whose April podcast on DeFi yields inspired this feature.

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