Yield in the DeFi Economy

To kick off a wave of releases in the run-up to our mainnet launch, we released the first iteration of the Sense Portal on Sept 21st. We were excited to deliver an improvement to existing yield dashboards, which lacked resolution and APY history.

Over the coming weeks, we’ll improve the Portal by adding new assets and incorporating feedback from the community. We’re also planning to launch our testnet where community members can interact with v1 of the Sense Protocol. To provide more context, we outline the mechanisms of yield-bearing assets, which play a fundamental role in Sense.

What are yield-bearing assets?

Tokens are a new digital primitive. They give property rights and can represent anything, such as money, art, game items, and access.

Yield-bearing assets are tokens that represent a share of some yield-generating activity, such as lending, exchange, or protocol dividends. They are the pipes of the digital economy, channeling yield to market participants for providing their capital or performing a service, and as such serve a fundamental role in DeFi.

They are equally important in Sense V1, which will allow users to hedge interest rate volatility and trade future yields on existing yield-bearing assets. In other words, users will have the flexibility to earn a fixed yield and go long or short the future interest rate of their preferred yield-bearing asset. With this newfound ability, users can plan for the future with fixed rates, easily express their view on future interest rates, and contribute to the DeFi economy in a self-sustaining way.

To best leverage the Sense protocol and other fixed-income protocols, we believe it is essential to understand the different ways yield can be generated in DeFi. Let’s dive in:

Types of Yield Sources

In DeFi, most yields are powered by: lending, exchange, staking, protocol dividends, liquidity mining, or some hybrid. Below we’ll cover each source, identify well-known examples, and mention factors that contribute to changes in yield.

Lending

Yield from lending comes from the interest that borrowers pay on their loans. Top lending protocols rely on algorithmic models to set interest rates for borrowers and lenders. Well-known assets that represent lending positions include cTokens (Compound), aTokens (Aave), and fTokens (Fuse). When lenders supply their assets to a lending market, they receive a token in return, representing a share of the lending activity in the market.

Yield, denominated in the underlying, is a function of:

• The interest rate model
• Liquidity in the lending market, i.e., utilization rate
• The appetite for leverage

Example: cUSDC

Exchange

Yield from exchange comes from exchange fees that traders pay for swapping against a pool of reserves. Well-known assets that represent exchange positions include Uniswap LP shares and Curve LP shares. When liquidity providers (LP) supply their assets to a liquidity pool, they receive an LP share in return, which represents their share of liquidity.

The yield, denominated in the LP share, is a function of:

• Exchange fee
• Trading Volume
• Market volatility
• The relative contribution of liquidity

Recent developments in the Automated Market Makers (AMM) space have added flexibility to LP positions at the expense of predictability. For example, with UniswapV3’s introduction of range orders, LPs can apply bounds to their liquidity offering between a lower and upper price bound. Range orders improve capital efficiency for the LP, but they add another important factor:

• Probability of price in range order

Staking

Staking yield comes from staking rewards issued by an L1 protocol to Validators who lock up capital for securing its network and achieving distributed consensus. For example, users can lock ETH to secure Ethereum 2.0 and earn yield for good behavior. Well-known assets that represent staking positions are called staking derivatives and include stETH (Lido). When stakers deposit their assets into staking pools, they receive a staking token in return, which represents a share of staking activity for a particular blockchain, such as ETH2.0.

The yield, denominated in the underlying, is a function of:

• The staking economics
• Total amount of underlying staked
• Market volatility

Example: stETH

Dividend

Dividend yield comes from the dividends a protocol distributes to its token holders as a reward for good governance. Rather than distributing literal dividends, protocols have explored other implementations, such as Buyback and Build and Buy&Burn models, whereby the protocol purchases the governance token from the open market. Whether the purchase is burned or used for incentive programs, the purpose is to add upward pressure to the token price due to decreased supply.

The yield, denominated in the governance token, is a function of:

• The protocol’s decision to distribute, buyback, or burn tokens
• The protocol’s profits

Liquidity Mining

Liquidity Mining (LM) yield comes from protocol rewards distributed to market participants for providing the desired service, such as lending or providing liquidity. In essence, it’s the protocol’s way of increasing the yields and incentivizing behavior in hopefully net beneficial ways to the protocol. Typically, LM rewards are denominated in the protocol’s governance token and are awarded automatically to holders of specific tokens related to the protocol. Well-known examples include COMP mining on cTokens and BAL mining on Balancer LP shares.

The yield, denominated in the governance token, is a function of:

• Emission rates
• The relative contribution of liquidity
• Governance token price

Hybrid

Hybrid yield sometimes comes from Yield-Farming structured products, which are pre-packaged strategies that farm multiple liquidity mining programs atop yield-bearing assets for extra yield, thereby “double dipping” or compounding returns. Well-known examples include Yearn Vaults and Harvest Finance.

The yield, denominated in the underlying, is a function of:

• All factors associated with the underlying yield sources
• The relative contribution of liquidity

Example: Yearn Vault v2 — WETH

Conclusion

In this post, we position yield-bearing assets as the primitives of DeFi, channeling yield to market & governance participants, and identify their sources, ranging from lending to staking activities. Moreover, we highlight their fundamental role in the Sense Protocol and its enablement of new yield primitives that will power the DeFi economy.

Over the coming weeks, we’ll be releasing new versions of the Sense Portal, announcing new features of the protocol, and inviting community members to join our upcoming private testnet. If you’re interested in joining the beta, please fill out this form, and we’ll reach out to schedule a user interview.

Join our community on Discord as we prepare for our testnet launch, and follow us on Twitter for updates!