Do you often wonder how certain projects can afford to pay six digits APY? Is it true that such rewards are created out of thin air? Are yields in DeFi sustainable, or is a collapse inevitable?
The best way to answer these questions is to trace yields back to their roots.
In the broadest sense, yields are the remuneration paid by those who purchase a good or service to those providing such good or service.
We can outline three main categories:
Demand for risk
Users that want to earn higher returns can increase their risk exposure by acquiring more risky tokens. Users that pay for such tokens are remunerated through a yield representing the return needed to compensate for the risk.
Risk can be taken in different ways. In crypto, one of the main risk-taking tools is leverage. Users increase their returns by acquiring new tokens in exchange for posting collateral as a guarantee. The lending protocols require borrowers to be overcollateralized, but leverage is mainly used to catch profit opportunities available for a limited time.
Another way in which risk is transferred across market participants is through derivatives. Option buyers, for instance, pay a yield (premium) to option sellers to access an asymmetric bet with unlimited potential profits and limited loss. On the other hand, option sellers earn a premium that compensates them for the unlimited risk they are exposed to if the option were to be exercised “in the money” at maturity.
The demand for risk is generally cyclical, with greater risk exposure during bull cycles and lesser risk exposure during bear cycles. Hence, market cycles can explain some of the yield volatility we are observing nowadays.
Demand for services
The functioning of DeFi protocols depends on the presence of actors, such as liquidity providers, validators or liquidators. These actors receive remuneration, such as swap fees, transaction fees or liquidation fees, for providing their capital or infrastructure to protocol users.
This yield component is highly dependent on volume. During strong bull / bear market phases, activity and volumes are generally higher, whereas sideways markets could suppress demand for services.
Incentives
Protocols could attract users to their products by providing incentives in the form of native tokens. Contrary to the previous points, this is a supply-driven mechanism to generate yields. The resulting demand depends on the native token’s valuation. Hence, liquidity incentives are generally more effective during bull market cycles. While this type of yield is widespread across DeFi, its sustainability depends on the actual product-market fit for which these incentives are supposed to stimulate demand.
How to capture different sources of yields with Tempus
Yield bearing tokens on Tempus allow users to gain exposure to all the different sources of yield previously mentioned.
- Demand for risk: Yearn tokens (i.e. yvUSDC, yvDAI,…) earn a yield by investing the backing tokens (i.e. USDC, DAI,…) into different strategies. The performance of such strategies is positively correlated with the demand for risk. When demand for risk increases, users can profit from it by holding more Yield tokens, whereas, during bear market phases, a fixed rate could be locked by holding more Capital tokens.
- Demand for services: liquid staking ETH (i.e. stETH) earns a yield representing the imbalance between supply and demand for ETH staking services on Lido Finance. When demand increases, the staking yield decreases and locking a fixed-rate upfront is the best option to hedge against a fall in yields. When demand decreases, swapping Capital tokens for Yield tokens increases the variable yield exposure, and users can gain from a rise in yields.
- Incentives: liquidity incentive programs could be launched on different Tempus pools. Incentives are paid in either TEMP tokens or native tokens from the yield-bearing token protocols (e.g. the stETH pool could be incentivized by Lido native tokens). Incentives can be earned by users who swap Capital tokens for Yield tokens. More details on each incentive program will be available in a separate Medium post.
Final thoughts
Yields are the blood of DeFi. They flow towards those who take more risk and/or satisfy a need for which there is demand in excess. Understanding where yields originate is essential to catch them in time. As the cryptocurrency industry transitions from an emerging sector to a consolidated reality, yields will become one of the critical building blocks of every investment strategy. Tempus provides a unique suite of products fitting the needs of both retail and institutional investors looking for different kinds of yields.
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Disclaimer
The information provided in this article is provided for informational purposes only and does not constitute, and should not be construed as, investment advice, or a recommendation to buy, sell, or otherwise transact in any investment, including any products or services, or an invitation, offer, or solicitation to engage in any investment activity. You alone are responsible for determining whether any investment, investment strategy, or related transaction is appropriate for you based on your personal investment objectives, financial circumstances, and risk tolerance. In addition, nothing in this article shall, or is intended to, constitute financial, legal, accounting, or tax advice. We recommend that you seek independent advice if you are in any doubt.
