Real-world Yield
Integrating DeFi with the real economy
Following a grim 2022, crypto is in the wilderness, with many builders left wondering where the ecosystem goes from here. Post-mortems of failed projects remain ongoing, but some lessons have already become clear. In particular, “real yield” has emerged as a popular standard for evaluating DeFi investment opportunities. According to its proponents, “real-yield” protocols are those that deliver yield to participants principally from protocol fees, and denominate these yields in stablecoins or other highly-liquid assets. This contrasts with protocols that achieve high yields principally through emissions of a native token, a practice which proves unsustainable in bear market conditions.
In our view, the “real yield” standard is a necessary correction, but it doesn’t go nearly far enough in addressing DeFi’s systemic challenges. At this stage of ecosystem development, most DeFi protocols are only useful to a small population of crypto natives (e.g., traders, crypto hedge funds), creating a high correlation between protocol usage (and revenues) and crypto market sentiment. In these bear market conditions, the amount of “real yield” that DeFi protocols can generate has thus declined, further hurting the competitiveness of DeFi with traditional financial products.
In our view, “real-world yield” is the proper North Star for DeFi. That is, DeFi must focus on integrating with the real economy, generating yield by solving real problems for real people. If DeFi remains insular and self-contained, it is doomed to fail.
“Real yield” discussions reflect structural weaknesses in DeFi
Discussions of “real yield” began in earnest following the Terra/Luna collapse. Terra’s Anchor Protocol, which boasted a TVL of $19 billion in March 2022, is now a cautionary tale about smoke-and-mirrors yield. Until the April 2022 Terra meltdown, Anchor was offering depositors 20% UST yield, already well above most other interest rates generally available in the market. Astonishingly, Anchor offered borrowers yield in the form of the protocol’s native token ANC, often at rates surpassing the borrower’s APR. These “ponzinomics” were an excellent marketing tactic, but they turned out to be less than helpful for the purpose of not going to zero.
In the wake of collapses like Anchor’s, “real yield” proponents argue that protocol fees returned in the form of mainstream assets (e.g., ETH, USDC) should be the new gold standard. Ethereum staking APYs are perhaps the best-known example of “real yield”: Stakers stake ETH to help secure the Protocol, staking rewards are generated in a highly transparent fashion (gas fees), and earnings are delivered as ETH. No Ponzis — just simple and straightforward earnings in a highly liquid digital currency.
To be sure, “real yield” is absolutely a standard to which protocols should be held. During the 2008 financial crisis, mind-numbing complexity and opacity in financial products were deployed to obfuscate the fundamental shakiness of the underlying economic activities, ultimately resulting in economic carnage. Many crypto projects are now guilty of the same behavior. The “real yield” standard properly scrutinizes these sorts of flashy, inflationary yields, and instead favors more sustainable yields rooted in clear, easily intelligible utility.
But the “real yield” standard is not ambitious enough
Despite its merits, the “real yield” standard fails to address a fundamental weakness of many DeFi protocols as investment vehicles: most DeFi protocols are neither useful nor attractive for the vast majority of potential users. Certainly, many DeFi protocols are amazing feats of technology, enabling permissionless financial interactions that were never before possible. But there is a problem: the population that wishes to engage in those financial interactions is vanishingly small. Take crypto lending, for example: most crypto loans require 100% (or more) digital asset collateralization and cannot consider credit scores or off-chain collateral. The vast majority of non-crypto-native borrowers would find these loan terms unacceptable, likely preferring TradFi loans, which are more accessible albeit with potentially less favorable terms, to the DeFi alternative.
Ryan Watkins (formerly of Messari, now at Syncracy Capital) provides fair pushback on this critique of financial markets in the cryptoeconomy:
Financial markets are a peculiar thing. On the surface, it can often appear as if they’re a sideshow — a zero sum game veiled over the real economy.
[…]
These relationships aren’t mediating something else on the “real” side of the economy; they are the constitutive relationships of the economic system.
But this framing misses a critical point: in the traditional financial system, these “constitutive relationships” are always connected to activities in the real economy, however distantly. Traders at the Chicago Mercantile Exchange may personally spend little time on the farm, but the Corn Futures Contracts they trade are linked to real economic output. In contrast, the decentralized financial system often serves only to shuffle risk among crypto natives, who trade based on economic conditions that are only relevant to the cryptoeconomy. As a consequence, DeFi funding rarely makes its way into the real economy, leading to fragile, insular DeFi markets and limited relevance for the majority of potential borrowers.
DeFi must pursue real-world utility and real-world yield
In our view, DeFi innovation should be focused on a higher standard of success: real-world utility and real-world yield. We define real-world yield as returns generated through financial operations serving the real economy. Real-world yield protocols solve problems for mainstream and crypto-native users alike, and they produce yields by doing so profitably. These protocols are competitive not only with other DeFi protocols, but also with TradFi products; they succeed not because of users’ enthusiasm for crypto, but because they provide best-in-class services.
Indeed, DeFi’s potential in the real economy is tremendous. Global capital markets are inefficient and inequitable, failing to properly connect credit supply and demand, especially across geographies. For example, small-and-medium businesses (SMBs) in emerging markets have an unmet capital need of $5.2 trillion every year. The average interest rates for SMBs in markets like Mexico (12%)¹, Brazil (19.5%)², and Peru (26%)³ would represent compelling debt investment opportunities for global investors. But the existing TradFi financial plumbing squanders these opportunities, with efficiencies lost due to excessive fees, lack of access, or corruption.
DeFi can, and should, be the answer. With a real-world focus, DeFi has the potential to bring about a more inclusive and accessible global financial system, connecting capital with creditworthy borrowers anywhere in the world. Unlike the current TradFi lending infrastructure, transparency and accountability would be baked into the DNA of a DeFi-forward system, exposing abuses by rent-seeking middlemen and resulting in more efficient markets. If DeFi scales successfully towards this vision, there will be no separate “cryptoeconomy”; rather, DeFi protocols will represent fundamental infrastructure for the real economy.
Building towards real-world DeFi
That sounds lovely, you might be telling yourself, but how do we get there? To be sure, this sort of real-world utility (and real-world yield) for DeFi will be wickedly difficult to achieve. But, in our view, it is the only vision of DeFi worth pursuing.
A (non-exhaustive) list of critical development areas for real-world DeFi includes:
- On-chain identity credentials.
- On-chain credit scoring.
- Diversifying collateral types, including off-chain assets.
- Loan workout and refinancing mechanisms.
- Fiat on- and off-ramping and off-chain visibility.
- Legal compliance and recourse for delinquency/default.
Talented builders throughout the ecosystem are already working on these challenges. In particular, our friends at Goldfinch Finance have made exciting advances in connecting on-chain capital to emerging market companies. Centrifuge has also pioneered a clever approach to representing off-chain collateral on-chain as NFTs. Tribal Credit is also a pioneer in connecting on-chain capital with high-quality, off-chain borrowers, deploying a $20 million USDC credit facility from the Stellar Foundation to fund emerging market borrower accounts.
Real-world DeFi remains in its early days, with exciting frontiers yet to be explored. Tribal is committed to realizing the real-world potential of DeFi. In subsequent publications, we will further articulate our thinking of how that can be best achieved.
[1] Bank of Mexico
[2] Central Bank of Brazil
[3] Peruvian Superintendent of Banking, Insurance, and AFP
DISCLAIMER: The views and opinions expressed herein are those of the speakers and do not necessarily reflect the views or positions of any entities they represent. The information provided does not constitute investment advice, financial advice, trading advice, or any other sort of advice, and you should not treat any of this content as such. Do conduct your due diligence and consult your financial advisor before making any investment decisions.
