Let's go down the rabbit hole together and deep dive into protocols like @Anchor or @Celsius, offering 10 to 20% on stablecoins. How is this possible and is it sustainable?
There is a lot to unpack on this topic and I am really excited to share all of the below content with you. I’m writing this article to incite conversations so please feel free to reach out and let’s grow together 📚
Akin to traditional asset classes, the cryptocurrency space opens the doors to 2 main sources of wealth generation: capital appreciation and recurring yield. Focusing on the latter, DeFi protocols often generate yields from 3 sources of returns:
Lending
Staking
Tokens distribution.
Let’s review each of them and address their sustainability.
Lending markets are a foundational element of ANY market as it contributes to the optimal allocation of capital. It has been so since financial markets ever existed and it continues to be the case with DeFi.
Lending is the act of supplying capital to borrowers and earning interests in return. The intermediary typically takes a cut in the process as it creates the possibility for both borrowers to borrow and lenders to earn a return. However, some juicy APYs cast doubts on their sustainability, and rightfully so. What should raise the investor’s eyebrow is a lending rate above a borrowing rate. Let’s look at some examples:
On @Compound, users receive 1.5% to lend $DAI and pay 3.25% to borrow. As a result, the borrowing rate largely pays for the lending one. But that is not always the case, which is where it gets interesting!
Looking at @Celsius or @Nexo, the situation is reversed. Why? Well, some protocols may inflate rewards to attract users, bringing me to the next chapter.
Staking is the consensus method used by many cryptocurrencies to verify their transactions. Essentially, participants put at stake (read: at risk) cryptos and are compensated for doing so. From a pure return perspective, staking is to cryptos what dividends are to stocks. Yields on staking currently range from 5 to 20%. Not bad…
From a pure return perspective, staking is to cryptos what dividends are to stocks
Staking can be used in two ways by DeFi protocols. The first and most straightforward one is to allow users to stake their crypto directly. As a result, users receive new tokens by locking in their capital. Cool.
Now, the second solution is a bit more tricky. “Why”, you ask? Let me explain.
DeFi protocols will most often ask for collateral before users can borrow cryptos or stablecoins. Thanks to overcollateralized loans, protocols end up with 2-3x the amount of capital lent on their platform. This collateral may be used to generate a yield through staking. The return is then (partly) distributed to lenders to boost their rewards. With higher rewards, protocols attract more TVL. More TVL = more money at work. That's a profitable strategy!
As I mentioned, staking is a necessary step to verify transactions. This process certainly is here to stay. While the yields may vary, DeFi protocols will always be able to use staking to improve rewards for their users.
On the other hand, some methods may be less sustainable over the long term. Time to review the tokens distribution mechanism.
Tokens distribution occurs when protocols give out their native token to users in order to increase the attractiveness of their product. The catch is here: tokens can originate from 2 sources: either from earnings generated by the platform or from newly-issued tokens. It is paramount to distinguish the two cases!
E.g. @Celsius distributes $CEL tokens to increase its yield. By doing so, Celsius redistributes 80% of the earnings it generates on the platform. This is healthy in how it builds loyalty among users.
On the other hand, issuing new tokens encompasses a dilution risk if no sufficient burning mechanisms are in place. This can destroy the value of a token, and good examples can be mentioned within the Play2Earn space. Potential red flag alert!
Attractive returns on fiat-pegged cryptocurrencies are sometimes marketed as a risk-free rate. Spoiler alert: it is not. Various risks may occur. Some of which are:
Smart contract bugs
De-peg of a stablecoin
Hack
Liquidations (if leverage is used)
Insurances exist for some of these risks, and protocols such as @unslashed or @insurace have a broad offering. For example, unslashed currently charges a 5% premium for buying a cover on a $UST de-peg.
On top of the 3 sources of yields I referred to earlier, other strategies may be used by investors to generate a recurring yield (arbitrage, liquidity mining, delta-neutral) but they'd need an article on their own. That might be ideas for future blog posts. If there’s interest, let me know.
I hope this content was helpful. I’m always happy to receive your comments. Keep going.
Wow, you’ve come this far! Thanks for reading and have a wonderful day.
I’ve already told you more than I know.