Author | Compiled by Mikey 0x | Produced by Huohuo | Vernacular Blockchain (ID: hellobtc)
One of the advantages of DeFi is that anyone can participate in it anytime, anywhere, that is, anyone has the opportunity to earn benefits as a DeFi participant at any time, and even earn benefits that are difficult or impossible to obtain in the traditional financial field. However, the permissionless and open-source nature of cryptocurrencies has turned DeFi into a complex ecosystem that is both broad and deep, as evidenced by the endless protocol mechanism designs and the more than 2,000 protocols that exist today. Therefore, discovering the types of yields available and sifting through them is a difficult task.
01 What is rate of return?
Yield is the percentage return you get for putting your capital into a specific protocol. There are two key components to defining a rate of return: the principal invested and the rate of return earned.
Principal: The capital invested at the beginning of the investment period. For example, deposit $1,000 USDC into AAVE. Yield: The return earned over a period of time. For example, earn $15 in USDC in one year (1.5% APR). Total return: Net profit or loss on principal + realized rate of return.
02 What are the different types of DeFi protocols?
There are two main types of principal in DeFi: price stable and price volatile.
Price stability type: The value of the principal does not fluctuate basically, so there is no price risk and dilution pressure.
-Examples: Stablecoins USDC, DAI, USDT.
-Inspiration: The main consideration is the opportunity cost of holding and investing, and there is almost no need to worry about the loss of principal value. The worst case scenario is that the total return is minimal, e.g. USDC deposited in AAVE will only earn 0.5% in a year. Best-case scenario, returns are at least double digits.
Price Volatility Type: The principal has large fluctuations in value and therefore involves price risk. The impact of price fluctuations on Tokens varies depending on the industry and specific projects.
-Example Layer1: ETH, SOL, MATIC, AVAX.
-Application: SUSHI, CRV, GMX, SNX.
-Web3 infrastructure: LPT, AR, POKT, FIL.
-Governance: UNI.
-Facial expression: DOGE, SHIBA.
-Inspiration: All types of price fluctuations involve price risk.
03 What are the different types of yields?
When the Token used as principal is put into use, two types of income can usually be obtained in DeFi: Token-independent income and Token fixed income.
Token-agnostic yields have nothing to do with the existence of project tokens because there is an indirect or direct value exchange between parties. All mainstream Tokens supported by the project can participate, similar to cash flow in web2. Token-specific yields must be issued directly from the project library and have an exact structure. Whether it is initial supply, inflation or destruction mechanism, it is decided by the holder or founder. Token fixed income helps to dilute the holder's continuous circulating supply. Only Tokens issued by the project itself can participate, similar to marketing or customer acquisition costs in web2.
Token has nothing to do with income
1) 4 types:
- Network staking fees: Delegate Tokens to or run validators that protect and regulate blockchain middleware, including blockchain and web3 infrastructure.
-Lending: Provide Token and allow others to borrow it.
-Liquidity supply: Provide Token and allow others to redeem/use it.
-Counterparty Liquidity: The party that takes a “swap,” such as shorting volatility, and earns a profit or loses principal based on the results.
2) Cases of Token-independent income
A) Token-independent income using price-stabilized principal
- Loans: Deposit USDC into AAVE and earn floating interest rates from borrowers.
-Liquidity supply: Provide USDC-DAI liquidity to Uniswap and earn exchange fees.
-Counterparty Liquidity: Deposit USDC into a Ribbon selling ETH put options, or sell derivatives to a market maker.
B) Token-independent income using price fluctuation principal
-Network Staking: Stake ETH to validators to earn network fees through basic fees and tips, or delegate LPT to the coordinator to earn fees through transcoding services and receive ETH rewards.
-Borrowing: Borrow BTC or ETH to Euler and receive a floating interest rate from the borrower.
-Liquidity supply: Provide ETH/UNI liquidity to Uniswap.
- Counterparty Liquidity: Purchase GLP and earn fees while serving as counterparty liquidity.
C) Achieve Token-independent income through protocol income distribution
Although not directly related to DeFi use cases, distributing fees to token holders also provides revenue opportunities:
-Pledge SUSHI to earn platform exchange fees.
-Switch BTRFLY to rlBTRFLY and earn ETH from platform fees.
-Stake GMX to earn platform fees and esGMX rewards.
3) Specific cases:
Bad Scenario 1: User deposits 1 ETH worth $1,000 into a decentralized options vault. This user earned 52% APR in one week. The user earned 0.01 ETH because the option expired out-of-the-money, but the price of ETH fell 25% in the meantime. In U.S. dollar terms, users’ portfolio values are now down 24.3%. Token-agnostic yields are still susceptible to negative total returns. In this case, price risk becomes a reality.
Bad Scenario 2: A user lends $500 USDC to a borrower who pledges $1,000 worth of NFTs. At the end of the loan, the borrower refuses to repay the loan because the NFT is now worth $250. Although there is no exposure to price risk, it is still possible to lose money. In this case, counterparty default risk becomes a reality.
Ideal Scenario 1: User deposits USDC into the AAVE lending pool and earns 5% on a $1,000 deposit. The realized rate of return at the end of the year was 5%.
Ideal Scenario 2: User provides $1,000 of DAI-USDC liquidity in Uniswap on Arbitrum. The realized rate of return at the end of the year was 5%.
Token fixed income
1) 3 types
-Token holder rewards: Provide benefits to people who hold or hold the same Token (usually DeFi or governance-based projects).
- Participatory rewards: provide benefits to people who use the project.
-Network Staking Emissions: Provide revenue validators and/or delegators that contribute to the proper functioning of blockchain middleware (layer 1 or web3 infrastructure projects).
2) Case of Token Fixed Income
A) Token fixed income using the price stability principle:
-Participation rewards: deposit stablecoins into Compound and earn $COMP Tokens, or deposit stablecoin pair liquidity into new DEXs and earn native Tokens, or earn airdrops by participating in the network early.
B) Token fixed income using the price fluctuation principle:
-Token holder rewards: Lock CRV for veCRV to gain enhanced power and rewards, or stake $APE to earn more $APE.
-Participation rewards: Participate in the network early to earn airdrops, or deposit wBTC/renBTC into Curve and earn $CRV rewards.
Token-agnostic yields are generally more predictable, but the return potential is always lower: it's much easier to sell shovels during a gold rush than to pick up a metal that appreciates 1,000x in value. Token fixed income is equivalent to discovering metals during the gold rush and realizing profits by selling these metals on the open market. These gains are only possible if another party is willing to be a buyer, with downward pressure on unit prices as more of the same metal is discovered.
3) Specific cases:
Bad Scenario 1: A user purchases and stakes 100 $MOON and starts earning 50% APR (denominated in $MOON) within a year. The user now owns 150 $MOON. However, $MOON started the year at $1 and dropped to $0.50 by the end of the year. User portfolio value dropped from $100 to $75. To realize the loss, the user sold all tokens to the market with 10% slippage and received $67.5. Although the advertised yield is 50%, the actual total return is -32.5%. In theory, if the price of $MOON remains the same and the user sells with zero slippage, the user’s gain is 50%. Advertising benefits lead to misperceptions of risk. In this case, price risk and liquidity risk become a reality.
Ideal Scenario 1: Users deposit funds into Optimism’s AAVE borrowing pool and receive $OP. By the end of the year, users earn 5% APY on $OP and sell on the market at a 5% return on top of regular borrowing yields.
Ideal Scenario 2: The user invests $1,000 in UP (assuming the Token is worth $1) and receives 20% of annual emissions. By the end of the year, $UP price increased by 500% as the project gained strong traction and distributed significant revenue. The user now has 1,200 $UP worth $6,000, a 6x gain.
04 What about Yield farming?
Yield farming is a way to generate returns by holding cryptocurrency. Simply put, lock up your crypto assets and earn rewards.
Yield farming is an act of minimizing risks and maximizing returns, mainly taking advantage of market inefficiencies. Yield aggregators like Yearn Finance execute a strategy of maximizing value for their savers by locking tokens into specific projects, which in turn hurts token holders of said projects. The Yearn USDC vault has a special strategy that deposits $USDC into Stargate, generates $STG to provide liquidity, and sells $STG to the market in order to return proceeds to vault depositors. This is also known as the dilution pressure problem for $STG holders. There are also new yield aggregators that focus on different types of yield farming actions, which can be divided into three main categories: 1) Interest rate arbitrage – borrowing an asset at interest rate x and lending it elsewhere for a higher rate income of x. Alternatively, hold a spot amount x and short an equivalent amount to obtain the funding rate differential.
For example, mortgage an asset, borrow USDC on AAVE at 2% interest, and deposit to an undercollateralized borrowing platform such as Ribbon/Maple/TrueFi to earn 10%+. Borrow DAI on AAVE and deposit into dAMM to earn surplus through dAMM native token specific rewards. A cash-carrying vault that goes long spot and short perpetual contracts to charge funding rates
2) Leveraged pledge yield - borrow one asset and convert it into another asset to increase productivity, thus increasing overall yield.
For example, deposit BTC, borrow AVAX for sAVAX, then repeat, increasing stETH yields via recursive ETH borrowing and staking via Index Coop
3) Delta Neutral Strategy – Hedges the price risk of the underlying asset to gain sole exposure to the yield itself.
For example, the liquidity aggregation layer on top of GMX accepts single-sided deposits of $USDC and hedges the price risk of $GLP through short selling in the vault.
Generally speaking, whether it is interest rate arbitrage or leveraged pledge yield, there is a relatively high liquidation risk. For example, many users were trapped when stETH broke away from the theoretical peg. Given that new yields often come from new platforms that have not been field-tested, cross-platform interest rate arbitrage yields may contain very high smart contract risks. In the case of delta-neutral farming, there is no guarantee that the hedging mechanism will completely eliminate price risk (risks include liquidation, deviations of derivatives prices from spot prices).
05 Summary
One inspiration for writing this article actually came from the ongoing “real earnings” narrative on Twitter.
Most "actual benefits" can be classified as benefits obtained by providing Tokens. While it's encouraging to see projects earning fees based on real user activity, and there are some examples of very profitable cash flows, "real earnings" is a dangerous statement, as the advertised APR may be based on general reflexive Sexuality changes rapidly. If usage of the protocol decreases, not only will yields decline, but negative public perception will lead to selling pressure, so total returns could become negative. Another interesting question to ponder is, does the protocol distribute the benefits first? Because typically, revenue earned in the early stages of a project should be reinvested in growth. Few, if any, protocols reach maturity in the first place. Additionally, in crypto, anything to do with yield effectively attracts farmers (stakeholders), so it’s easy to optimize for short-term price gains based on hype rather than long-term fundamentals. While it can be challenging, understanding a founder's motivations and intentions can provide a better indication of a project's suitability for the long-term.
In cryptocurrencies, risk appetite is directly related to yield and total return potential. The greater the rise, the greater the fall. Of course, the most important thing is that users have the right to choose, and DYOR (Do Your Own Research) is still necessary.