The Yield Question No One Wants To Address
The Yield Question No One Wants To Address
Where is your yield coming from?
Welcome Anon! Today we are discussing where the sources of DeFi yields actually come from and where to find sustainable ones. Remember you are reading the opinion of a random Degenerate Sensei on the internet and this is not financial advice.
Among the most exciting part of the creation of DeFi is the access to yield-bearing assets. Despite the possibilities and can of worms that Bitcoin opened to the crypto community, it previously didn’t allow for a lot of capital efficiency despite its resilience. The rise of Ethereum and programmable smart contracts changed this notion and changed the crypto industry forever.
Decentralized Finance gave normal plebs and degens like me access to financial services that you do not have on a normal basis. Since it has opened a can of worms called tokens, it has led to high yields being distributed to token holders. While these numbers are attractive, to say the least, more questions should be asked about where the yield is coming from.
Source of DeFi yields
Questioning where protocols yield is coming from is normally the elephant in the room. To be frank, a lot of the DeFi yields are simply vaporware. Emitting valueless governance token has no meaning as long as they have no actual value. We have seen this during OHM fork season where there were countless protocols offering thousands of percent APY (clearly a ponzu). While lucrative yields are possible in the so-called Wild West that is crypto, developing a mental model before diving into risky liquidity pools will serve you well in the long run.
The risk of high yields
The higher the yield is, the higher the financial risk you are taking. While this is basic finance 101 in my opinion, it normally gets lost as you get desensitized to constant high-yield farms in DeFi. Tokens can be created out of thin air and if the APR is absolutely absurd it increases the likelihood that it’s a valueless token. Also, even if that wouldn’t be the case, those high yields are to the detriment of the protocol as it puts extreme pressure on the token as it’s being farmed and most likely dumped. Despite how much I personally love DeFi, there is some warranted criticism that needs to be addressed.
The Source
When you are navigating through the DeFi space you will hear a lot of extravagant ideas at times without substance and you have to learn how to filter through the noise and ask the real questions. If a protocol can’t easily define where the yield is coming from, it’s a red flag. Taking a look into the “business model” of the protocol is fundamental. Is it a lending protocol? Then look at the spread. Are they operating at a negative spread? How long do they plan on doing that and is it sustainable? We are well aware that protocols normally aggressively emit tokens in the beginning to attract users, if they do not have a plan on how to keep users when the yield becomes less attractive, you might want to stay away.
If it’s a Decentralized Exchange you might want to take a look at the trading fees and run a calculation on the volume. Are there enough users for the protocol to generate any substantial amount of revenue? While TVL is the de-facto metric that people use to measure the performance of protocols, it’s fallible as it doesn’t really tell the full story depending on what type of protocol you’re working with. For lending protocols it’s more important as it contributes to the spread, for exchanges while it provides liquidity, volume is a much better metric as it lays out the daily user appetite for swaps in the protocol.
Are they a yield aggregator or treasury management protocol? What fee do they take to provide this service for you? There is no free lunch and even though some protocols have costlier services than others, it indicates that they have actually developed a model that will provide consistent revenue over time. Do they have a treasury? How much runway do they have? Either the team gets paid through already vested tokens or they have operating expenses that will eat away at their treasury.
Different questions for different protocols.
Protocols practicing sustainable yields
Since a lot of protocols won’t survive the test of time, looking into how they provide their yield and revenue plays a big part. While native tokens might be lucrative if you consistently dump them (to the detriment of the protocol), yield in tokens that have a higher staying power such as Ethereum provides a better option. As the industry develops, it wouldn’t surprise me that people will demand quality yield from reputable tokens instead of DogeInuRocket with 1000% APY.
This makes the Arbitrum ecosystem very attractive at the moment (the only thing Offchain Labs needs to do now is to not f*** it up). Protocols with sustainable revenue models that provide yield in ETH will become increasingly demanded as time passes, and a few protocols provide this.
Note: You don’t need to hold the tokens in some of these protocols. However, utilizing them to your advantage makes them worth looking into as you try not to nuke your portfolio during bad macro environments.
The first one is GMX which I have covered in one of my previous posts. A decentralized perpetual exchange, capturing immense value in a growing perps industry (they did insane volume during the Terra debacle). The protocol provides part of their yield in an escrowed version of their native token $GMX and the other part of the yield in actual ETH. The native ETH yield is a feature that will increasingly become more standard as people get tired of farming and dumping.
Dopex is a decentralized options protocol that aims to maximize liquidity and minimize losses for options writers while maximizing gains for options buyers. They have enabled participants to easily get a grasp, of options without needing extensive knowledge as it can be a complicated matter. While holding the Dopex token induces higher risk, you can interact with the protocol without doing so and hedge your portfolio to limit your losses during market downturns through put options or writing covered calls that would allow you to capture valuable premiums.
Umami Finance is a treasury management protocol that runs a risk hedged high yield strategy to distribute to participants that lock funds in their vaults. It was previously a rebasing protocol that revamped a failing model into something better (more protocols should do this). They have partnered with TracerDAO which allows them to take long and short positions in BTC and ETH with leverage without running the risk of liquidation. The protocol offers yield in WETH and USDC which is lucrative in an environment of garbage tokens.
A very interesting thing about UMAMI is their liquidity-capped USDC vault that provides 25% APY by providing delta-neutral risk strategies. This is something that probably will become increasingly popular as protocols aspire to not have a fluctuating TVL while maintaining a high demand for their products. Liquidity capping their vaults indicates that they can sustain high yields for their users as it doesn’t get heavily diluted as the users increase. A first come first serve the type of market will be healthy for DeFi as protocols develop loyal customers that benefit from their services by paying a performance fee. It will lead to competition that indicates that protocols will be able to take higher performance fees depending on the consistent yield they can generate paid out in stablecoins or coins with staying power.
Umami partnering with TracerDAO ties all the protocols mentioned in the article together. Tracer’s delta-neutral yield farming strategy is built on top of GLP, while it also offers risk protection through its own perps. The protocol also intends to utilize Dopex incoming Atlantic Options that enable liquidation protection for leveraged perps and bonds. It’s already well-documented that Atlantic Options will be a GMX integration.
This will increase the importance of good Treasury Managers in protocols that understand that simply using their treasury to invest in the next risky token and FOMOing is not a good way to deploy capital. Solid risk management through the use of options and perps will most likely become the norm over time.
Note: Realizing as I am writing this that a separate substack post diving into this strategy would provide some value for the readers.
TL;DR these protocols are built to capitalize on each other’s success and provide sustainable yields for the DeFi ecosystem. The protocols on Arbitrum have the potential to be the new gold standard of DeFi.
The idea with this article is not to shill protocols but to instead train your mind in regards to how to view DeFi yields and sustainability. While the space is exciting, it’s easy to fall for the next narrative and end up being a bagholder. While you hope that DeFi is based on fundamentals, a lot of it is narrative-driven. However, the narratives can be based on fundamentals. If you can optimize your farming experience and extract value through tokens you desire, suddenly DeFi becomes a much better experience than before.
Also, while you can interact with true degen protocols, it also poses further smart contract risk with every protocol you try. Deploying mercenary capital can be very profitable as you jump from farm to farm and leech out value (see the people that gamified the rebasing during OHM fork season). That doesn’t mean that it is risk-free. To be frank, most people should stay away from high APR DeFi yields in a bear market (or in general). You need to get realistic, why would you receive 500% APY for depositing your hard-earned money? It’s just recycled inflation through tokens.
A large number of tokens will be dead by the time we get another cycle and from a risk-reward standpoint, most people are better off doing DCA on large caps (or not doing anything) as the markets do some necessary healing. Nonetheless, it is refreshing to see DeFi yields going in the right direction as it makes yield farming during turbulent markets a pleasant experience.
Long may it continue.
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Disclaimer: All Content on this site is information of a general nature and does not address the circumstances of any particular individual or entity. Nothing on the site constitutes professional and/or financial advice, nor does any information on the site constitute a comprehensive or complete statement of the matters discussed or the law relating thereto. I am just a random degenerate sensei sharing an opinion.