Exploration of High Returns in DeFi Mining and Sustainability Analysis

This article is written by Julian Koh, the founder of the DeFi protocol Ribbon Finance, and published on his medium. Compiled by: Perry Wang

One of the main narratives of decentralized finance (DeFi) is that, given the high yields in DeFi, ordinary people will have to move their fiat currency into the DeFi space. From experience, this is true—nowadays, the lending rates for stablecoins on the Compound protocol exceed an APY of 10%, and there are many mining opportunities in the DeFi space with APYs ranging from 50% to 200%. It’s worth noting that in the real world, most banks offer deposit rates that do not exceed 1%.

However, when ordinary people first hear such yield numbers, most are filled with skepticism rather than confidence. "This must be a scam!" The yield must reflect some hidden risks that we cryptocurrency enthusiasts have not considered. This is a reasonable assumption—smart contract risks are difficult to quantify, so lenders may require borrowers to pay high rates to compensate for this risk.

Historical lending rates of USDC in the Compound protocol

Looking at the historical lending rates of USDC in the Compound protocol, we can see that over the years, lending rates have skyrocketed from -1% to over 10%. The smart contract risks in this protocol have not changed materially, indicating that high rates may be driven more by demand than by supply.

Now that we have clarified why borrowers are willing to pay such high rates to borrow crypto assets, let’s delve deeper. Lending assets is just one way for people to earn yields. To truly understand where yields come from, we first need to seriously consider how money grows and why it can be invested in certain things to earn returns. I believe yields come from four categories: borrowing demand, risk exchange, service provision, and equity growth.

This article will analyze each of these categories in detail to truly understand the yields in DeFi.

Natural Borrowing Demand

The most obvious source of yield is the naturally existing borrowing demand. Businesses need to borrow assets to purchase capital goods, banks need short-term loans to fund their activities (repo markets), and individuals may need loans to pay for college tuition. Due to this natural borrowing demand, a market for borrowers and lenders begins to form, and these loans are also priced—one person's demand for borrowing is another person's yield.

Looking ahead, it is precisely because this natural borrowing demand remains at a very fundamental level that this yield is unlikely to ever be exhausted.

Another reason for the natural existence of borrowing demand is that people crave leverage. As some say, "Leverage is a drug."

Investors who are extremely bullish on assets may want to borrow cash to purchase more assets, especially if they expect the asset's growth rate to exceed the interest rate paid on the loan. This is very clear in the DeFi space. Platforms like dYdX and Alpha Homora have some of the highest lending rates among all DeFi protocols because these platforms create very simple ways for borrowers to use the borrowed assets for leveraged positions.

To create high-yield products, a significant amount of borrowing demand needs to be stimulated, and investing with leverage is one of the best ways to encourage lending in the current market environment.

Risk Exchange

Another source of yield comes from risk exchange, intersecting with borrowing demand. The simplest example here is insurance.

If Alice wants to obtain financial protection in case she gets involved in an accident that could lead to compensation, she is willing to pay Bob a certain fee for this. Essentially, Alice and Bob are exchanging risks with each other, and Bob earns a yield for taking on that risk.

Another prominent example of risk exchange is through options contracts. Option buyers are willing to pay a premium to protect themselves from significant price fluctuations in assets, while option sellers earn some yield for being on the other side of the trade.

One of the new methods of exchanging risk in the DeFi space is through risk tranching. Protocols like Saffron Finance absorb cash flows and divide them into different parts—the Junior (the riskiest) tranche receives a larger share of the cash flow returns but must bear the risk of cash flow losses, while the Senior tranche receives lower cash returns but has a guaranteed investment in the cash flow.

Essentially, Junior and Senior level assets are exchanging risks, and they fundamentally represent yield opportunities with different risk profiles.

These risk exchange contracts represent a huge market in traditional finance, as different individuals/institutions inherently have different risk characteristics, creating a persistent demand for risk exchange.

Therefore, in the long run, I suspect this will also become one of the main sources of yield in DeFi.

Service Provision

A less intuitive source of yield is that you can earn money by providing services with your assets. For example, currency exchangers can charge fees because they use their own assets to provide services. The reason for earning in the exchanger context is that they provide convenience for the exchange between two currencies.

Another example is ATMs—machines that hold cash, allowing customers to instantly withdraw funds from their bank accounts to purchase goods and pay for services. ATMs are a service that customers are willing to pay for.

In the DeFi context, providing liquidity to Automated Market Makers (AMMs) falls into this category of earning yield. By supplying assets to an AMM, you effectively provide a service to users who want to exchange assets. For instance, in the Uniswap protocol, liquidity providers (LPs) earn a 0.3% compensation for each transaction that occurs.

As long as we expect the demand for these services to persist over time, we can also anticipate that their respective yields will continue to exist.

However, providing such services comes with its own risks, specifically the potential for "impermanent loss" when providing assets to an AMM. In the long run, if the cost of hedging these risks is sufficiently lower than the yields earned from providing the service, supplying liquidity to AMMs will be a positive yield endeavor.

Equity Growth

Another source of "yield" comes from the value of equity growth. If you lend money to Uber during its seed stage in exchange for equity in the company, the yield on that investment could be astonishing, primarily driven by the growth in equity value.

Currently, much of the high yield in DeFi is driven by the growth of equity (crypto assets). For example, when you mine on Compound, you are essentially lending money to the protocol and receiving free equity (free COMP tokens). Thus, you earn a basic yield from the loaned assets (from natural borrowing demand) and also benefit from the appreciation of COMP tokens as "yield."

Since DeFi assets are currently in a high-growth phase, most of the crazy yield numbers you see come from equity growth.

Many DeFi protocols view this pathway as a short-term method to attract users to their protocols. They hope to win over a large number of users by offering free equity. Therefore, the main strategy for current asset holders is "yield farming," which involves obtaining these equity incentives for free and hoping that the value of these assets rises, thereby skyrocketing their overall yield.

It remains unclear whether this source of yield will persist in the long term. Once protocols realize that the equity incentives offered to attract users are not cost-effective, they may shut down these incentives.

The primary strategies for earning yield in DeFi in the future are likely to be driven by one of the other three factors rather than equity growth.

Conclusion

As the DeFi ecosystem matures and develops along the S-curve, we may see yields drop from absurd levels of 1000% APY to more "normal" levels.
Over time, equity incentives may decrease, and assets will move away from their high-growth phase. In the future, as people design more complex financial products that can enhance yields, I expect to see more sophisticated product designs in the risk exchange sector.

Ribbon Finance is creating a protocol to build these complex financial products, aimed at simplifying them so that a large retail audience can easily access such products.

Special thanks to Dave White for helping me organize my thoughts and structure this article around the topic.