Where Do Yields Come From?
Understanding Returns in DeFi: Why 30% Yield on Stablecoins is Not a Scam
I often hear skepticism about the viability of higher yields, drawing parallels to the unfortunate case of Terra crash. However, the reality is quite different.
I'll shed light on the origins of these yields, compare the different ways of which the yield is composed, and clarify that there are hundreds of yield farms opportunities that are not ticking time bombs like UST & LUNA.
The Terra crash was not caused by a 20% yield, what is the real reason people lost billions?
Terra's collapse was a major event that put a full stop to a bull run lasting since 2020. The event that wiped out almost $45 billion in market capitalisation within a week. This event left a deep impression on many, instilling a fear of high yields on stablecoins.
To set the things straight, Terra's collapse was the result of a fundamentally faulty algorithmic relationship between USTs and LUNA. UST did not have a backing of physical reserves and relied on the mint and burn mechanism with LUNA to provide stability. This structure failed under pressure, leading to a loss of confidence, a vicious cycle of hyperinflation and mass withdrawals.
What if the mechanism fails in other projects?
Let's address why many of the yield farming opportunities, particularly with stablecoins like USDT or USDC, are different. These stablecoins are backed by USD reserves, with transparent monthly reports. Even in farms that might expose you to impermanent loss, such as pairing BTC with ETH, the risks are not akin to those with UST. However, there are always several risks, which highlight the importance of choosing audited and reputable protocols.
Where do yields come from?
Yields primarily arise from trading fees, liquidity mining / incentives, interest from borrowers, protocol revenue sharing, liquidation penalties... Providing liquidity in a well-audited protocol's e.g. USDT/USDC stable pool is generally safe and potentially lucrative. It's important to consider the nature of incentives, their long-term potential and the strategy of claiming or selling them before entering into yield farms, and whether it is even worth, especially in the context of transaction fees on networks like Ethereum. With less capital you should definitely use blockchains that have cheap transaction fees.
Additional yield opportunities may be from tokenized RealWorld Assets (RWAs). The RWA sector offers yields from sources like rental income, corporate debt, fixed-income assets… For instance, yields in MakerDAO's DAI or Frax Finance's FRAX stem from investing in T-bills, increasing exposure to low-risk, traditional assets.
Today, it's possible to get yields from the complexity of many protocols. A great example is Pendle. Thanks to participate in pools on Pendle, you can earn composable yields from underlying assets, PT yield, liquidity mining, and trading fees.
I frequently hear "Real yield", what exactly does that mean?
"Real yield" in the context of DeFi refers to earnings generated from productive activities within a protocol that add more credible value, as opposed to yield derived from inflationary token rewards or speculative activities. Real yield is sustainable and comes from actual economic activities or services provided by the protocol.
Your inflation, my yield.
However, you will usually get the highest yield from token incentives. Incentives are a way for protocols to attract users, there is nothing wrong with that, except that it causes inflation and, in the case of a poor tokenomics and speculative protocol, a quick decrease in the price of that token. However, that doesn't change the fact that you can earn e.g. 30% of the amount of your liquidity provided in stablecoins. You need to have a good strategy for selling rewards, and even if you are not betting on the long term growth of incentivised asset, you can sell it for your favorite long term holds or into stablecoins.
Barking at the conclusion
What am I trying to convey with all of this? Simply put, Terra's collapse cannot be equated with providing liquidity using assets like USDT, USDC, BTC, ETH, and many others. When you opt to supply liquidity with stable assets such as USDT or USDC, the likelihood of losing your deposit due to de-pegging is significantly low. What does this mean for you? It means your earnings are practically assured. The amount you earn will depend on several factors: the protocol you choose, the source of the yield, the potential growth of any incentives you receive, and how popular the protocol is, which influences the trading fees you'll accumulate.
Risk lives here with us, mainly smart contract risks, impermanent loss risks if you choose the wrong assets to provide liquidity, liquidity risks, rug pull if you choose the wrong protocol, composability risk if returns come from different protocols.
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Not financial or tax advice. This article is for informational purposes only and should not be construed as financial advice. Investing involves risk and you may lose some or all of your investment.