Crypto for Advisors: DeFi Yields, the Revival

In today’s Crypto for Advisors newsletter, Crews Enochs, from Index Coop discusses the revival of of DeFi Yield and how it will be organic this time. DJ Windle answers questions about DeFi investing in Ask an Expert.

– S.M.

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In past cycles, yields in DeFi have largely been paid in novel, valueless and inflationary governance tokens. The result was initial bursts of unsustainable activity on new protocols and gains for early entrants. Everyone else was left holding the bag.

As digital asset yields have soared in recent months – stablecoin and ETH yield rates hovered above 20%, far exceeding the base rate in traditional finance – some have evinced skepticism about this new cycle of yield farming. But while inflationary dynamics impact current points farming trends, overall the increasing rates are driven by organic and more sustainable demand than in past cycles.

Up until early 2023, liquid staking yield was the benchmark rate for digital assets and the only organic yield left, as borrowing demand dried up during the bear market. While the liquid staking rates exceeded federal funds rate for much of 2022, rate hikes last year rendered liquid staking unattractive. Nevertheless, liquid staking remained a solid organic option for digital asset users who didn’t want to move their capital off-chain.

As market conditions began to improve in Q1, digital asset yields began to climb. At the end of April, enterprising digital asset users could earn over 31% APY on Ethena, Maker moved the DAI savings rate up to 15% and lending protocols Aave and Compound offer 6-10% to lenders.

While these opportunities are undeniably attractive, digital users who recall previous cycles may wonder where these yields come from.

For the most part, stablecoin and ETH yields are sourced from interest paid to lenders by overcollateralized borrowers. Stablecoins in particular are the most liquid and in-demand asset in the digital asset ecosystem, and users are borrowing them to lever up exposure to their favorite asset.

On the higher end of the risk/reward continuum, some of the biggest opportunities come from points speculation. The enthusiasm for EigenLayer points, most notably, has driven up yield rates for lending ETH, as speculators anticipate an EIGEN token airdrop later this month. Interest in a potential Ethena drop has driven demand for stablecoins. While airdrop speculation is undeniably inflationary, borrowers are paying real interest in stablecoins or ETH that lenders can realize as profit now. Read more about Airdrop points here.

Digital asset users who are interested in lending directly to EigenLayer and Ethena points farmers can utilize protocols like Gearbox. Given the extreme enthusiasm for points farming, borrowers are not cost-sensitive and willing to pay upwards of 30-40% to fund their leveraged points farming.

Users who are uncomfortable lending against exotic new assets, like Ethena’s sUSDe or liquid restaking tokens,can lend via tried-and-true protocols like Compound and Aave. The Ethena and EigenLayer assets have not been onboarded as collateral for Aave and Compound, where ETH, staked ETH, and USDC remain the primary forms of collateral. Nevertheless, Aave and Compound have enjoyed the second-order effects of the interest in points farming, as well as overall price improvements in Q1.

Regardless of platform or protocol, all lending in crypto is overcollateralized, mitigating risk for lenders. That said, lenders do run the risk that borrowing could dry up on whatever protocol they use, resulting in lower yields.

Overall, market watchers anticipate that speculative fervor will drive borrowing demand through the next few quarters. Given the cost-insensitivity of borrowers participating in leveraged points farming and other speculative investments, the opportunities for lenders are significant. While conservative digital asset users are understandably concerned about unsustainable yields, current lending infrastructure better isolates risk. For digital asset users who are uncomfortable engaging directly with novel primitives, lending offers an opportunity to benefit from borrower enthusiasm.

–Crews Enochs, Ecosystem Growth Lead, Index Coop

Q. How might new government regulations affect DeFi investing?

As DeFi platforms mature, government oversight is expected to increase. This could lead to the implementation of standardized regulatory frameworks, which may include stricter KYC and AML policies. While these measures are designed to protect investors and prevent illicit activities, they could also limit the anonymity and flexibility that many DeFi users currently enjoy. For the average investor, this means a safer but potentially more cumbersome investment process.

Q. What changes with traditional banks’ get involved in DeFi?

The involvement of traditional financial institutions in DeFi could bring a blend of innovation and stability to the ecosystem. Banks can provide expertise in risk management and access to a broader customer base, which could lead to more capital flowing into DeFi. However, this might also result in lower yields due to the conservative nature of traditional banking.

Q. Do DAO’s impact DeFi yields and security?

DAOs (Decentralized Autonomous Organizations) are integral to the governance of many DeFi protocols, offering a level of transparency and community involvement not seen in traditional finance. They allow stakeholders to vote on key decisions, including those affecting yield rates and security measures. This can lead to more aligned interests between users and developers, potentially resulting in more robust and user-centric platforms.

– D.J. Windle, founder and portfolio manager, Windle Wealth

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