DeFi
Sustained growth thanks to organic demand
In today’s Crypto for Advisors newsletter, Index Coop’s Crews Enochs discusses the rebirth of DeFi Yield and how it will be organic this time. DJ Windle answers questions about DeFi investing in Ask an Expert.
In previous cycles, DeFi returns were largely paid in the form of new, worthless, inflationary governance tokens. The result was an initial burst of unsustainable activity on the new protocols and gains for early movers. Everyone else was left holding the bag.
As returns on digital assets have soared in recent months – yield rates on stablecoins and ETH hovered above 20%, far outpacing the base rate of traditional finance – some have expressed skepticism regarding this new cycle of yield farming. But even if inflationary dynamics have an impact on current agricultural trends, rates of increase are generally driven by organic and more sustainable demand than in past cycles.
Until early 2023, liquid staking yield was the benchmark rate for digital assets and the only organic yield remaining, as borrowing demand dried up during the bear market. While cash down rates have exceeded the federal funds rate for much of 2022, last year’s rate hikes have made cash down unattractive. Nonetheless, liquid staking remains a solid organic option for digital asset users who do not want to move their capital off-chain.
As market conditions began to improve in the first quarter, yields on digital assets have started to climb. At the end of April, enterprising digital asset users could earn over 31% APY on Ethena, Maker increased 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 remember previous cycles may wonder where these returns are coming from.
For the most part, stablecoin and ETH returns come 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 borrow them to increase their exposure to their favorite asset.
At the high end of the risk/reward continuum, some of the biggest opportunities come from speculating on points. The enthusiasm for Layer Clean Points, most notably, has driven up ETH loan yield rates, as speculators anticipate an EIGEN token airdrop later this month. Interest in a potential decline in Ethena has boosted demand for stablecoins. Although airdrop speculation is undeniably inflationary, borrowers pay real interest on stablecoins or ETH which lenders can now make as profit. Learn more about Airdrop Points here.
Digital asset users who want to lend directly to EigenLayer and Ethena point farmers can use protocols like Gearbox. Given the extreme craze for point farming, borrowers are not cost sensitive and are willing to pay more than 30-40% to finance their leveraged point farming.
Users who are uncomfortable with lending against new exotic assets, like Ethena’s sUSDe or liquid buyout tokens, can lend through proven protocols like Compound and Aave. Ethena and EigenLayer assets have not been included as collateral for Aave and Compound, where ETH, staked ETH, and USDC remain the primary forms of collateral. Nonetheless, Aave and Compound benefited from the side effects of interest in points farming, as well as overall price improvement in the first quarter.
Regardless of the platform or protocol, all crypto loans are over-collateralized, which mitigates risk for lenders. That said, lenders run the risk of borrowing drying up regardless of the protocol they use, leading to lower yields.
Overall, market watchers expect speculative fervor to drive borrowing demand in the coming quarters. Given the cost insensitivity of borrowers participating in leveraged point farming and other speculative investments, the opportunities for lenders are significant. While conservative users of digital assets rightly worry about unsustainable returns, current lending infrastructure better insulates risks. For digital asset users who are not comfortable with new primitives, lending offers the opportunity to benefit from borrower enthusiasm.
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 could include stricter KYC and AML policies. While these measures are designed to protect investors and prevent illicit activity, 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 from traditional banks are involved in DeFi?
The involvement of traditional financial institutions in DeFi could bring a mix of innovation and stability to the ecosystem. Banks can provide risk management expertise and access a broader customer base, which could lead to an increased influx of capital into DeFi. However, this could also lead to lower returns due to the conservative nature of traditional banking.
Q. Do DAOs impact DeFi yields and security?
DAOs (Decentralized Autonomous Organizations) are an integral part of the governance of many DeFi protocols, providing a level of transparency and community involvement never before seen in traditional finance. They allow stakeholders to vote on key decisions, including those affecting rates of return and security measures. This can lead to more aligned interests between users and developers, which could result in more robust, user-centric platforms.
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