Understanding DeFi yield – lending, market making, and staking

What is DeFi yield?

High yields set decentralized finance (DeFi) apart from other opportunities, but many new investors do not understand where the yield comes from or how returns can be so high compared with other investment opportunities. It’s common to see annual returns above 7%, with many projects yielding more than 10%. These figures are impressive, but even savvy investors can get drawn into the siren song of risky projects. Mastering DeFi investing starts with understanding yield – here’s what you need to know.

Some yield opportunities are highly sustainable, but others are not. The source of the sustainable yields lies in demand for borrowing, platform-generated fees and token incentives. We believe that the first two sources are likely sustainable at a fundamental level as long as demand for decentralized services exists.

Incentives built into decentralized finance (DeFi) protocols have led to some extraordinary yields. These incentives are paid through the inflation of a protocol’s native token and serve as a user acquisition strategy to bootstrap demand early on for a project. This has driven the buzzy practice of “yield farming,” where investors can supercharge their returns by moving their assets from one opportunity to another.

) and found that over 50% of all yields were incentivized, and nearly 80% of yields were paid out in token incentives. This is the riskiest and least sustainable yield source over the long term as continued dilution can lead to severe crashes. We’ve already seen the impact of Anchor’s 20% APY that led to the death of LUNA/UST.

 – a period of continuous deterioration that may lead to catastrophic failure or destruction.

As with many investment opportunities, if it sounds too good to be true, it probably is. DeFi is no exception, but it’s still in its infancy. The full scope of risk in DeFi is still being defined, but we have made significant progress in understanding and identifying risk vectors.

The most important (and sustainable) DeFi yield sources to understand are:

interest earned for providing assets for others to borrow

 trading fees earned for providing liquidity to fill decentralized trades

 compensation for helping secure the blockchain network

In traditional banking, you earn interest on your deposits through other people’s demand for borrowing. The bank’s business model is to earn the spread between the interest rate it charges borrowers and the interest paid to you. These transactions depend on a bureaucratic system of credit ratings, account management, and more. This makes banks very expensive middlemen, which eats into your returns.

In DeFi, the middleman is a piece of code, or a smart contract, that enforces contractual obligations among parties. By cutting out the middleman, lenders pocket the profit from interest rates, not the bank. This enables investors to earn nearly the full market rate on a loan via a programmable and open-source way. This new primitive is enforced and maintained through overcollateralized loans (borrowers must post collateral to borrow against and are limited in the amount they can borrow).

Like any other financial market, the interest rates in DeFi are driven by supply and demand. There is no central authority that determines the rates. Humans have a natural desire to borrow assets that will always persist at some fundamental level, whether it’s to purchase goods, pay for services, or desire for leverage (borrow cash to buy more of an asset).

A key development in decentralized finance was the introduction of automated market makers (AMMs), which have enabled the trading of assets across a decentralized exchange. The AMM concept was popularized by Uniswap, which saw more than $1 trillion worth of trades pass through its platform as of May 2022.

AMMs are a decentralized mechanism that allows you to provide liquidity to smart contracts, enabling isolated markets. Liquidity providers (LPs) are rewarded for providing this service with trading fees by users who want to exchange their assets. You can think of AMMs as similar to institutional market makers who earn spread fees for ensuring there’s enough liquidity in the markets. This amazing technology now allows any individual to be a market maker and earn yield on idle assets.

Staking is a newer concept that is unique to decentralized finance and based on proof-of-stake (PoS) technology. With staking, you lock assets into a smart contract in order to help support a blockchain's operations and earn fees or block rewards in return.

Most blockchains today use some form of staking to achieve decentralized consensus. In PoS models, validators stake a native token as collateral in order to create new blocks. This staked token can be slashed—or taken away— if the validator behaves maliciously. Validators are selected to create the next block based on various methods ranging from the number of assets staked to pure randomization.

As a pioneer in the cryptocurrency space, Ethereum has recently transitioned to a PoS consensus model that will reduce the annual issuance of ETH. By staking assets and helping validate new blocks, anyone with ETH can help secure the network at a rate of around 4-6% annually. This yield is expected to be more robust and less reliant on inflationary incentives as operating a validator is not as economically intense.

This is just the beginning – DeFi is already proving to be a revolutionary technology with far-reaching potential. DeFi’s impact goes beyond crypto enthusiasts, it has the potential to improve financial services in emerging markets, support the financial needs of the unbanked, and redistribute wealth from traditional financial institutions to individual people. As the products and users mature, yields will likely decline, but the impact will sustain. At Exponential, we’re doubling down on this generational opportunity by building products that make it easy for anyone to discover, assess, and invest in DeFi.

Now that you understand how DeFi yield works, it’s time to discover new yield opportunities. To help you get started, check out our favorite protocol pages.

Exponential is on a mission to make decentralized finance accessible to all by building the easiest way to invest in DeFi. 

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