Where Does DeFi Yields Come From?

If you’re an active member of the cryptocurrency community, you may have seen posts about insanely high yield returns on investment (ROI) from decentralized finance (DeFi) protocols.

While the APYs (annual percentage yields) on offer are often eye-watering, it’s important to remember that with higher returns comes greater risk. You may have heard about the “to the moon” stories where a coin’s value can unpredictably surge 10,000x and then go to zero days later. The truth is, there are several underlying factors working in concert to drive up ROI in the DeFi space.

In this article, we’ll take a look at some of the factors driving these high APRs and whether or not they’re sustainable in the long term.

What are the Foundations of Yield in DeFi

There are four primary ways to earn a robust yield in DeFi protocols:

Staking Rewards: Staking your crypto in a proof-of-stake (PoS) network or validator can net you regular rewards, paid out in the native currency. For example, staking ETH in the Ethereum 2.0 Beacon Chain can currently earn you around 5% APR.

Lending Rates: Lending platforms, like Compound and dYdX, offer interest rates on your deposited cryptocurrency. You can withdrawn at any time. The APR you earn will fluctuate based on the underlying supply and demand but is generally around 3–5% for most assets.

Just like you deposit money into TradFi banks savings account, there are just significantly fewer middlemen taking their cut along the way.

Exchange Rewards: This generally entails providing liquidity to a DEX pool in exchange for a portion of the trading fees generated. Some exchanges now offer yield on deposited cryptocurrency, paid out in the form of their native token. For example, Binance currently offers up to 7% APR on deposited crypto, paid out in Binance Coin (BNB). Uniswap currently offers 0.30% of trading fees to LPs, paid out in UNI tokens.

Fee Distributions: Some DeFi protocols generate revenue through transaction fees that are then shared with users who provide liquidity or otherwise contribute to the ecosystem. For example, Bancor currently offers 0.25% of traded value to LPs, paid out in BNT tokens.

These are the basics of yield generation in DeFi protocols, but there are other important factors to consider.

These are the four main ways to earn a robust, sustainable yield in DeFi protocols. However, It’s tough to feel content with your 6% for robust yield when you see the 100% or even 1,000% interest rates you can earn elsewhere.

None of the big four foundational yield sources offer rates that high. So where are they coming from? Let’s take a tour of each!

Crazy Interest Rates from Incentivized Liquidity Pools

In almost all cases, there’s the high-risk, high-reward one that drives most of the really insane interest rates: Incentivized Liquidity Pools(ILPs)are a type of pool where you deposit cryptocurrency in exchange for extra tokens that give you a larger percentage of the platform’s profits. Also, you’re paid extra tokens in exchange for helping a newer platform launch.

Here’s how they work.

New projects need people to buy their tokens so the projects can function. So they offer an insane return on investment (ROI) to early users. Something like 10% per day. 100% per week. 1000% per month.

For example, say you want to help a new DEX launch. You might be asked to deposit $100 worth of ETH into an ILP. In exchange, you’d get $150 worth of the new DEX’s tokens. Now, when that DEX earns trading fees, a portion of those fees are distributed to all the token holders. So you’d get more back than you put in, giving you a nice return on your investment.

These rates are so high that people are practically forced to buy the token, just to keep up with the Joneses. And since the project is new, there’s a good chance the price of the token will go up as more and more people buy in. So people who got in early can make an absolute killing.

Incentivized liquidity pools use high-interest rates to bootstrap a new token’s ecosystem. However, we’ve seen this happen time and again with platforms that try to attract tons of hype by dishing out insane APRs. The APR can’t keep pace with inflation, so they end up devaluing themselves in the process!

People who provide liquidity to these incentivized pools are taking on a huge amount of risk. They could end up getting nothing, or even losing money if the price goes down.

Auto-Compounding Protocols

Another source of yield related to the insane yield is auto-compounding protocols. It is a type of DeFi protocol that automatically reinvest your earnings back into the platform, so you can compound your returns over time.

This is different from staking, where you have to manually decide whether or not to reinvest your earnings. With auto-compounding, it’s all done automatically for you.

Auto-compounding protocols are becoming increasingly popular since they offer a way to compound your returns without having to do any extra work. And in some cases, they can even offer higher returns than traditional staking or lending platforms.

For example, Compound offers an annualized return of around 10% on Ethereum. But some auto-compounding protocols can offer 100% or more returns per year.

These higher returns come with a tradeoff, though. Since your earnings are automatically reinvested, you’re essentially taking on more risk. If the protocol fails, you could lose everything you’ve put in.

Conclusion

So where’s the yield? DeFi protocols offer some of the highest interest rates in the crypto world. But these rates come with a certain amount of risk. Before you invest, make sure you understand where that yield is coming from.

» Ready to get started? See our DePro picks for the optimized DeFi Yield protocols.