Crypto for Advisors: DeFi Yields, the Revival

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

-SM

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Revival in DeFi Returns in 2024: Organic This Time

In past cycles, returns on DeFi were largely paid with new, worthless, and inflationary governance tokens. The result was the first bursts of unsustainable activity on the new protocols and gains for early starters. Everyone was holding the bag.

As digital asset yields have risen in recent months (stablecoin and ETH yields are running above 20%, well above the fundamental rate in traditional finance) some have made clear their skepticism about this new cycle of yield farming. However, while inflation dynamics affect current agricultural trends, overall rising rates are driven by organic and more sustainable demand compared to past cycles.

Until early 2023, liquid staking yield was the reference rate for digital assets and the only remaining organic yield as borrowing demand dried up in the bear market. While liquid staking rates have exceeded federal funds rates for much of 2022, last year’s rate increases have made liquid staking unattractive. However, liquid staking has remained 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, digital asset returns began to increase. At the end of April, enterprising digital asset users were able to earn over 31% APY on Ethena, Maker DAI increased its savings rate to 15%, and lending protocols Aave and Compound offered 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 are derived from interest paid to lenders by over-collateralized borrowers. Stablecoins, in particular, are the most liquid and in-demand asset in the digital asset ecosystem, and users are borrowing them to increase interest in their favorite assets.

At the upper end of the risk/reward continuum, some of the biggest opportunities come from point speculation. Interest in EigenLayer points has, most notably, increased ETH lending yield rates, as speculators anticipate an EIGEN token airdrop later this month. Interest in a potential Ethena drop has increased demand for stablecoins. While airdrop speculation undeniably leads to inflation, borrowers pay real interest on stablecoins, or ETH, which lenders can now capture as profit. You can find more information about Airdrop points here.

The story continues

Digital asset users interested in lending directly to EigenLayer and Ethena point farmers can leverage protocols like Gearbox. Given the overwhelming interest in point aggregation, borrowers are not cost sensitive and are willing to pay up to 30-40% to finance leveraged point aggregation.

Users who are uncomfortable lending against exotic new assets like Ethena’s sUSDe or liquid repurchase tokens can lend through tried-and-true protocols like Compound and Aave. Ethena and EigenLayer assets are not included as collateral for Aave and Compound, where ETH, staked ETH and USDC remain the primary forms of collateral. However, Aave and Compound benefited from second-order effects of interest in scoring points, as well as overall price improvements in the first quarter.

Regardless of platform or protocol, all lending transactions in crypto are over-collateralized, reducing risk for lenders. However, lenders face the risk that borrowing will dry up and therefore yields will fall, regardless of the protocol they use.

Overall, market observers predict that speculative excitement will increase borrowing demand in the next few quarters. The opportunities for lenders are significant, given the cost insensitivity of borrowers participating in leveraged point farming and other speculative investments. While conservative digital asset users are understandably concerned about unsustainable returns, existing lending infrastructure better insulates risk. For digital asset users who are uncomfortable interacting directly with new primitives, lending offers an opportunity to capitalize on borrower excitement.

– Crews Enochs, Ecosystem Growth Leader, Index Coop

Ask an Expert

Q. How might new government regulations affect DeFi investments?

Government oversight is expected to increase as DeFi platforms mature. This could lead to the implementation of standardized regulatory frameworks that could include stricter KYC and AML policies. While these measures are designed to protect investors and prevent illegal activity, they may 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 are there with traditional banks getting involved in DeFi?

The involvement of traditional financial institutions in DeFi can bring a mix 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 greater capital flows into DeFi. But this can also result in lower returns due to the conservative nature of traditional banking.

Q. Does DAO have an impact on DeFi returns and security?

DAOs (Decentralized Autonomous Organizations) are an integral part of the governance of many DeFi protocols and offer a level of transparency and community participation not seen in traditional finance. It allows stakeholders to vote on important decisions, including those affecting rates of return and security measures. This could lead to more aligned interests between users and developers, potentially resulting in more robust and user-centric platforms.

– DJ Windle, founder and portfolio manager of Windle Wealth

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