Sustainable Yields in DeFi

Marco_112358
6 min readJan 14, 2022

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Anyone who loves to degen around in DeFi is hoping to get some yield, and currently there are a couple ways to do that.

  • Lending — You can lend out your digital assets to different protocols, which is nice because your yield is paid back in the asset you lend (though that’s not always the case…).
  • Single Asset Staking — You can go to specific protocols and stake your tokens with that protocol. These protocols reward you with more of that token.
  • Yield Farming — You can provide liquidity to Liquidity Pools, and then depositing those LP tokens in Yield Farms. Yield farming can provide some really juicy yields, but most times these yields are based on emissions from the protocol and are paid in the specific token trying to bootstrap liquidity. Check out my piece here on yield farming.

Single Asset Staking and Yield Farming

Single asset staking and yield farming provide their yield in the underlying protocol’s token that is trying to generate consistent hodlers, and/or trying to create a market for that token, where people can swap into and out of that token. These yields come from token emissions, which may have schedules with lots of tokens being distributed up front, then less and less over time, eventually ending. Unfortunately, it seems like people jump into a farm, then quickly jump out and dump tokens, creating a negative feedback loop for prices. See the quote and articles below.

“Here’s what might be a more interesting statistic: A whopping 42% of yield farmers that enter a farm on the day it launches exit within 24 hours. Around 16% leave within 48 hours, and by the third day, 70% of these users would have withdrawn from the contract.” (https://www.nansen.ai/research/all-hail-masterchef-analysing-yield-farming-activity)

Also check out the “ROI is the new APY” section of this Friktion Article

Any liquidity providing has ‘impermanent loss’, which really means that you would be better off just hodling both tokens instead of using them to provide liquidity anytime the price ratio of those tokens changes. The more volatile the price ratio is, the higher your impermanent loss can be. We all hope that the yield we get from yield farming is greater than the impermanent loss.

Lending

Lending comes with its own challenges as well. The biggest risk here is borrowers not being able to repay their debt. Lots of protocols use Liquidation Bots to make sure that borrowers pay back their debt by automatically liquidating those borrowers when their collateral ratios get too low. Also, as more money comes into DeFi chasing these high yields, its possible that these floating, algorithmically defined rates, will float lower over time. If more people come to supply tokens for lending, and the demand for borrowing doesn’t keep up with this increased supply, lending yields will have to fall.

Token Yields and Total Returns

A potential issue with all quoted yields is that they may not reflect the actual value (total return) you get from yield farming, depending on what you use as your ‘numeraire’ (base currency, like USD, EUR, ETH, BTC, SOL, etc.). If the token you receive as yield goes down in price relative to your base currency, your actual return will be less than what you see quoted as the yield. So your Total Return (Price Return + Yield Return) may not be positive if prices drop (price return is negative) relative to your positive yields (yield return is positive).

Sustainable Yields

I believe a more sustainable yield strategy within DeFi can be found through selling volatility, really using options to generate yield. You can earn yield by writing (selling) options. When you sell an option, you receive a premium that the buyer pays. The buyer pays this premium in order to have the option to buy or sell the underlying at a specific price. The seller is on the hook to deliver the underlying, or buy the underlying, at that specific price. So you are definitely taking a risk by selling these options, but you get paid to take this risk.

In my opinion, yields from selling volatility are less likely than other strategies (described above) to compress over time as more money comes into DeFi. I believe this because a major factor of option pricing is the implied volatility. Crypto volatility is quite high, and I expect it to stay high for a while. And demand for optionality and asymmetry will continue to require a premium. I am sure this volatility, and thus yields, will compress at some point, but I expect they will stay higher than single asset lending, and safer than single asset staking and yield farming.

I would not recommend people trying to take these risks alone. There is a lot of analysis that should be done before you go selling options. However, there are some great protocols being developed, and on mainnets, that manage option vaults. These protocols are like Asset Managers in TradFi, that take your deposits, lump them together with other users’ deposits, and manage a strategy. These strategies are professionally managed, which means you will get much better pricing on the options than you would if you tried to do this on your own. Also, vaults tend to swap the premium token recieved back into the underlying, or token you deposited. So you get yield back in the token you deposit. My current favorite is Friktion on Solana, but there are plenty other great protocols out there.

Random Analysis on modeling impermanent loss using options

The main reason to use option strategies is to generate yield on your digital assets without having to lend or supply liquidity to a liquidity pool. Some strategies, like covered calls, will still gives you some of the directionality of hodling the underlying. Maybe surprisingly to some, providing liquidity to a liquidity pool exposes you to that pesky impermanent loss, and modeling impermanent loss actually looks similar to a covered call strategy that also sells some puts. The point here is that if you are already comfortable with yield farming and providing liquidity to liquidity pools, you are already taking on similar risks as you would for a covered call strategy in search for yield.

Model of Impermanent Loss of a 50/50 Constant Product Market Maker

Model of Buying the Underlying Asset, Selling some Calls and Selling some Puts

Conclusion

I hope this helps explains some of the different ways to generate yield in DeFi, and explains my bias for using an options asset managers protocol to generate sustainable. It’s important to know the risks you are taking when participating in different DeFi strategies. Many times it’s not obvious and you really do have to DYOR. But it definitely is possible to make some money out there, and in this constant search for yield, new asset management protocols like Friktion will continue to bring you new strategies to use.

Good luck and happy degening!

About the Author

For full disclosure I mostly use Solana for DeFi, because I don’t have enough assets to justify Ethereum gas fees. I have a little bit in Algorand, Cardano and Polkadot DeFi. I am actively involved in multiple Friktion volts and a contributor in their Discord, and am beta testing Dappio Wonderland 🐰 .

I am invested in SOL, ADA, ETH, DOT, ALGO, MIOTA along with plenty of other tokens.

This is not Financial Advice!

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Marco_112358

TradFi background (CFA/CFP), DeFi Degen. Love ETH, ADA, ATOM, KUJI, SOL, DOT, NEAR,