This report explores the concept of yield in the decentralized finance (DeFi) sector, focusing on sustainable and unsustainable yield generation, the impact of market conditions, and the future sustainability of yield relative to traditional finance. It delves into the dynamics of proof of stake inflation, real-world interest rates, borrowing/lending, and non-incentivized liquidity provision. The report also discusses the implications of market conditions on yield, the role of active and passive yield, and the potential future scenarios for Ether yield post-merge.
Understanding Yield in DeFi
- Unsustainable Yield Generation: This typically occurs during the bootstrapping phase of protocols, where native tokens are issued at highly inflationary rates to incentivize liquidity provision. However, this approach often leads to destructive effects.
- Sustainable Yield Sources: Sustainable yield in DeFi primarily stems from proof of stake inflation, real-world interest rates, borrowing/lending, and non-incentivized liquidity provision.
- Impact of Market Conditions: The yield production of digital currencies decreases in an upward rates environment, making the understanding of asset yields’ sustainability crucial in contractionary markets.
Yield Generation Mechanisms
- Blockchain Inflation: Layer One blockchain inflation is a basic source of yield in crypto, with Ethereum offering compensation for validation in the form of native tokens.
- Non-Incentivized Yield Farming: Historical yields of non-incentivized pools provide a sense of ‘true’ yield in the ecosystem. However, yield for liquidity providers is slim, making it less likely to incentivize taking on LP risk.
- Borrowing / Lending: Demand for additional asset exposure is an important upward force for funding rates, seen in DeFi through the existence of Collateralized Lending Protocols (CLPs).
- Future for Ether Yield: Staking rewards have been trending down as total supply increases, but the merge is expected to push these numbers upward initially.
- Active vs. Passive Yield: The relationship between active and passive yield leads to additional effects on lending yield, creating opportunities for those willing to be more active.
- Post-Merge ETH Staking Rate: If basis trade rates remain low after the merge, there will likely be little to no incentive to lend to protocols, leading to potential scenarios for correction.
- Investigate the Potential of Sustainable Yield Sources: Given the destructive effects of unsustainable yield generation, it’s crucial to explore sustainable yield sources such as proof of stake inflation and non-incentivized liquidity provision.
- Consider Market Conditions: In an upward rates environment, understanding the sustainability of asset yields becomes crucial. Therefore, it’s important to consider market conditions when evaluating yield production.
- Monitor Future Implications: With the expected changes in Ether yield post-merge and the relationship between active and passive yield, it’s important to keep an eye on these future implications for yield in DeFi.