In this article, we explore the definition of Yield, what Yield is in the context of cryptocurrency, the types of yield-generating opportunities available, as well as the risks and considerations associated with investing in them.
As the cryptocurrency market continues to gain mainstream attention, more and more investors are turning to digital assets as a way to earn a return on their investments. To mitigate risk, maximize returns and enjoy several other benefits of Decentralized Finance, it is important for crypto investors to understand DeFi yield and how it works across different protocols.
In this article, we will explore what Yield is in the context of cryptocurrency, the types of yield-generating opportunities available, as well as the risks and considerations associated with investing in them.
Many will argue that the establishment of the New York Stock Exchange in 1792, marked the creation of yield bearing passive income instruments in global finance. But, as far back as the 1300’s —to hedge the risk of a ship mishap ruining their fortunes, ship owners had long been in the practice of seeking investors who would pool money together for a commercial voyage.
The funds raised were spent on maintaining the ship and outfitting crew. In return, the investors would earn a percentage of the voyage proceeds. To diversify their risk, Investors often split up their money, and put it into several different voyages simultaneously.
Like the 13th century voyage Investor who earned returns on investment (ROI) in the form of a percentage of gold haul and whale oil —today, when you purchase a company issued stock, you earn a dividend. When you purchase a government issued bond, you earn yield. And when you save your money for lengthy periods in a bank, you earn interest.
In 21st century Decentralized Finance (DeFi), Yield works slightly differently. But the fundamentals remain the same. Cryptocurrency Investors put up assets, and they are compensated for any combination of risk taken, utility provided and commensurate time value of money.
Yield in DeFi refers to the return on investment (ROI) generated by holding or staking digital assets. Investors can earn Yield on cryptocurrencies in a number of ways, including interest earned, staking rewards, governance tokens or a split of transaction fees.
Competitive yield is one of the distinct features that has drawn attention of investors to the DeFi space in recent times. The stock market has greatly underperformed for many years that followed the 2008 global financial crisis. With inflation creeping up by double digits 2021, to erode most of the gains on fixed-interest savings and government bonds, investors sought solace in high-yield bearing DeFi protocols.
For instance, if you saved $1000 in Bank of America in January, 2022, you would receive a return of $4 at the end of year at an 0.04% APY.
With this considerable gap in yield rates between the TradFi and DeFi markets, it is no surprise that Total Value locked in global DeFi markets has surged by over 5,000% in the last 3 years, according to data collected by Nansen.
Yield farming is an investment strategy in decentralized finance which involves staking or lending your cryptocurrency tokens to a protocol in exchange for a defined set of rewards ranging from interest payments to governance tokens. Yield farming is the technical process deployed by investors actively seeking out the most profitable strategy to maximize returns on their locked-in cryptocurrency holdings.
Yield farmers typically move their funds around a lot between different protocols, in search of higher yields. And consequently, DeFi platforms may also provide other economic incentives such as governance token, voting power, priority in transaction blocks etc. to attract and retain more capital on their platform. Ideally, protocols that offer the highest yields often attract the most liquidity.
A successful Yield farming strategy sometimes involves deploying different liquidity mining methods, and spreading assets across different DeFi protocols. All in a bid to minimize risk accumulate maximum ROI over a given period of time.
Before we assess the various yield-generating opportunities and strategies available in the crypto markets. It is important to first understand how yield is calculated in DeFi.
Yield farms deploy smart contracts to lock-in tokens and pay interest with rates ranging from a few percentage points to triple-digits depending on the timing as well as demand and supply dynamics of the locked tokens.
There are different forms of yield in DeFi. Firstly, Interest is a way to earn a return on deposited assets, similar to how traditional savings accounts work. Staking, on the other hand, involves holding a certain amount of cryptocurrency to participate in block validation and earn rewards. Finally, Liquidity mining is a portion of the trading fees earned from providing liquidity to trading pools on decentralized exchanges (DEXs).
Just as yield in TradFi bank deposits are calculated in terms of annual interest rates, and earnings or stocks as dividend per share, Yield in DeFi is usually expressed as an annual percentage rate (APR) or annual percentage yield (APY).
Annual percentage rate (APR) or annual percentage yield (APY) are two sides of the same coin that measure the same concept. To a DeFi lender, it is very important to understand the difference between them because it can significantly impact the actual returns earned on their locked-in assets.
APR, which stands for "annual percentage rate," is the interest rate that a lender receives as interest on their deposited funds. This rate is usually advertised by DeFi lending platforms as a flat interest rate per year. However, the actual return that a lender earns on their deposited funds depends on the frequency of compounding. This is where APY, or "annual percentage yield," comes into play.
APY takes into account the effects of compounding interest. This implies that the interest earned on an asset deposited is accumulated over time and reinvested to earn additional interest. The more frequent the compounding is, the higher the APY will be, compared to the APR.
For example, a DeFi lending platform offers a 10% APR on a stablecoin deposit pool. If the platform compounds interest on a daily basis, then the APY earned on the deposit would be higher than 10% due to the compounding effect. Conversely, if the platform compounds interest on a monthly basis, then the APY earned on the deposit would be lower than 10%.
In summary, DeFi lenders and investors should pay close attention to both APR and APY when evaluating potential investments on DeFi lending platforms. While APR provides an indication of the interest rate being offered, APY gives a more accurate picture of the actual returns earned on deposited funds, taking into account the effects of compounding interest.
There are several yield-generating opportunities in DeFi, here are some of the most popular ones:
These are just a few examples of yield-generating opportunities in DeFi, and there are many more emerging as the space continues to evolve. The onus rests on investors to examine each investment option and make informed choices based on their risk appetite.
DeFi protocols deploy different methods to autonomously apply the yield earned by investors, into their digital wallets. Hence, it is important for investors, lenders and liquidity providers to understand each of them, and identify which applies to different protocols before locking in their funds.
Reward Tokens are newly-minted tokens paid as rewards to fund providers who participate in various decentralized finance (DeFi) activities, such as liquidity provision, staking, and governance. Typically, Reward tokens are usually different from the original token staked. Often, they can also have additional features, such as unique access to certain limited features or collectible characteristics or enhanced voting power. Each of these can make them more valuable and desirable.
Reward tokens are routinely minted to incentivize staking and liquidity provision without increasing inflationary pressure on the primary token.
Token Emissions refer to the process of creating new tokens, to pay rewards to fund providers which in-turn adds to the circulating supply of the primary token. In decentralized finance (DeFi), token emissions can be done through various mechanisms, such as mining, minting commands or token unlocks.
The amount and rate of token emissions paid as rewards can have a considerable impact on the price of the token , as well as the long-term sustainability of the DeFi protocol.
Balance Rebasing is a mechanism used in some decentralized finance (DeFi) protocols to adjust the balances of the volume of tokens held by a user. With rebasing, the balances held in specific wallets/pools are adjusted periodically to reflect the volume of staking rewards earned, burned tokens or fees deducted. An example of DeFi staking protocol that deploys the rebasing method is LIDO.
Exchange Rate Adjustment is a process used in decentralized finance (DeFi) protocols to adjust the exchange rate between two different assets, typically stablecoins. Certain DeFi protocols may require users to stake tokens to mint the native token which is to be locked in a wallet. The native token is initially pegged 1:1 to the staked token — known as the base token.
Overtime, Staking rewards are then applied by algorithmically adjusting the value of the native token against the base token Frax Finance is an example of a DeFi protocol that uses this method.
The exchange rate can also be adjusted periodically based on other factors, such as the supply and demand of the assets and the overall market conditions.
Investing in yield-generating opportunities in cryptocurrency, especially in decentralized finance (DeFi), can offer high returns. However, it also comes with its own set of risks that investors should be aware of before investing their funds.
Here are some of the common risks associated with investing in yield-generating opportunities in decentralized finance
Yield-generating protocols in DeFi are built on smart contracts, which are self-executing terms of the agreement between the parties being directly written into lines of code. Smart contracts are typically open source, meaning that anyone can read the code and potentially identify vulnerabilities.
If a smart contract has a flaw, it could be exploited to devastating effects by malicious actors and result in the irretrievable loss of funds. This is particularly heightened for protocols that host custody of users’ funds. Such as cross chain bridges and staking protocols.
Many yield-generating opportunities involve providing liquidity to a pool of funds, which can be locked up for a period of time. If the value of the cryptocurrency being staked decreases, or if there is a sudden drop in liquidity, it can be difficult to exit the position without significant slippage which can lead to a varying degree of losses.
When providing liquidity to a DeFi protocol, there is a risk of impermanent loss. This occurs when the value of the cryptocurrency being staked fluctuates in a way that results in a loss of value for the liquidity provider. Cryptocurrency prices can be volatile, and there is always a risk of price fluctuations in the market. Even if a yield-generating opportunity has high returns, the considerable drop in the value of the underlying assets earned can still lead to catastrophic losses.
The cryptocurrency industry is still largely unregulated, and there is always a risk that governments and regulatory bodies could impose new regulations or restrictions that could impact the value of cryptocurrency investments.
As with any online financial transaction, there is a risk of hacking or fraud. In the world of cryptocurrency, there have been many high-profile cases of exchanges and DeFi protocols being hacked or sabotaged, resulting in the loss of funds.
Hence, it is important to thoroughly research and understand the risks involved in any yield-generating pool before investing. In some cases, investors may deploy algorithm-assisted tools to help them identify high-yield opportunities and diversify their portfolio.
For instance, One Click Crypto deploys proprietary AI & machine learning technology to analyze on-chain transaction history related to the particular wallet owner and provide personalized portfolio recommendations based on the data acquired.
In addition, One Click is completely non-custodial which helps to minimize third-party risk.
In summary we have explored what Yield means in DeFi, the different methods to maximize yield as well as the many risk factors involved. It is imperative for all investors to have in-depth understanding of the various passive income opportunities that exist in decentralized finance in order to earn maximum Returns on their Investments in today’s economy.
Compared to century-old TradFi stock markets and banking institutions, DeFi is a relatively young industry. Many DeFi protocols are still evolving at different stages of innovation, so it is crucial to stay informed and get ahead of the curve.
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