The current crypto winter has dried up liquidity, which was so essential to feed yields in the expansionary phase. In order to build up TVL, an arguable key measure of success, a flurry of new protocols were coaxing investors into providing new dollars to their ecosystems. Higher yields were manufactured through native token distributions.
Attracting dollar liquidity for the sake of it, is not a good business. In a contraction phase, like the one we are in, native yields go down as the tokens stop appreciating. Liquidity providers know that and are therefore quick to pack-up and leave when the wind turns.
While rewarding users, native yield farming also attracts mercenary capital, and sucks up most of protocols resources, away from actual yield allocation. It the end, it deflates the value of the protocol for its stakeholders through time. Taking FRAX as an example, 0xHam highlights that FRAX supply got divided by 2 during the LUNA/UST crash.
FRAX is mostly using its collateral for CVX purchases, and very little for actual lending. This is rewarding in expansionary phases, but place the protocol at risk during contractions. This is probably all the difference between endogenous and exogenous value. Endogenous value comes from intrinsic yield opportunities, only unlocked for sticky stakeholders.
Locking liquidity for longer is key to stability. This implies that such lockup should be rewarding enough to attract deposits. DeFi finds depositors supply at a fair 7-8% APY these days, even against a 6-month lockup. Importantly, this assumes that the deposit currency would remain stable.
Securing liquidity for longer periods enables allocation to yield-producing investments. This is similar to the job of a bank really, which is about working the spread between depositors and borrowers. Yield sourcing can be found in DeFi yield farming, and more extensively into real-world loans.
What are the limitations of DeFi so far? First, recent episodes show that not all self-labelled “stablecoins” are actually stable #UST. Secondly, the asset allocation terribly lacks consideration for risk management, and it is hard to tell what is the investor’s net risk-adjusted return. Thirdly, most of yields come from recursive lending fed by farming rewards, which is only gradually supplemented by real-world yield opportunities.
Tapping into real-world loans is the key success factor for DeFi in the long run. Real-world loans are being made accessible through credit protocol such as TruFi, or Goldfinch. Maker also started to offer them. For now, the use cases are limited to short-term collateralized trade financing in emerging markets, or fintech treasury management. This is expanding fast though. At the moment, Goldfinch offers 8% APY on its “senior pool”, which provides a diversified allocation to its various credit deals. While Goldfinch makes sure that its “senior pool” is protected by a first-loss “backers” tranche, it doesn’t change the high-risk nature of the underlying illiquid credit investments, mostly in local currency to midsized companies in emerging markets.
What is the great opportunity for DeFi? DeFi protocols should design their own senior-junior tranching, whereby deposits will be senior and underwriters will be junior. Thus, not only will depositors receive the native yield of their deposit currency, but also some yield for their senior tranche allocation. The allocation will be made across real-world as well as DeFi yields.
What does it take to get there?
- Choose your deposit currency well: USDC, DAI, USDT, FRAX
- Build a sticky stakeholder base. Promote staking for validation, instead of just rewarding stakers.
- Map out risk-return across your yield allocations. Carefully analyze counterparty and structuring risk, for DeFi-only as well as real-world deals. This requires expert skillset in both areas, quants versed in DeFi yield farming, and credit specialists.
- What is a safe short-term return? Can a non-incentivized USDC/DAI pool on Uniswap v3 be considered a low-risk rate for DeFi short-term liquidity? How does it compare to TradFi’s money market rates?
- Make sure that you buffer accordingly for transaction risk, through hedging and insurance. This should alleviate your standalone default risk.
- Provision an equity buffer to insulate your protocol against systemic risk. Basel III require banks to provision ~10% of their risk-weighted assets as equity, as well a liquidity coverage ratio of 100% (high-quality liquid assets/total net cash flows). What are the ratios supposed to apply to decentralized banks?
360 Advisory LLC is a Boston-based RIA managing investments, including crypto