Demystifying DeFi Yields: How are They Generated?

The fallout from the collapse of Centralized Exchanges (CEXs) like Celsius and FTX in 2022 is a painful demonstration of the risks of trusting CEXs with your assets. It also serves as a cautionary tale, highlighting the self-sovereign benefits of decentralized financial instruments.

Centralized entities will always exist as a central point of failure in the legacy financial system. In many ways, decentralized finance (DeFi) offers superior alternatives, yet investors continue to choose CEXs over DeFi protocols because of the comfort and accessibility they claim to provide. Understanding DeFi and how to get started with navigating yields has never been easier. Here’s how.

It has been over two years since DeFi broke into the mainstream. The summer of 2020, a period commonly referred to as DeFi Summer, saw the proliferation of Automated Market Makers (AMMs) like Uniswap and Curve, and decentralized lending protocols like Aave and Compound

Real vs Incentivized Yield

These two categories of protocol innovation laid the foundation for what DeFi is today. They created decentralized services, like token pair swapping, lending, and borrowing. These allowed users to earn yield by providing the liquidity that allowed these protocols to function. The return available is a direct result of market demand for these activities. This is what is referred to as ‘real yield’. This form of yield is self-sustaining but highly volatile and dependent on market conditions and broad consumer demands. 

It is important to understand that not all yield is real yield. 

DeFI projects will also use ‘incentivized yield’ to stimulate growth and usage on their platform. Incentive programs typically involve a token reward for users who interact with the protocol in the intended way (lending/borrowing). This yield comes at the expense of diluting the holders of the tokens unless they are also participating. This yield is not self-sustaining and should be viewed as an investment by the protocol to increase real yield. The combination of the real yield and the incentivized yield is the total yield for the end user.  

AMMs and decentralized lending protocols form the basis for many other DeFi projects and enable a diverse ecosystem of yield-generation opportunities. DeFi users that seek to earn yield should understand the mechanics and fundamentals of these protocols. Doing so will help DeFi users evaluate opportunities with accuracy and help them better understand the risks involved.

Yield From Lending

Decentralized liquidity protocols allow anyone to provide liquidity into a pool and act as a lender. A borrower can then access that pool by depositing collateral and borrowing desired assets against their collateral. In this scenario, the party earning the yield is the lender, who earns off of the collateral provided by the borrower.

The primary form of yield generation in decentralized liquidity protocols is through the interest paid by the borrower. This is similar to how banks earn interest in traditional finance. With decentralized financial protocols, anyone can play the bank's role and earn the bank’s fees. Due to the permissionless and transparent nature in which returns are generated, the decentralized money market gives users access to the true market rates of these assets without a percentage being siphoned by intermediaries like banks.

The yield generated from the amount of interest paid varies by the demand from borrowers for each specific token they seek to borrow. The higher the demand, the higher the interest, and vice-versa. The reasons for borrowing are broad. One of the most common reasons is that market participants may want to leverage their current holdings to avoid taxable events. They achieve this through accessing a medium of exchange like a stablecoin. This allows borrowing without losing exposure to the collateral asset. Another reason for collateralized borrowing is for shorting a token.

Additional yield in the form of protocol incentives is often paid out from AMMs. Liquidity protocols will often offer 'yield boosts' paid in their own token on top of standard yield to attract more users. For example, on the lending platform, WX.Network users are rewarded with gWX tokens for providing additional WX tokens to the platform. gWX can then be used to access an increased amount of regular reward in WX for staking LP tokens. Liquidity providers should consider these incentives when evaluating which liquidity protocols they engage with.

Yield From Automated Market Makers (AMM)

In traditional finance, liquidity providers are typically wealthy investors and institutions looking for yield in financial markets. The system restricted who could become a market maker to a small group of investors by design. Automated Market Makers (AMMs) allow users to swap between crypto assets easily. However, to be able to swap certain assets, sufficient liquidity must still be available to fulfill the demands of the users' swapping. 

This is where permissionless liquidity provision with AMMs comes in. Users seeking yield can deposit a pair of tokens in liquidity pools where they earn fees paid by traders of this asset pool.

The users providing liquidity are given a claim of custody for their assets in the form of a Liquidity Provider  'LP Token.' This LP token can claim the ratio and amount of tokens from the smart contract at any time. Once redeemed, the depositor will receive the fees their position has generated and their initial deposit. 

Some protocols offer users these LP tokens as a reward in the form of incentivized yield. For example, in the case of the WX network, Curve users are rewarded with WX tokens for staking their LP tokens. Users are additionally rewarded with WX through trading on the WX Network just like any other verified token.

LP tokens enable flexibility when providing liquidity and opportunity for multiple yield sources. Providing liquidity to AMMs is one of the most popular yield-generation techniques within DeFi.

DeFi vs CeFi

The counterparty risks associated with Centralized Exchanges have never been more evident. DeFi has opened the door for retail investors to access financial markets that were previously only available to centralized institutions. Crypto's foundations are based on removing the need for third-party intermediaries. 

DeFi allows the legacy banking system to be disrupted, and is becoming the infrastructure for developing an industry entirely independent of it. It is crucial for DeFi users to have a clear understanding of the protocols they use before deploying their capital. There has never been a more exciting time to explore DeFi opportunities through the WX Network