DeFi
From staking to recursive lending
The following is a guest post by Vincent Maliepaard, Marketing Director at IntoTheBlock.
Staking
Staking is a fundamental yield generation strategy ChallengeIt involves locking up a blockchain’s native tokens to secure the network and validate transactions, earning rewards in the form of transaction fees and additional token issuance.
Staking rewards fluctuate based on network activity: the higher the transaction volume, the greater the rewards. However, stakers should be aware of risks such as token devaluation and network-specific vulnerabilities. Staking, while generally stable, requires a thorough understanding of the underlying blockchain dynamics and potential risks.
For example, some protocols, such as Cosmosrequire a specific unlocking period for stakers. This means that when you withdraw your assets from staking, you will not be able to actually move them for a period of 21 days. During this period, you are still subject to price fluctuations and cannot use your assets for other yield strategies.
Liquidity provision
Liquidity provisioning is another method of generating yield in DeFi. Liquidity providers (LPs) typically contribute two assets to a liquidity pool on decentralized exchanges (DEXs). LPs earn fees on each trade executed within the pool. The yields of this strategy depend on trading volumes and fee levels.
High-volume pools can generate substantial fees, but LPs should be aware of the risk of impermanent loss, which occurs when the value of the pool’s assets diverges. To mitigate this risk, investors can choose stable pools with highly correlated assets, ensuring more consistent returns.
It is also important to keep in mind that the projected returns of this strategy are directly dependent on the total liquidity of the pool. In other words, as more liquidity enters the pool, the expected reward decreases.
Source: In the block
Ready
Lending protocols offer a simple yet effective method of generating yield. Users deposit assets that others can borrow in exchange for paying interest. Interest rates vary based on the supply and demand of the asset.
Strong borrowing demand increases returns for lenders, making it a lucrative option in bullish market conditions. However, lenders must consider liquidity risks and potential defaults. Monitoring market conditions and using platforms with strong liquidity buffers can mitigate these risks.
Airdrops and Points Systems
Protocols often use airdrops to distribute tokens to early adopters or those who meet specific criteria. More recently, point systems have emerged as a new way to ensure that these airdrops are targeted to actual users and contributors of a specific protocol. The concept is that specific behaviors reward users with points, and these points are correlated to a specific allocation in the airdrop.
Trading on a DEX, providing liquidity, borrowing capital, or even just using a dApp are all actions that would typically earn you points. Points systems provide transparency, but are by no means a surefire way to generate returns. For example, the recent Eigenlayer airdrop was limited to users in specific geographies and the tokens were locked during the token generation event, which sparked debate within the community.
Leverage in Performance Strategies
Leverage can be used in yield strategies such as staking and lending to maximize returns. While this increases returns, it also increases the complexity of a strategy, and therefore its risks. Let’s see how this works in a specific situation: lending.
Recursive lending capitalizes on the incentive structures within DeFi lending protocols. It involves repeatedly lending and borrowing the same asset to accumulate rewards offered by a platform, thereby significantly improving overall yield.
Here’s how it works:
- Asset Supply: First, an asset is supplied to a lending protocol which offers higher rewards for supply than the costs associated with borrowing.
- Borrow and Replenish: The same asset is then borrowed and replenished, creating a loop that increases the initial stake and corresponding returns.
- Incentive Capture: As each loop is completed, additional governance tokens or other incentives are earned, increasing the total APY.
For example, on platforms like Moonwell, this strategy can turn a 1% offering APY into an effective APY of 6.5% once the additional rewards are factored in. However, the strategy carries significant risks, such as interest rate fluctuations and liquidation risk, that require ongoing monitoring and management. This makes strategies like this more suitable for Institutional DeFi participants.
The Future of DeFi and Yield Opportunities
Until 2023, DeFi and traditional finance (TradFi) operated as separate silos. However, the increase in Treasury interest rates in 2023 has driven demand for integration between DeFi and TradFi, leading to a wave of protocols entering the “real-world asset” (RWA) space. Real-world assets have primarily offered on-chain treasury yields, but new use cases are emerging that leverage the unique characteristics of blockchain.
For example, on-chain assets like sDAI are making it easier to access Treasury yields. Large financial institutions like BlackRock are also getting into the on-chain economy. Blackrock’s BUIDL fund, which offers on-chain Treasury yields, has accumulated over $450 million in deposits within months of its launch. This indicates that the future of finance is likely to become increasingly on-chain, with centralized firms deciding to offer services on decentralized protocols or through permissioned paths like KYC.
This article is based on IntoTheBlock’s most recent research paper on institutional DeFi. You can read the full report here.