Where Does Yield Come From in DeFi?

Decentralized finance, or DeFi, has opened up various avenues of income for investors. One such avenue is yield farming. This involves taking advantage of your cryptocurrency assets to receive rewards. By lending or staking tokens with a particular DeFi platform, investors can receive periodic payment in the form of “interest”, much like how banks reward their customers for saving their money with them.

Although it is not an exact science, yield farming is a strategy that involves moving crypto through various protocols. It has long been considered as the main driver of the DeFi sector's growth.

One of the main narratives in DeFi is that people will start moving their fiat into the platform due to the higher interest rates. In reality, this is true as most banks only offer sub 1% rates on most of their money. The reason why people are skeptical about the crypto yield numbers is that they seem to reflect some hidden risk. It is a fair hypothesis that crypto investors are taking on more risk to get higher rates. However, one question remains – where does the money come from to make yield farming a sustainable venture?

Sources of Yield

1. Borrowing

The existence of demand for borrowing naturally leads to the existence of yield farming. To put it simply, individuals and businesses need to obtain capital to purchase goods and services. Because of this, markets for borrowing assets are formed, and lenders expect to get a certain amount of reparation for their loans. Looking ahead, it is unlikely that these rates will eventually go down since loans are an important part of the DeFi market.

At the same time, the loans market will always be active as people are naturally looking for leverage. If we look at the futures and options market, we can see that traders lured by the prospects of high profits borrow recklessly.

Finally, if traders are extremely optimistic about the price increase of an asset, then you may want to borrow more to purchase it. This is because the asset's growth will out-perform the interest rate that they are paying.

2. Providing a Service

Investors can also earn yield by using their assets to provide a service. For example, a money-changer may charge a fee for providing a service, as they are using their assets to convert one currency for another. Customers are willing to pay a small fee for the sake of convenience, and this is the same for the DeFi market.

Being able to provide liquidity to an automated market maker (AMM) is a type of yield-generation. It allows users to swap different cryptocurrencies with ease and is worth the small sum of transaction fees that are levied on these users.

Although demand for these services is expected to continue, they are also carrying their risks, such as impermanent loss. Over the long term, if the fees earned outweigh the potential risk, asset-delivery management will still be a yield-positive endeavour.

3. Investing in Equity

Another type of yield is derived from the growth of a company's capital. Much of the high yield in DeFi is due to the eventual growth of a protocol’s native token. For example, by providing liquidity to a protocol, you would earn a percentage of the liquidity pool’s transaction fees plus the protocol’s native token.

If the protocol gains more traction, it stands to reason that its native token would be in higher demand, and may even undergo a parabolic growth. This translates to a higher yield for liquidity providers.
Since the competition for liquidity is fierce, some protocols see giving this as a way to encourage users to participate in their ecosystem by paying a nominal fee. If the native token of a protocol does well, it becomes a win-win situation for everyone.

In conclusion, yield farming has become a “science” for some investors, and they are constantly exploring new avenues that may net them a higher APY. However, it is important to take note of where exactly the yield comes from, and take the necessary actions to secure profits gained.