Yield Quality in Crypto Markets
Terms, types of yield, quality of yield
Most market participants are in crypto for the yield, let’s face it, we’re addicted to finding the best yield we can for our assets. As bull turns to bear, we can see a social shift from ‘in it for the yield’ to ‘in it for the tech’. The inner degen starts its hibernation and presents us with a less chaotic, stressed and cluttered mind. Now may be a good time to evaluate the different forms yield can take in crypto, what influences it and most importantly a look into the quality of the yield.
There are many things that can affect yield,, and it’s important to evaluate the business model and sustainability of a project. It is, however, but one side of the story, and we won’t get into that here (I’ll leave you some good resources at the end of this article which cover the topic of sustainability, yield types & business models very clearly). The other side of the story is looking at what I like to call the Yield Quality and is akin to the Total Return in the tradfi dictionary.
SETTING THE STAGE— defining terms
Without wanting to offend too many degens, let’s take a quick look at the TradFi dictionary since I think some definitions will help us to later frame Yield Quality in crypto, don’t worry I’ve added the crypto translations below.
Yield: Income returned on an investment, such as the interest received from holding a security
Translation: triple digit APRs on your crypto (there’s a caveat here, covered below)
Return: Change in dollar value of an asset over time
Translation: token pumps or dumps
Principal: original sum committed to the purchase of an asset (independent of any earnings or interest)
Translation: what it cost you to buy the tokens
Dividend: Cash distribution of a company's earnings to its shareholders
Stock dividend: A dividend paid to shareholders in the form of additional shares in the company, rather than as cash. This type of dividend may be made when a company wants to reward its investors but doesn't have the spare cash or wants to preserve its cash for other investments.
Translation: emissions (i.e. paid in protocol token)
Total return: (yield) + (change in asset price)
Translation: you either made it or got rekt
Words are largely inefficient at conveying meaning, and they often differ from sector to sector or people to people. It's important to note that in the crypto space, we don’t tend to think about Return or Total Return and simply use the word yield for most things. The problem with this is that we forget that change in asset price forms part of our ROI, but why is this important?
In the crypto space yield comes in two main forms; fee share and emissions. Fee share is akin to a standard dividend, and emissions are more akin to a stock dividend. In a tradfi sense, stock dividends are not considered yield, in the crypto space it is similar since emissions affect your principal investment by increasing supply.
This is applicable to whatever asset you choose to denominate your portfolio in, not simply in dollars. But there are differences between denominating your portfolio in ETH vs USD, which I’ll cover in the Yield Quality section.
TYPES OF YIELD & EXAMPLES
Ok, you can take off your suit and tie now. Let's take a look at the different forms yield takes in the crypto space but remember, crypto is not tradfi, many of the yields that we can find in crypto would not be deemed actual yield in traditional finance, but as mentioned, sectors differ, and simply because crypto yield doesn’t fit into the predetermined slots of traditional finance doesn’t mean we should dismiss it completely. We will deal with this later by looking at what influences yield and how we can measure the quality of said yield along a spectrum.
This type of yield refers to PoW chains. In PoW, miners have high running costs due to hardware requirements of mining rigs and electricity required to do the computation of hashing through nonces until finding the solution that suits the protocol requirements. In return, they are remunerated with new coins.
This is the OG of crypto yield.
Ex.: In the Bitcoin network, miners are remunerated in $BTC for their work securing the chain.
This type of yield refers to (1)PoS chains and (2)protocols.
In PoS chains, there are two actors. The first are validator nodes, but unlike PoW, there are no expensive rig requirements or high electrical costs, validator nodes perform their tasks and are remunerated in the form of token emissions which are determined by the chain itself. The second actors are token holders. By staking, these holders are contributing to the economic security of the chain and thus are remunerated accordingly. It is also the case that rather than remuneration for staking, there can be punishment for not staking, where holders that don’t stake get diluted by inflation (emissions).
Protocols don’t have nodes and simply have an emission schedules that distributes their token as a form of incentive or reward based off of:
Activity Rewards: where certain activities remunerate the user. Ex.: an airdrop
Contributor Rewards: where a DAO remunerates users with tokens for certain tasks. Ex.: TokenomicsDAO rewards contributors for creating awesome content and consultants for creating amazing tokenomic designs
Liquidity Mining Rewards: where users are remunerated with tokens for providing their liquidity into a pool. Note that this is different from swap fees, LP rewards are typically used to incentivise liquidity in certain pools, this is also where the ‘farm token phenomenon’ and ‘mercenary liquidity' ideas come from. Ex.: Uniswap provides $UNI rewards in certain pools to incentivize liquidity in said pools
This type of yield refers to fees generated by protocols. The two most common sources of fees are from DEXs swaps and Money market interest rates.
In the case of a DEX, a fee is charged for every swap in a liquidity pool, and a portion of those fees go to the LPs. One thing to note is that this yield is commonly grouped together with token emissions or rewards as mentioned above, but they are different things. Ex.: Uniswap 3% charge to swap in assets in a pool
In the case of a Money market, fees come from the spread between lenders and borrowers. Ex.: AAVE allows users to borrow from depositors, an interest is charged to the borrower, and it is split between the platform and the depositor
This type of yield refers to revenue paid out in a token other than the one that your principal investment is denominated in. The reason I call it clean yield, is that it has no effect on your underlying investment value and thus can be considered more so a dividend, the reason for this is that this type of yield is not increasing the supply and thus not affecting the price of the asset. It also has the added benefit of allowing people to realise profit without the underlying asset experiencing sell pressure to do so.
QUALITY OF THE YIELD
When I say quality, I don’t mean that said yield is more sustainable, but rather the fact that different types of yields have different effects on your ROI or Total Return. As mentioned at the beginning of this piece, in the traditional finance sense many of these yields would not be considered actual yield, but crypto is somewhat different in this regard, it's not that these are not yield, but rather they will have different effects on your return or total return.
INFLUENCES & THINGS TO CONSIDER
Each chain/protocol is unique, but there are some shared factors that we can consider when looking at yield
Economic Activity & Growth
There is a difference between a protocol that is growing and one that is simply decaying. Growth in user adoption, TVL and transaction count are all aspects to look into when considering yield.
It is also very important to understand the revenue source and figure out if it’s sustainable or not. An unsustainable yield does not mean that you shouldn’t touch it, but you’re playing with fire and the risks of burning oneself should be understood before entering.
Holdability of the token
The holdability of a token refers to factors that will make people want to hold it for a longer period of time. This can be useful in some situations.
Usability: If the token you are receiving emissions/fees in has a lot of use cases, then there may be less sell pressure since people can see it holding value for longer.
Ex: ETH staking will pay users in ETH, this is more akin to a stock dividend but since ETH has so many uses in Defi, mainly that it can be used as collateral and LP almost anywhere, we can assume that it will not have the exact same effect as a typical stock dividend (people won’t have the urge to sell)
Monetary Policy: Each token is unique (**cough** copy pasta **cough**). Certain aspects like if the token is inflationary or deflationary affect holdability since people can speculate on the future value of the token.
Ex.: We will supposedly see a deflationary ETH with Ethereum 2.0, this has the effect of increasing the strength of the token
Narrative: Narrative, hype, memes.. Call it what you want, but they too have an effect on the holdability of a token
These influences are more of a social phenomenon than an empirical effect, but this doesn’t mean that they should be ignored since the yield score can change depending on whether a token is more attractive and more importantly, attractive to many.
What is the yield paid in?
The numbers (APRs) we see on our screen are not always true, in that there are more factors at play when it comes to judging ROI. One of the most important things to understand is what you are being paid in, and how it will affect your overall ROI or Total Return.
Here are some great resources to understand the sustainability/business model side of protocols:
The Hitchhiker's Guide to Yield – by Jack Melnick
150% APR? How Are DeFi Yields So High? – by Nat Eliason
How to Earn Passive Income in DeFi – also by Nat (great writer)
Crypto has some of the best yields around, but don’t get taken away by those juicy APRs too much since, as we’ve covered, there are a few things that affect what the actual yield will be, whenever I’m looking at an APR I like to ask myself these questions:
What’s the type of yield? (See types of yield & examples)
What’s the quality yield? (See Quality of Yield)
What’s the actual yield? (See Influences & things to Consider)
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This post does not contain financial advice, only educational information. By reading this article, you agree and affirm the above, as well as that you are not being solicited to make a financial decision, and that you in no way are receiving any fiduciary projection, promise, or tacit inference of your ability to achieve financial gains.