Hi friends 👋

Unless you have been living under a rock, it has been hard to miss the news - inflation is back.

First in the US, inflation hit the highest level in 30 years, and now the UK has followed the US to a 10 year high in inflation.

Inflation hits the poorest in society hardest. If you receive your income from a salary rather than assets, as most of the poor do, you are getting worse off.

At the same time, if you are keeping your money in a savings account, that's not going to do you much good either, with savings rates around 0.01%.

In contrast, DeFi yields of 10's, 100s or even 1000s of percent per year are not uncommon.

No wonder people have started to pay attention.

At the same time, it's worth asking why these protocols are able to offer such high yields - where does the yield come from?

Sources of Yield

The first thing to note is that not all yield is sustainable, in fact a lot of the very high yields are due to printing lots of tokens, and that's likely to pretty rapidly lead to a collapse in price.

More sustainable yield usually comes in a couple of different forms. Let’s take a look at each in turn.

1. Lending

If you provide assets such as stablecoins for lending on a platform such as Aave or Rari, anyone that borrows capital pays an interest rate. On platforms such as Aave, the yield might be around 2.7% on stablecoins.

That might not be enough to offset inflation, but it's still an order of magnitude greater than you will get from your bank. Newer (read, more risky) platforms such as Rari might offer 15-25%.

It's fascinating to see what people are willing to pay to borrow in an essentially unregulated lending market.

2. Staking

Securing blockchain networks requires resources, whether that is through running specialised computers 24/7 (proof of work), or locking up assets (proof of stake). Proof of work is the way that Bitcoin and Ethereum currently secure their networks, but Ethereum will at some point switch to proof of stake.

When you stake your ETH you will be rewarded for doing so, because you are helping validate transactions, and therefore making the network more secure for everyone. Right now, ETH staking will earn you about 5%, and this could go significantly higher after the ETH 2 merge.

This yield comes from a portion of the fees that all users have to pay to use the network. Staking can be a little complicated, but some services such as Lido make it much easier.

3. Exchange fees

When you use a decentralised exchange such as Uniswap, you pay a fee. A part of that fee goes to liquidity providers. Liquidity providers are people that have chosen to provide their tokens into a pool that is used to swap between the tokens.

For example if you deposit ETH and DAI liquidity, whenever someone trades between ETH and DAI you'll earn a percentage of the 0.3% fee charged on that trade.

The easiest way to see what your yearly returns are is to use a service like Zapper.

So these are 3 of the big ways that yield is generated sustainably. There are other ways that yield is created, but these are some of the basic ones that everyone should be aware of.

You will notice that the yields I have described so far aren’t stratospherically high, just up to about 20%.

But what about those crazy yields you have heard so much about, the tens or thousands of percent?

Generally what is happening when you see an APY in the 000’s is that massive token inflation (i.e. creating lots of new tokens out of thin air) will probably lead to price collapse. The other possibility is that the protocol is offering a high APYs as a short term bootstrapping strategy to incentivise people to provide liquidity for a new protocol, again not a strategy that will last very long.

Finally, Olympus DAO pioneered another model that seems to offer eye wateringly high APY’s,(1000’s of percent) in a way that might be somewhat sustainable, but is also highly inflationary (by design).

This article is getting too long already, but if you want to learn more about Olympus DAO, check out this article I wrote on it recently.

I hope this basic overview helps you to start to think about where that high APY is coming from before you jump into a project.

Until next time.

Jamie

🚨 Disclaimer: This is not investment advice. Everything in this newsletter is for entertainment and education purposes only. Do your own research. You should assume that I am financially invested in any and all the projects mentioned in this article. In the unlikely event I receive any financial reward for linking to a project, that will be clearly highlighted.