How to spot if a crypto yield opportunity is “too good to be true”?
IMPORTANT NOTICE: This blog does not constitute financial advice and is for informational purposes only. The price of digital assets can go down as well as up and you may lose all of your capital. Investors should consult a professional advisor before making any investment decisions.
- There are several things to look out for to understand whether the yield offered on your digital assets is unsustainable
- There are many different ways to achieve yield in finance, and as a general rule of thumb, the higher the yield being offered, the greater the risk being taken
- Some examples of popular strategies for generating yield are: liquidity provision, lending and borrowing, and market-neutral trading strategies (including arbitrage)
- Through a combination of DeFi and these strategies, it has been historically possible to deliver around 10%+ per annum on stablecoins
- Very high yields are likely achieved utilizing riskier strategies
- The key thing to remember is: “If you can’t find where the yield is coming from, you are the yield”
During the Blockchain Week Rome event at the end of May, our CIO Lucas Kiely delivered a keynote speech looking at yield-generating opportunities available in decentralized finance (DeFi) and the wider digital asset market and how to spot when they are “too good to be true”.
Hot on the heels of the Terra/LUNA collapse and amid the current sell-off in the digital asset market, it is no wonder investors are concerned about the safety of the assets they have deployed into yield-generating protocols. In his speech, Lucas emphasized the need for a strong due diligence framework to understand where the yield is coming from.
“If you can't find where the yield is coming from, then effectively you are the yield,” he explains. As such, a key piece of advice is: “Don't put your money in boxes you don't understand.”
“Most of these are short credit default swaps, which are exposed to the risk of default,” he goes on to explain. “In crypto speak, default means rug pull.”
Three main ways to generate yield
In his speech, Lucas highlighted three key strategies for generating yield.
- Liquidity provision to automated market makers (AMMs). AMMs require liquidity and they incentivize this by providing rewards in exchange for it. Market makers enable buyers and sellers of assets to trade smoothly without having to find a counterparty to complete the trade. By providing the assets that allow market participants to tap into that liquidity, the market maker receives a fee and thus earns a return.
- Lending and borrowing, where the lender receives yield in exchange for lending their assets. This can either be collateralized (lower-risk, lower yield) or uncollateralized (higher-risk, higher yield).
- Market-neutral strategies, often utilized in addition to DeFi and other strategies to enhance returns. This includes arbitrage strategies such as basis trading, venue arbitrage, triangulation arbitrage, or volatility arbitrage.
How to spot if it’s “too good to be true”
So how do you spot if a yield-generating opportunity in crypto is too good to be true? Lucas identifies a number of ways to find the “outliers” in the overall crypto yield market offering.
The first step is to compare the yields on offer across the entire crypto market. In the current market conditions, Lucas explains that standard returns for stablecoins are around 4-8%. Higher yields indicate that more speculative investments are being used to generate them.
Lucas points to the Anchor protocol, Terra's largest DeFi protocol, which paid an 18% yield on UST. The high returns on offer caused the Terra ecosystem to experience explosive growth, with total value reaching $18 billion at its peak last May. However, as we know, the Terra ecosystem was not able to sustain its peg as investors had believed.
To understand the risk/reward opportunity of a crypto liquidity pool, Lucas highlights several real-time metrics to consider:
- Ratio of circulating market caps of the respective coins
- Flows in and out pools
- Balance of liquidity reserves in pools
- Burn rate of APY generating reserves
- Behavior of large holders
- Order Book dynamics
In addition, there are several sustainability factors that should be assessed before committing to an allocation. These include some the following questions:
- Who are the founders? What is their track record?
- What is the economic loop? Where does the money go?
- Do the fees generated justify the yield being paid?
- What kind of runway exists to build long-term value and sustainability of the protocol?
- Can the reward tokens earned underpin a long-term value proposition and therefore provide potential speculative upside to the published APYs?
Lucas explains that as the TVL of any asset class increases significantly, it attracts more sophisticated participants which in turn compresses the overall yields available. Where market professionals find weaknesses, these can be traded against the intentions of the protocol builders. When this happens, the question is, “can you defend the economics of your token in the face of huge amounts of capital that will challenge the thinking behind it?” he says.
Alternative yield-enhancing opportunities
Aside from DeFi, there are ways to generate yields above normal market rates on stablecoins. Alternative yield-enhancing opportunities include arbitrage strategies – which look to trade similar instruments across different markets. Volatile markets in a highly fragmented and decentralized market place are particularly fertile ground for creating such opportunities, but increasingly require more sophisticated execution capabilities to achieve returns.
“Extreme volatility and high momentum, with temporary dislocations, and lower liquidity, create these opportunities,” says Lucas. “Crypto is primarily a retail and sentiment driven market, which makes liquidity provision and sentiment trading exploitable.”
He further explains that the crypto derivatives trading market is nascent, and therefore illiquid, which leads to mispricing. Growing trading volumes coupled with a lack of credit lines throughout the crypto market, in turn, lead to arbitrage opportunities.
A combination of volatility, momentum, temporary drawdowns, huge leverage in the system, and the correlation between coins contribute to an increase in alpha-generating strategies.
How to find out where the yields are coming from
Based on the above, investors can gain an understanding on whether the yields offered by a certain protocol are sustainable.
For example, as Lucas explains, a yield of 10% per annum for simply providing liquidity to market makers is unlikely to be a “risk-free opportunity”. A 10% yield for lending the biggest coins out is also “not a sustainable model”.
On the other hand, 10% per annum based on a combination of strategies, such as DeFi, lending and arbitrage, is a much more reasonable yield to expect. This is because there is a whole range of different arbitrage strategies, including triangular, liquidation, integrated, or options arbitrage, that can be combined to generate the expected yield.
Arbitrage opportunities delivered around 20% in 2019, 18% in 2020 and as much as 36% in 2021. The majority of the latter was generated in April 2021, when a large amount of leverage entered the market, which saw a big rally in crypto assets.
“As we move through the different cycles of the crypto ecosystem, these opportunities come and go. The risk-free rate now in pure DeFi is around 1-3% on stablecoins, around 1-2% in lending, and around 8-9% in arbitrage strategies,” Lucas says.
Commenting on the performance of portfolios during the month of May, he adds: “The great thing about the arbitrage strategies this month, given the Terra/Luna situation, is that they're all returning positive yields, because essentially they're not taking any directional risk.”
Lucas’s most important piece of advice comes down to one thing: trying to understand where the yield is coming from. “If those yields are paid using a multi-strategy approach, such as a combination of DeFi, arbitrage, lending and borrowing, then they are likely a lot more sustainable,” he says.
Keep an eye on our social media channels for clips of Lucas’s speech, and remain diligent to avoid crypto earning opportunities that are not sustainable. Remember: if it seems too good to be true, it probably is.
For a full video of Lucas’s speech, head to our YouTube channel.
Yield App CIO Lucas Kiely brings with him over 25 years of experience in the traditional finance world, having spent 15 years managing over $14 billion of risk capital across 44 funds at the world's leading investment banks.