Are DeFi’s High Yields On Stablecoins Worth The Risk?

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General description

Just as investors became accustomed to record risk-free yields on short-term US Treasuries, yields on stablecoins like Tether (USDT) and USD Coin (USDC) have risen in recent weeks. With cryptocurrencies starting to move as investors gear up for spot ETFs not only for Bitcoin but also Ethereum, where most of DeFi resides, stablecoin holders suddenly have multiple options to put their money to work. work.

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Key background

DeFi gained popularity in the summer of 2020, primarily driven by the innovative concept of yield farmingfirst introduced by the lending protocol Compound Governance Token. Yield farming, a speculative, high-risk, high-return practice of earning “free money” by depositing tokens into various DeFi protocols, triggered a massive capital inflow into the DeFi ecosystem, surpassing $175 billion. in November 2021. The most prominent decentralized lending protocols, Aave and Compound, saw almost 40% of deposits in stablecoins.

As background, stablecoins are digital representations of a dollar that reside on a blockchain such as Ethereum, Tron, BNB Smart Chain, and many others. Their fungibility has made these assets key sources of liquidity for cryptocurrencies. Dollar-pegged stablecoins are a $127 billion industry, with the two largest players being Tether's USDT ($88 billion) and Circle's USDC ($24 billion).

The unsustainability of these returns became evident in mid-2022 with the collapse of the TerraUSD stablecoin ecosystem, which built on its own DeFi lending project called Anchor to encourage people to hold tokens. With $50 billion disappearing from the Terra ecosystem in a matter of days, investors began withdrawing funds from yield farming protocols across blockchains. Centralized custodians like Celsius and Voyager also announced double-digit returns on stablecoin deposits, which they then lent to trading desks or put into the DeFi ecosystem. Those practices diminished sharply when the market crash exposed misuse of client funds. This led to the eventual bankruptcy of both companies along with many other notable industry participants such as FTX and Genesis Global Trading, among others.

Loss of trust in centralized custodians combined with decades-long high interest rates in the US has increased demand for on-chain TradFi solutions that provide yield to stablecoin holders but give them the option to trade in crypto markets as they wish. One solution has been tokenized Treasury bonds, which have skyrocketed since $104 million invested at the beginning of the year to $675 today. It is true that these figures are still a very small percentage of the $23 Trillion Treasury Bond Marketbut it has an upward trend.

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Key Statistics

The table below shows the current lending yields on the Ethereum Aave protocol for popular cryptocurrencies and stablecoins.

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Perspectives and implications

On-chain and off-chain Treasury yields are likely to remain elevated at the current pace due to a number of factors. For one thing, the full pain of the inflation cycle introduced by pandemic-driven stimulus measures has yet to be felt, which would rule out any rate cuts next year. But that also doesn't mean the target rate will change from 525 to 550 basis points because it would be difficult for the seemingly apolitical Fed to raise rates again during an election year.

It is more difficult to predict future DeFi rates for stablecoins, which, like any other product, depend on a balance between supply and demand. From a demand perspective, industry experts suggest that the new drivers of stablecoin demand are centered on investors looking to invest in spot cryptocurrencies, specifically bitcoin or ether. Spencer Hallarn, head of OTC trading at market maker GSR, says many traders looking to invest in bitcoin, which is up 120% this year, are taking advantage of DeFi markets as a cheap and relatively easy source of stablecoins to fuel these bets.

Another market participant suggested that traders are using stablecoin pools in DeFi to go long ether with leverage. They can deposit ether into a lending pool on a DeFi protocol like Compound to take out more stablecoins, exchange them for ether again, and repeat the cycle over and over again. While ether has underperformed bitcoin so far this year, investors taking this approach are betting on a rise next year after spot bitcoin ETFs begin trading and mutual fund applications. ether, led by one of the world's largest asset managers, BlackRock, come up for consideration. by the Securities and Exchange Commission. This trend suggests that the demand for stablecoins will remain high. But given the huge volatility of cryptocurrencies, their prospects will likely be riskier than those of US Treasuries.

One final point: It is important to note that while stablecoins are intended to be fungible, the risk profiles of various assets depend on their issuer. For example, Boston-based Circle Financial Ltd, issuer of USDC, claims to embrace regulation and positions its asset as the safest stablecoin possible. On the other hand, market leader. Tether has been dogged by controversy Since its inception, it has never conducted an audit and refuses to name its banking partners. However, this does not necessarily mean that USDC is "secure" and USDT is "insecure." During the March banking crisis, it was revealed that Circle had $3.3 billion in unsecured deposits at Silicon Valley Bank while Tether was not affected.

The purpose of this discussion is to point out that stablecoins can be lent/borrowed at different rates in DeFi. However, as you can see in the chart below, where the interest rates for USDC and Tether change over the course of the last three months, there is no consistent pattern between the two. Hallarn says there is usually a lot of “noise” in these markets. Another possible explanation for these fluctuations is that traders are arbitraging spreads between these assets to make incremental profits on their existing trading strategies.

Decision points

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Investors who want to deploy cash on-chain must decide whether they want the consistent return of a TradFi-based product or ride a rollercoaster of DeFi returns.

There are several excellent options for investors who want to stay in stablecoins and keep their powder dry for the next bull market, which may be just beginning. Accredited custodians like Coinbase offering interest rates in USDC comparable to national banks. In the world of tokenized Treasuries, Franklin Templeton is the leader in the TradFi space, with over $300 million currently invested. US Government Monetary Fund Franklin OnChain launched on Stellar Network.

The net expense ratio is a reasonable 20 basis points and the yield is currently over 5%. For DeFi purists, a Maple Finance cash management offering has attracted $20 million in assets. The group accepts USDC deposits on Ethereum and invests in US Treasuries through a related entity, charging 50 basis points and delivering an APY of just under 5%. It is also worth noting that these projects offer daily liquidity to investors who want the ability to roll back their holdings to stablecoins for trading purposes.

If you choose to let your assets rely on DeFi protocols, be sure to check interest and borrowing rates daily, as they can suddenly change in either direction at short notice. Potentially positive stimuli could include news of the approval of a bitcoin or ether ETF by the SEC, while, on the other hand, unexpected thefts or hacks of a DeFi protocol or regulatory actions against DeFi itself or the key tokens it supports could weaken demand. The two most established and secure DeFi lending protocols are Aave and Compound, so investors looking to get into DeFi for the first time may want to consider those options first.

Ultimately, investments should align with your time frame and risk tolerance. When a bull market hits, it is always better to be early rather than late. The greatest progress is made at the beginning of the cycle. If your digital assets are not for speculation and could be used in the real world, feel free to enjoy higher returns and even some TradFi products.