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Yield in Crypto Markets
Crypto-assets like bitcoin and ether have traditionally been commodity-like, but a new wave of crypto-assets entail automatically-enforced rights to future cash flows.
These debt-like crypto-assets generate their yield from two primary sources:
  1. 1.
    interest rates on decentralized secured loans
  2. 2.
    trading fees from automated market makers

Decentralized secured loans

Blockchains enable the origination and management of secured loans without reliance on trusted actors like escrow agents. Investors originate decentralized secured loans on protocols like Compound and Aave that allow users to pledge one type of crypto-asset as collateral so that they or others can borrow another supported crypto-asset. Smart contracts allow investors to borrow crypto-assets only up to limited loan-to-value ratios (“LTV”) and manage auto-liquidation of the pledged collateral if the LTV increases to a certain trigger (e.g., 80%). Depositors of collateral in these systems receive yield paid out from borrowers. For instance, a depositor of Dai into Compound receives cDai, which is paid a block-by-block yield from borrowers of Dai. These yield-generating tokens (cTokens for Compound, aTokens for Aave, etc.) are themselves transferable and can be staked in other protocols, including to be used as collateral for more loans.
As the value of natively on-chain assets grows, and as tokenization of natively off-chain assets continues, we believe that non-custodial secured on-chain lending will prosper.

Automated market makers

Automated market makers (“AMMs”) enable non-custodial trading of on-chain assets, typically via market orders where the price is set automatically per a predetermined formula. Most of these AMMs set the price of a particular trading pair (e.g., ETH-USDC) such that the product of the number of tokens offered for sale on both sides of the pair (e.g., ETH and USDC) remains constant. In other words, where x is the number of tokens of ETH pledged for sale and y is the number of tokens of USDC pledged for sale, and k is some invariant, it is always true that x * y = k.
AMMs democratize market making -- investors can simply pledge assets to an AMM to make markets in a trading pair without needing to write their own trading algorithms. They do this by depositing both assets of a trading pair (the “base assets”), typically with equal value of each. In return, they receive liquidity provider tokens (“LP tokens”) that accrue a percentage of fees paid by traders. Like the cTokens and aTokens described above, LP tokens are transferable and can be staked in other protocols, including as collateral for loans. LP tokens can also be redeemed at any time for the associated base assets.
LPs ordinarily suffer trading losses from arbitrageurs who keep prices on AMMs in line with prices on other liquidity venues. These trading losses are referred to in the industry as “impermanent loss (IL)”. The amount of IL that LPs experience is a function of how much the price of one of the base assets changes with respect to the other. We present below a chart of IL plotted against changes in relative price:
Source: Liquidity Folio.
Last modified 5mo ago
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