By Rafael Cosman, Co-Founder and CEO of TrustToken
The decentralized finance (DeFi) space has become synonymous with yields that seem crazy next to their traditional-investment counterparts. But yields do tend to be proportional to the risks involved, and the risks are defined by the underlying business model. Anchor, Terra’s signature lending protocol, and its collapse are a case study of what happens when this model is at best lacking polish—and what fundamentals the industry should move to for delivering similar yields in a more sustainable fashion.
The simple matter of $14 billion
Terra’s recent fall from grace sent ripples across the crypto space, prompting concerns both for other algorithmic stablecoins and the larger crypto ecosystem. Its attempts at a rebound aren’t going too swimmingly, and at this time, it’s quite possible to say that the saga is basically over. And a sad saga it is—the protocol was positioning itself as a safe and secure investment vessel, lulling investors into a sense of trust… So much so, in fact, that many chose to put their entire life savings into Anchor and had to come to terms with the fact that the money they had been saving up for years is gone.
The ecosystem’s demise began with a massive exodus of funds in UST from Anchor, the aforementioned popular yields farm on Terra. These funds were used to attack UST’s exchange rate against other stablecoins, de-pegging its value from USD and setting off a death spiral that ran the token further and further from its peg.
While the pegging mechanism behind the algorithmic stablecoin was flawed, the situation would hardly have escalated so dramatically and so fast if it had not been for Anchor. Anchor promised its users an APY of about 20 percent, which supposedly came from its “lending” operations. This premise seems doubtful, especially given the $450 million injection the protocol received from Luna Foundation Guard. Still, with super-lucrative returns like that, it’s no surprise Anchor was wildly popular—so popular, in fact, that at its peak, it held about $14 billion of UST or 74 percent of the token’s total circulating supply. It’s no exaggeration to say Anchor was the primary component of UST’s adoption.
Anchor’s promise of wild gains brought hype into the network and stirred up the demand for UST—an engine that swiftly pumped up Terra’s overall market cap, setting the stage for its eventual unraveling. As some commentators have pointed out, if you don’t know where the yield comes from, you are the yield. The truth is, however, getting close to Anchor’s promised yields is possible in on-chain lending, but requires a whole different approach, and a much deeper understanding of the risks.
The myth of zero risk yields
Many of today’s DeFi lending models rely on token-fueled incentives or obfuscated high-risk lending. The prevalent model sees the borrower overcollateralize their loan, usually issued in a stablecoin, for the service to offset the risk of lending without a proper Know Your Customer check. Should the value of the collateral, usually paid in one of the non-pegged cryptocurrencies, drop below a certain threshold, the service liquidates it to make sure it can deliver lenders the bang on the buck.
This system is meant primarily to eliminate the risk for lenders, as they are the ones that bring liquidity to DeFi lending services. What this results in, however, is a service that sacrifices capital effectiveness for marginally reduced risk for lenders. When fused with a promise of Anchor-style sky-high yields coming from unclear revenue streams, it is basically a recipe for disaster.
Furthermore, on-chain lending is the business model of choice for a wide array of yield farms favored by both retail and institutional users. Here is a rough sketch of the economy they end up creating. First, they lock their token A in as collateral for a loan in token B, which comes from a pool made up of funds loaned by other investors. Then, they put token B into another yield protocol, which lends these tokens to another user following exactly the same plan, to get a yield on it while keeping the initial stake. This creates an ouroboros of an economy, spiraling through dozens of lending and borrowing cycles without ever creating any tangible value whatsoever.
The real opportunity for sustainable yields lies in real-world financial instruments with known risk models and proven business fundamentals, from B2B and venture lending to mortgages. They can achieve competitive yields (although rarely 19 percent, at least consistently) while relying on tangible financial processes to deliver risk-adjusted returns and deliver real-world outcomes.
Institutions pivot in search for alpha
The blockchain industry needs to do away with the token-fueled recursive lending that creates little real-world impact. Too few projects work to integrate crypto and blockchain into the real-world economy. The industry needs to build bridges outside of DeFi itself and seek to enter niches where we can meaningfully compete against TradFi alternatives.
Many crypto-native entities such as MakerDAO and FRAX are already looking to make this transition and leverage real-world assets as a powerful backbone for their economies. The former rolled out a major plan to move toward off-chain value through lending, tapping into the larger global debt market, which stood at $226 trillion last year. The latter is expanding into real-world loans to sustain the peg on its own algorithmic stablecoin.
All of this should be encouraging for financial institutions in their never-ending quest for risk-adjusted yields. On-chain credit is shaping up as a prime source for those as stocks and other traditional markets are in a disarray. Moving this industry to a healthier business model underpinned by a more clear-cut risk assessment is crucial for securing long-term institutional presence and investment in the DeFi space.
The retail investors will likely hop on board with the push for more exposure to real-world markets and assets, for exactly the same reasons as institutions. High risk-adjusted yields make for a lucrative offer in a market where few other assets can bring you the same returns. Sure, there will always be a proportion of crypto enthusiasts aping in on whatever exudes the most hype, but the more intelligent crowd will channel its collective wisdom to get the best risk-to-reward ratio in the market.
At the end of the day, real yields come from real-world assets. Putting your money to work for tangible outcomes and opportunities brings you returns; chasing yields out of thin air gets you into a Terra crash.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.