Continued from Part I: Contrary to popular belief, most crypto lending activity facilitated by previously mentioned platforms is not peer-to-peer – it is customers lending directly to the platform, which then deploys customers’ assets into more lucrative strategies to generate yields.

Crypto lending: where did the yield come from?

Such yield is what various market participants had been looking for in the crypto space. Two popular trades throughout 2021 were the GBTC arbitrage and the futures market contango. By taking advantage of specific pricing dynamics between Bitcoin’s spot market and selected derivatives like the Grayscale Bitcoin Trust and Bitcoin futures contracts, various market participants were doing profitable, yet market-neutral arbitrage.

These two strategies were the sources that contributed a big junk to the various yield products that emerged. The more the demand grew though, the more these arbitrage possibilities with both the futures market and with GBTC funds disappeared though. With these arbitrage trades being gone, where did the yields come from now?

It was mainly DeFi protocols. What has been referred to as the DeFi summer of 2020 helped kick off a wider range of crypto lending activities. With GBTC and bitcoin futures arbitrage plays gone, many so-called CeDeFi players tapped into DeFi protocols to provide highly competitive yields, particularly when compared to the yields in traditional markets.

Nonetheless, yields ranging from 10% to up to 20% on stablecoins left many market observers wondering, where they were coming from. Notwithstanding the fact that many DeFi protocols experienced high capital inflows during their initial hype cycles, most of the yields were generated through protocol token inflation, which only nominally enabled such high pay-outs by DeFi protocols and thus CeDeFi crypto lenders. Soon enough, it dawned on more and more market participants that these mechanisms would have a hard time being sustainable and that if a lender does not know where the money comes from, then he most likely is where the money comes from.

There is no real yield in DeFi

It’s now clearer than ever: With the majority of DeFi protocols, there is no yield in the actual sense of the word. By definition, there cannot be as of yet. Why is this? Hardly any DeFi protocol is connected to the real-world economy. However, this is exactly, where a sustainable source of yield would have to be coming from. It is economic returns, which are the result of deploying capital successfully to meet consumer needs in the real economy, that generate real yield. In other words: Yield is the generated flow above maintenance costs or depreciation of the carrying capacity of some stock of economically productive assets. DeFi is generally lacking exactly this.

Not only are there no real yields in DeFi, but such yields can also only be artificial since credit is not adequately measurable. The popular metric referred to as “Total Value Locked (TVL)” is highly deceivable. TVL, as it is measured today, does factor in a lot of double counting. This makes the concept into a bloated number that hardly bears any substantial meaning. As a matter of fact, TVL obfuscates the actual leverage in a DeFi protocol as well as the DeFi ecosystem as a whole.

This fact cannot be understated: Because the real scope of leverage cannot be assessed adequately, the total ecosystem’s leverage remains un-auditable and therefore un-audited. And with leverage not accounted for, yields cannot even be properly underwritten. This in turn means that there is no way of knowing if the yield that is being given is adequate compensation for the risk taken. Consequentially, DeFi protocols are not something that lends itself to crypto lending as risk management as of today is hard to come by.

Read more about the topic in the upcoming Part III where we cover counter party and collateral risk and a solution to the current crypto lending market situation.