On Non-Dilutive Yield

According to Blk_7wan, tradfi investors are fleeing the rampant speculation of growth stocks to seek shelter in market neutral strategies or value stocks with strong cash flow. I believe these strategies have equivalents in the crypto world, and there has never been a better time to learn about them. I’m talking about the farming of revenue-based yield.

A lot of people swore off yield farming this past year as unsustainable farming practices flourished in the last run up. A lot of protocols would offer unthinkable yields to attract new liquidity, then use that price appreciation to sustain – you guessed it - more unthinkable yields.

A lot of these protocols nuked under the weight of their excessive emissions last year, but that doesn’t mean there aren’t rich opportunities available in farming yield from healthier sources. To differentiate takes a bit of discernment on our part, so let’s take some time to hone our skills. Let’s first take a look at the interplay between rewards and token supply, and maybe we can learn to diagnose healthy versus unhealthy sources of yield.

It starts with Tokenomics. Tokenomics design is a fine art, and one that’s frequently misunderstood by novice investors. Any token’s price is a function of supply and demand, and “tokenomics” is shorthand for the incentive structures set up at a project’s outset that will influence these factors throughout its lifespan. If the circulating supply goes up without a commensurate rise in demand, for example, the price will inevitably come down. You can see how a project’s plan for introducing tokens into circulation might have consequences for its price down the road.

Perhaps the most important variables in that plan are the project’s distribution and emissions schedule. Distribution refers to how a token’s maximum supply is initially divided between different groups (founders, pre-sale, staking rewards, etc.), and the emissions schedule dictates when locked tokens become available. Easy enough.

But what do tokenomics have to do with yield farming? The tokenomics laid out at a project’s inception determine the schedule on which new tokens will be introduced to circulation – they determine when and how the circulating supply will be diluted. While some portion of this dilution occurs when the tranches allocated to founders or seed investors finally vest, certain projects allocate tremendous amounts of tokens to staking rewards as part of their strategy to attract users and liquidity. In other words, they set aside a portion of their supply to bribe users to lock tokens on the contract. In the worst cases, this is done as a conscious effort to artificially inflate price.

While this strategy may function well in a bull market, where dilution will always be offset by new money aping into the token with the greatest hype, it tends to fall flat as soon as this flow of speculative liquidity dries up. As GCR notoriously foresaw in November, there comes a point in every ponzi when finite demand can no longer keep up with an expanding supply, and that’s when the music stops.

Take one example.

Bastion Protocol is a Compound fork on the NEAR ecosystem, aspiring to be the liquidity hub of that L1’s EVM, Aurora. Lending, borrowing, stableswap, you know the drill. The thing is, liquidity hubs tend to require a lot of uh, liquidity, and new protocols are faced with the difficult question of how to bootstrap it. The classic solution is to offer astronomical rewards to people who lock their tokens in liquidity pools on the protocol, and the classic outcome is being sacked by a horde of mercenary liquidity providers who move on to the next host body as soon as the rewards dry up. This is, of course, the route that Bastion elected to take.

In the page above there are two images, and they tell the same story from two perspectives. On the ground level, Bastion’s bootstrapping escapades look like 100% APY staking rewards for a protocol that was collecting almost zero fees (or worse, negative 700% fees.) From 10,000 feet, it looks like the circulating supply being slowly inflated by 30% for the benefit of a TVL that’s fallen by 67.5% since their insomniac comms director posted that tweet at 4:00 in the morning. And don’t even get started on what’s happened to the price. Since its initial launch, Bastion has mooned by exactly negative 94%.

In its defense, putting the blame for BSTN’s cratering value solely on the shoulders of its brutal supply inflation is ignoring a pretty conspicuous elephant (or bear) in the room. It’s worth questioning, however, how much of a future recovery is likely for projects that employ such inflationary tactics to bootstrap liquidity. When things turn around for crypto as a whole, will price ever recover to previous highs when so much supply was poured into circulation early on? I don’t know. Ask Yam Finance. Have you guys kept in touch at all? Yeah, me neither.

The takeaway is simple: not all forms of yield are equal, and there’s a right kind and a wrong kind to ape into. It’s natural to feel your eyes dilate a bit when the APY for single-sided staking has a third digit tacked on, but if those returns come from a supply inflation that’s only going to nuke the price down the road, all you’re doing is putting losses on layaway. It’s a trick as old as defi itself. Next we’ll cover what it looks like to have healthy and sustainable yield based on operational revenue, and how you can put your capital to work to earn it, even in a bear market.

Bad yield is easy to diagnose. It looks identical in every case, and the effect is that of a protocol begging you to stake with the only incentive they have – dilutive supply. Revenue-based yield, on the other hand, comes always from the actual operations of the protocol, and every protocol generates revenue in its own way.

Where might this revenue come from? Well, let’s find out. We can get a sense of this by looking at the top 25 projects in crypto by protocol revenue.

Protocol revenue is a metric that measures the fees that go either directly to a protocol’s treasury or indirectly towards its tokenholders by way of burn mechanisms that reduce supply. While there may be other protocols with higher total revenue, these are the ones with the most revenue contributing to their token value, and thus counteracting any severe supply dilution (which a few of these protocols aren’t exactly innocent of either). An even better way to calculate it would be dividing each protocol’s revenue by its circulating supply, but this should suffice for a simple overview of where a project’s yields may come from.

The revenue streams seem to fall into a handful of categories:

L1s. These are the layer one blockchains with which we’re all intimately familiar. Every transaction on a layer one – including the transactions of the dApps on this list – requires a decentralized network of computers in order to be validated and finalized. When you pay fees to a layer one blockchain, you are in essence paying for the computational effort of these transactions being performed.

Exchanges. There are a number of different exchange models that deal in a variety of products, but they all rely primarily on swap fees for their revenue. The process is fairly simple – when you trade one token for another, a certain percentage of the trade’s value is added onto the transaction to fund the protocol and/or its liquidity providers.

Derivatives Exchanges. Derivatives exchanges operate similarly to DEXes, but the fact that they extend leverage to their users makes a significant difference in their fees. On the one hand, leverage is made possible by the enhanced buying power of margin trading, and users pay margin fees for the time they spend borrowing to make their trades. Additionally, the swap fees on derivatives exchanges are based on the notional value of trades and thus much higher than they are on a typical exchange. A user who employs 10x leverage to purchase 10 ETH will pay 0.3% on the value of 10 ETH, not the 1 ETH he uses as collateral. This makes for a much more capital efficient use of a derivative exchange’s liquidity.

Lending and Borrowing. Lending and Borrowing protocols allow users to lock their tokens on a smart contract to be used as collateral for a loan. Some gather liquidity for a variety of different tokens in order to loan different assets out, and others simply lock user collateral in exchange for a self-issued stablecoin. The majority of their revenue comes from interest paid by the borrowers, though some amount also comes from loan origination fees.

Liquid Staking Tokens. This is a somewhat arbitrary classification for Convex and Lido, but both were built on top of other protocols at least in part as solutions to the non-transferability of their native tokens. While Lido imparts users a liquid stETH token to represent their ownership of staked Ether and Convex cvxCRV to represent their veCRV, both charge a percentage of users’ staking rewards as a fee.

Non-Financial Services. This is a broad category to describe utility tokens that have each carved out a niche for themselves performing some non-financial service. ENS is a protocol for creating vanity ETH addresses, Helium provides a decentralized, peer-to-peer wireless network in which IoT devices transmit data between each other, Filecoin is a decentralized data storage protocol, and Tornado Cash provides a non-custodial intermediary between ETH wallets that makes their transactions private and untraceable. In every case, the revenues simply come from fees charged during transactions for the performance of these services.

Insurance. Protocols like Nexus Mutual offer insurance products to guard against threats like protocol or custodial risk. In the event of this type of loss, users can file claims for reimbursement to be voted on by the community. Typically, users will pay a percentage of the amount for which they are insured as an annual fee for the service.

Gaming. Finally, there are gaming protocols. In this case, the only example is Decentral Games, and its fees come from NFT mints, secondary sales fees, and in-game upgrade fees. Ultimately not far removed from how games are monetized off-chain.

This should give you a basic idea of how crypto projects actually earn money, beyond drawing in speculators with memes and hype. With so much of that hype dying down as speculative liquidity drains out of the market, these revenues represent what actually remains behind the token values.

Armed with this information, we can conclude that one method of limiting dilution of the tokens we stake is to choose them based on protocol revenue, under the assumption that those with substantial fees accruing to the treasury will hold up better in a downturn and bounce back more quickly during a recovery. Collecting 42% yield from a perp exchange’s margin fees may not provide the outlaw thrill of an 800% DEX LP that launched before breakfast, but as a source of safe and sustainable yield, you’ll probably enjoy it more than being married to an altcoin that peaked two bull runs ago.

While this approach does deliver us from some of the perils of supply dilution, one can’t help but wonder if we’re leaving money on the table. Capital efficiency never strays far from the degen mind, and you could make a strong argument that the torment of forfeited gains takes its own, equally profound toll on one’s well-being. These externalities deserve consideration as well. Fortunately, there’s another metric we might find useful in our pursuit of higher yield.

If we turn our sights to Token Terminal again, we may notice that there are five entries that appear on the list of top protocols by total revenue but not by protocol revenue. This means that while they are among the most lucrative crypto projects currently in existence, the primary beneficiaries of their revenues are not the protocols themselves. Of course, there are tokens that bring in vast amounts of fees and then distribute them all to their node operators – in fact, one of them has been around since all the way back in 2009. But where did the revenues go for these five?

In every case – Uniswap, Maple Finance, Ribbon Finance, Balancer, and Quickswap – a huge percentage of the revenue went to liquidity providers and not the protocols themselves. Maple keeps two thirds of its loan origination fees, for example, but the borrowing interest goes entirely to pool delegates. Uniswap takes it one step farther, with liquidity providers splitting all of its swap fee and no protocol fee taken at all. Rather generous!

The lack of protocol fees tells us very little about the future prospects of UNI or MPL, but quite a bit about the profitability of providing liquidity on these services. One response to this would be to buy and hold based on a project’s tokenomics and protocol revenue, then seek yield elsewhere by contributing to the services of other protocols.

ETH has the highest revenue in all of crypto, for example, and its net issuance will cap at 2% after it transitions to proof of stake. While its staking yield pulls in 4.0% today, we could also buy ETH and deposit it in an options vault on Ribbon for 25% a year, paid out in Ether. In fact, Ribbon even has a stETH vault, which means we could stake on Lido and add the 4.0% staking yield onto the premia paid out from selling theta on Ribbon.

This is just one example of how we could check all the boxes here – avoiding irresponsible emissions, investing in tokens with solid revenue and tokenomics, and still pulling an impressive yield from the operations of a protocol rather than the dilution of its supply. When you consider that simply buying and holding ETH a year ago would have netted a -37% return, the intelligent yield farming approach to crypto investment really starts to look attractive.

Hopefully this was a helpful guide to distinguishing between dilutive yield and more sustainable alternatives, to identifying when a protocol has a sufficiently robust source of revenue to support its staking rewards, and to thinking critically about how to develop strategies that capitalize on the relative merits of many different projects. We may be weathering a downturn, but yield farming in defi still provides a viable way to earn, and crypto natives who are less familiar with it would do well to cross over. Next time you step outside to touch grass, pay attention to the beating sun and rising heat. Go to the beach and start to form a plan. Crypto is healing.

Summer is here.