Risk and reward in the world of stablecoin lending ๐งต ๐
1/ It's no secret that stablecoins can generate higher yields on-chain than fiat currency can off-chain.
Yield farming stablecoins is also viewed as a relatively low-risk strategy.
Yield farming stablecoins is also viewed as a relatively low-risk strategy.
2/ But in any stablecoin yield farming strategy, it's important to understand where that yield comes from, and how durable it is.
In particular, there are two red flags -- one more serious than the other...
In particular, there are two red flags -- one more serious than the other...
3/ ๐ฉ A large portion of your yield comes from token incentives
This is a red flag, since it's questionable how sustainable that yield is.
Lenders are incentivized to sell the tokens, continuously depressing their price, and therefore, the lending yield.
This is a red flag, since it's questionable how sustainable that yield is.
Lenders are incentivized to sell the tokens, continuously depressing their price, and therefore, the lending yield.
4/ ๐ฉ๐ฉ๐ฉ A large portion of the borrower's cost of funds is subsidized by token incentives:
This is a MUCH bigger red flag. If the value of the token incentive declines, the borrower's cost of funds spikes, increasing the likelihood that they default on the loan.
This is a MUCH bigger red flag. If the value of the token incentive declines, the borrower's cost of funds spikes, increasing the likelihood that they default on the loan.
5/ In some cases, the token incentive is so large that that the borrower is actually getting paid to take out a loan.
By comparison, teaser rates on subprime mortgages in the 2000s look downright conservative.
By comparison, teaser rates on subprime mortgages in the 2000s look downright conservative.
6/ Let's look at an example:
Imagine a protocol where the yield from token incentives exceeds the borrower's cost of funds (yes, such protocols exist).
The borrower is getting paid to take out a loan (see Borrower Net APR below).
Imagine a protocol where the yield from token incentives exceeds the borrower's cost of funds (yes, such protocols exist).
The borrower is getting paid to take out a loan (see Borrower Net APR below).
7/ This example has both red flags.
๐ฉ The lender's yield is enhanced with a token distribution.
Fine, but don't expect that yield to last.
๐ฉ The lender's yield is enhanced with a token distribution.
Fine, but don't expect that yield to last.
8/
๐ฉ๐ฉ๐ฉ Not only is the borrower's cost of funds subsidized by token distribution, the borrower is actually getting PAID to take out his loan.
๐ฉ๐ฉ๐ฉ Not only is the borrower's cost of funds subsidized by token distribution, the borrower is actually getting PAID to take out his loan.
9/ For the borrower, this is great!
A rational actor will borrow MORE if his cost of funds is lower, and STILL more if he is getting paid to borrow.
For the protocol, this behavior boosts TVL, perhaps even driving up the its token price in the near-term (because TVL good).
A rational actor will borrow MORE if his cost of funds is lower, and STILL more if he is getting paid to borrow.
For the protocol, this behavior boosts TVL, perhaps even driving up the its token price in the near-term (because TVL good).
10/ As that happens, expect team members to begin borrowing against their suddenly more valuable (but locked) protocol tokens.
@cobie told us to think about incentives!
cobie.substack.com
@cobie told us to think about incentives!
cobie.substack.com
11/ So where does all this lead?
Over time, constant sell pressure on the token incentive (from both lenders and borrowers) erodes the Token Distribution APR.
Eventually, the borrower actually needs to pay for the funds he is borrowing (see Borrower Net APR below).
Over time, constant sell pressure on the token incentive (from both lenders and borrowers) erodes the Token Distribution APR.
Eventually, the borrower actually needs to pay for the funds he is borrowing (see Borrower Net APR below).
12/ If team members have been borrowing against their own protocol tokens, downward price action will accelerate as their tokens are liquidated, while they cash out the funds they borrowed against them.
13/ Meanwhile, the borrower, who was getting paid 5% when he took out the loan, now has to pay 12% to avoid default.
Now that his cost of funds has jumped 17%, he is much more likely to decide to (or be forced to) walk away from the loan, leaving the lender holding the bag.
Now that his cost of funds has jumped 17%, he is much more likely to decide to (or be forced to) walk away from the loan, leaving the lender holding the bag.
14/ When you are lending, you are implicitly selling a put to your borrower.
If the value of their collateral drops below what you have lent them, they have an incentive not to repay the loan, and to leave you with that less valuable collateral.
If the value of their collateral drops below what you have lent them, they have an incentive not to repay the loan, and to leave you with that less valuable collateral.
15/ So in this case, while you are lending to avoid the volatility of L1 tokens, you instead:
--> earn a fragile and unsustainable yield
--> have no upside if the collateral appreciates
--> take on the downside risk for a borrower who is encouraged to be over-levered
--> earn a fragile and unsustainable yield
--> have no upside if the collateral appreciates
--> take on the downside risk for a borrower who is encouraged to be over-levered
16/ TL;DR
There is no way to sustainably pay both borrower and lenders.
You get paid to take risk, and to provide liquidity.
You pay to offset risk, and to take liquidity.
Games that try to get around this mathematical fact have an expiration date.
There is no way to sustainably pay both borrower and lenders.
You get paid to take risk, and to provide liquidity.
You pay to offset risk, and to take liquidity.
Games that try to get around this mathematical fact have an expiration date.
17/ If you found this thread useful, feel free to follow, or check out my other ramblings here:
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