While the best case scenario for fixed income products is avoiding default, the best case scenario for crypto yields is driven by increased demand for decentralised finance services. This upside can be substantial.
What drives crypto yields
The money market in crypto yield is driven by supply and demand, unlike fiat money markets which are driven by monetary policy.
Crypto yield is generated by lending crypto assets and by the activity on various decentralised finance (DeFi) platforms such as decentralised exchanges (DEXs) which share the fees earned with the liquidity providers. In addition, as protocols vie for market share, their treasuries may offer incentives to users of the platform.
In bullish market conditions, the demand for borrowing for leverage by traders increases sharply, as do the volumes and activity on the various types of DeFi platforms (DEXs, decentralised insurance, etc.). This elevates the yields substantially. DeFi projects are also more likely to offer token incentives during bull markets, and rising token prices further increase the value of the incentives.
The other driver of crypto yields is the supply of liquidity. The income generated by the various lending, DEXs and other DeFi protocols is distributed across the liquidity providers. If the Total Value Locked (TVL) rises faster than the income generated, this will reduce the yields.
In the last bull market of 2021, prudent managers investing in crypto yield could earn approx. 25 percent annualised return. Those willing to take greater risks on lower tier platforms where hacks, bugs and exploits are more likely could earn yields far in excess of this.
Comparison with traditional fixed income
The crypto yield market emerged in the summer of 2020 (the “DeFi summer”) when DeFi protocols proliferated. Initially, the yields offered were extremely generous to attract liquidity providers to this new market.
As the TVL increased sharply in 2021 and more liquidity was provided, the yields decreased somewhat but remained very attractive due to the prevailing bullish crypto market conditions.
During the bear market of 2022, the crypto yield space experienced multiple shocks through the failure of a string of centralised lenders (Celsius, Genesis, etc.) and the collapse of the then third largest stablecoin TerraUSD. These led to some losses even for some of the most prudent yield managers and the bearish conditions in the crypto market reduced the available income substantially. The yields earned in 2022 were substantially lower than in the years prior, and most of that was earned in the early part of the year.
The low liquidity and anaemic activity in the crypto market so far this year has meant that the demand for DeFi services has been depressed, leading to low yields by historic comparison. Crypto yield managers have also refined their risk management practices and spend a portion of the income earned on hedging and insurance (such as insuring against smart contract hacks or stablecoin depegs).
The yields offered currently are much lower than in the past, and increased fiat interest rates also offer a tougher comparison than a couple of years ago when fiat yields were near zero percent. However, as more bullish conditions return to the crypto market, crypto yield has substantial upside. If traditional fixed income and money markets attract more capital, liquidity will grow slower in crypto yield than the income generated, putting further upward pressure on crypto yields.
Overview of annualised crypto yields vs. US high yield and US money market yields
Source: St Louis Fed, Trading Economics, Sygnum Bank
NB high yield = 5y government bond yields + ICE BofA US High Yield Index Option-Adjusted Spread
The risk/reward is stacked the opposite way for traditional fixed income. Government bond yields have risen in response to higher inflation, while high yield credit spreads have been on a downtrend since mid-2022 despite the increasing risk of a recession (and therefore defaults). High yield spreads currently stand at 3.77 percent while Fitch reported a 2.8 percent default rate for July, up from 2.6 percent in June, and predicts the default rate to end the year at 4.5–5 percent. Investors who purchase high yield bonds at the current rates risk seeing greater defaults than the credit spread they earn.
It is also important to note that the duration risk on crypto yield is extremely low, akin to fiat money markets, while bond investors carry substantial duration risk on top of the default risk.
Although fiat money markets currently offer broadly similar yields to crypto, they do not offer the same upside. A rise of fiat interest rates to 20 percent would signal an economically disastrous scenario unfolding, while a rise of crypto yields to 20 percent would be the result of increased activity in the DeFi sector as crypto market sentiment and liquidity improve.
The outlook for crypto yields
The downside for crypto yields is cushioned by:
- The decline in the incidence of hacks and bugs as DeFi protocols have matured and DeFi security best practices have developed
- Mature practices of risk management, including auto-response to economic exploit signals, insurances, hedging, and self-insurance
- The low level of activity in the crypto market leaving little room for further declines
Fiat money market yields will either level off soon or their continued rise would signal dire macroeconomic developments, while credit risk is priced at levels not commensurate with the risks. In contrast, crypto yield has significant upside from the current conditions of depressed demand.
Crypto yield is a diversifier for income-oriented portfolios as its drivers are specific to the crypto space and offers upside exposure to increased activity in the crypto market.
Read more about crypto assets from Sygnum here.
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