Decentralized Finance, more commonly known as “DeFi”, has taken the blockchain space by storm. Yield farmers are rushing to lock their tokens into Liquidity Pools on platforms like UniSwap, yearn, Compound, and SushiSwap. In return, they are earning rewards in the form of valuable cryptocurrencies, much as savers in a traditional bank earn interest on their deposits. As of mid-July 2021, slightly over $100 billion dollars worth of cryptocurrencies have been locked up in DeFi Smart Contracts. This is a significant amount of wealth, but still represents a decrease from the May 2021 peak when over $150 billion dollars worth of total value was locked in DeFi Smart Contracts.

Savvy operators in the cryptocurrency world are now shifting their tokens between different Liquidity Pools to maximize their rewards, a trend referred to as “yield farming” or “liquidity farming”. As of mid-July 2021, the top liquidity pools are reporting yields ranging from over 1% Annual Percentage Yield to over 10% Annual Percentage Yield, much higher than the less than 0.1% earned on most bank accounts. It’s an exciting and fruitful time to be a yield farmer.

However, there’s reason to believe that these outsized yields are unsustainable. As successful strategies are observed and copied by other yield farmers, the returns from those strategies face diminishing returns. The entry of traditional financial institutions into the DeFi space threatens to exacerbate this problem, as moves from these large whales eat away the low hanging fruit yields. Based on our theoretical model, there is a clear inverse correlation between yields and the number of users entering the DeFi Liquidity Pools.

Already, many of the most liquid Farming Pools are seeing their yields decline. As the chart below shows, after an increase through late 2020 and early 2021 that was largely driven by margin trading, yields have declined rapidly in past few months as larger amounts of capital surge in to chase yields. Meanwhile, margin trading activity has certainly been unable to keep up with the availability of capital chasing such returns.

As further evidence, in the past months, the amount of stablecoins in circulation has skyrocketed, growing faster than the rate at which the number of yield farms and liquidity pools have expanded, as shown in the chart below. According to coinmarketcap, USDC alone has skyrocketed from 4B in circulation to over 25B as of July 20 2021 and the effect of this has been the rapidly reducing yields as more farmers chase rapidly diminishing returns.

At the same time, there are major risks facing DeFi yield farmers. There’s no FDIC insurance protecting the funds locked into Liquidity Pools, and the yield offered by any liquidity pools can fluctuate wildly. Successful yield farmers must pay close attention to large price drops in their locked cryptocurrencies, and to the ever-shifting yields of different liquidity pools. In many ways, the most highly outsized yields offered by some Liquidity Pools can be interpreted as the market indicating the instrument presents greater risk. Some of these behaviors can be likened to picking up pennies on train tracks in front of an oncoming train, with disastrous results in the form of complete loss of principal due to exploited smart contracts or manual rug pulls.

Between the new market entrants, rapid imitation of successful strategies, effects of margin trading, and the increasing hesitancy around riskier Liquidity Pools, multiple forces are driving the unsustainably outsized yields of DeFi downwards. As the total value locked into these pools increases, these yields are expected to further revert towards the mean. Does this mean DeFi is doomed to diminishing yields, leading to slower growth and eroded dynamism? Will the DeFi revolution stumble and crash before it even has a chance to change the world?

Not necessarily. These lower yields simply reflect doubts about the value of the underlying collateralized assets. It can be interpreted as a natural and even healthy response to the massive amount of value being locked into the DeFi ecosystem. The entire space is calling out for a source of real yield to support this growing Total Value Locked (TVL). What do we mean by “real yield”? These are sources of value that have proven their value in the “meat space” of the real world. The assets we have in mind possess the qualities of being:

• Income Generating — the asset must be able to generate positive cash flow
• Sustainable — the asset must have a proven historical track record as a source of value
• On-Chain — the asset’s ownership and legal rights must be clearly mapped from the “meat space” of the real world into a tokenized asset on the blockchain (and ideally, the asset would even benefit from being moved “on-chain”)

As the DeFi ecosystem continues to evolve and grow, we expect more real yield-producing assets to be moved onto the Blockchain. We have seen a clear demand for these types of assets from yield farmers, and at the same time the owners of these assets can clearly unlock a lot of liquid wealth by moving these assets onto the Blockchain. Citadao was motivated by the challenge of creating sustainable income generating assets that can be moved onto the blockchain, and we believe our innovative solution will unlock the true potential of DeFi. Stay tuned for more!