DeFi Lending, Passive Income, and the Bear Market Risks

Bob Mason
Updated: Jul 19, 2022, 03:03 GMT+00:00

The crypto winter has extended into July, with the total crypto market cap falling below $1 trillion. For decentralized application developers and exchanges, it has been a particularly tough year.

DeFi Lending, Passive Income

In this article:

Key Insights:

  • Passive income sees greater crypto investor focus amidst the extended crypto winter.
  • For lenders, DeFi Protocols are offering higher APYs to draw in crypto Hodlers.
  • Lenders and borrowers need to tread with care, however. High Supply APYs can mean low liquidity that could lead to withdrawal freezes.

Reflecting investor sentiment toward the current crypto market environment, the Bitcoin (BTC) Fear & Greed Index sits within the ‘Extreme Fear” zone, indicating investor fear of another bitcoin sell-off.

BTC Fear & Greed Index
Fear & Greed 100722

Current market conditions have led to a shift away from riskier assets and move into a range of decentralized protocols to increase passive income and offset the impact of inflation.

When choosing to use lending protocols, it is important that you carry out your own research and understand the risks.

DeFi Lending Defined

DeFi protocols provide users a platform to borrow and lend crypto assets. Such platforms support P2P lending across the respective networks, removing the need for third parties and, more importantly, banks and other centralized lenders.

Crypto lenders can earn interest by depositing their cryptos on a DeFi platform and staking their crypto assets.

Longer-term crypto Hodlers can earn annual percentage yields (APY) that dwarf those offered by more traditional financial products. While this gives lenders and borrowers access to income and liquidity, APY movement dictates the stickiness of the crypto deposits.

DeFi v Traditional Financing Explored

In traditional finance, fiat currency deposits have tended to be far more sticky, in other words, deposited for the long term, allowing banks to farm the money out to borrowers to deliver net interest margins and bank earnings.

In the DeFi world, crypto hodlers search for the best APYs, resulting in sharp movements in total value locked, depending upon market conditions.

For hodlers in search of the best yields, it can be a time-consuming process. More importantly, it can also be challenging to complete the necessary research to identify the most suitable DeFi platform.

Borrowers across the DeFi space face similar benefits and pitfalls. Crypto loans provide easy access to funds to meet unexpected expenses and provide additional liquidity. It is particularly beneficial during crypto market downtrends, where borrowers prefer to hold rather than sell cryptos at a loss to access liquidity.

However, unlike more traditional loans, the volatility associated with cryptos means that borrowers should tread carefully. Pledged collateral needs to cover crypto price swings. Borrowers also need to understand DeFi liquidation procedures.

DeFi platforms set liquidation parameters to protect against under-collateralized loans and, ultimately, platform illiquidity. In essence, liquidations are comparable to stop-loss mechanisms in a trading environment.

In circumstances where collateral comes within range of the loan amount, DeFi platforms allow third-party network participants to repay an outstanding debt at a discount in exchange for the pledged collateral.

For this very reason, it is essential that borrowers monitor and maintain the appropriate level of collateral to avoid a forced liquidation and loss of pledged crypto assets.

While the DeFi space provides a means to enhance passive income and for borrowers to access liquidity, both need to consider crypto market volatility and, for borrowers, the borrowing APYs and risk of losing pledged assets in a crypto market event.

In Search of the Highest APYs Across the DeFi Space

To make APY comparisons and track protocol changes, investors can access products that assimilate data from lenders including TraderJoe, AAVE, Geist, Iron Bank, and Venus.

AnalytEx is one such product that provides the crypto space with APY data across lending protocols.

DeFi yields
Crypto Lending APY Ranking 100722

Based on the above AnalytEx figures, a lender can earn a different yield for the same token on the same chain.

For example, Geist offers $3.45 per day for every $10k for lending MIM on the Fantom Chain, while Iron Bank offers just $2.33.

In other words, by using a DeFi APY aggregator, lenders can materially enhance earnings with little effort. In the above example, we sorted by the Earn per $10k daily column to make like-for-like token comparisons.

Sorting by Supply APY, we can also see differing yields and amounts earned per $10k daily for USDT.e.

Crypto Lending APY Ranking (B) 100722

Iron Bank offers an APY of 5.63% for USDT.e on the Avalanche chain, while Trader Joe offers 3.58%. Per 10k daily, this leads to an earning differential of 76 cents per 10k daily.

Risks across the DeFi Need Consideration

As with any financial product, there is no such thing as risk-free. Lenders and borrowers, therefore, need to consider the risks before entering the DeFi space.

Liquidity is one key issue that protocols face in adverse market conditions. Protocols with higher Supply APYs are likely to have tighter liquidity, which increases the risk of withdrawal freezes.

Here, protocols could freeze withdrawals where the ratio of deposited to borrowed funds (Utilization Rate) falls below an embedded threshold or even to zero.

Protocols with lower APYs are likely to be more liquid. They don’t need to attract crypto inflows with high APYs to maintain liquidity levels and an appropriate utilization rate. Highly liquid protocols are therefore more suitable for lenders looking for passive income but at a lower risk premium.

This is comparable to investing in rated fixed income products across the more traditional financial markets. Bond ratings are based on the probability of default. The yield on an investment-grade corporate bond is significantly lower than that of a sub-investment-grade corporate bond.

The probability of default for an investment-grade corporate bond is significantly lower than that of a sub-investment-grade bond. For this reason, sub-investment grade companies need to attract investors by offering higher yields.

In the DeFi space, APYs reflect the risk premium associated with a particular protocol. When selecting a DeFi protocol, lenders and borrowers should be mindful of this.

Reviewing the utilization rates of protocols would be an advisable component of the selection criteria. Avoiding protocols with particularly high utilization rates doesn’t guarantee withdrawal freezes, but reduces the risk of a freeze.

Protocol Utilization Rates Key to the Decision-Making Process

Protocols provide utilization rates. Investors should be mindful of any transparency issues where such information is unavailable.

Taking Iron bank as an example, the WETH Utilization Rate (UR) stands at 100.46%, meaning there is no free liquidity and the likelihood of a withdrawal freeze is significantly high.

Iron Bank
Iron Bank UR 100722

Lenders and borrowers interested in Iron Bank would be best advised for the UR to fall below 80% or even 70% before considering Iron Bank as a viable option. However, investors with a high threshold to risk may be comfortable with a UR of 100% because of the resultant APYs on offer.

Another consideration is the possibility of a protocol reinvesting free liquidity to enhance its earnings. Protocols that place tokens with other lending protocols face similar risks to lenders and borrowers. Therefore, it is important to dig beyond the Utilization Rate.

For this reason, understanding the actual balance on a cToken contract, and comparing it with the protocol liquidity, is also an important step.

In conclusion

The current bear market environment provides crypto holders and investors an opportunity to earn attractive annual percentage yields via the DeFi space.

Market volatility and uncertainty over the near-term outlook have led to DeFi protocols increasing APYs to draw in much-needed crypto liquidity.

Understanding the DeFi space and carrying out the necessary research is essential when selecting a DeFi protocol.

As with any financial product, there are varying degrees of risk. More risk-conscious investors must consider risks associated with lending crypto through DeFi protocols and how to mitigate these risks by conducting the appropriate research to identify the most suitable protocol.

About the Author

Bob Masonauthor

With over 20 years of experience in the finance industry, Bob has been managing regional teams across Europe and Asia and focusing on analytics across both corporate and financial institutions. Currently he is covering developments relating to the financial markets, including currencies, commodities, alternative asset classes, and global equities.