Every new project inevitably turns to yield farming, also called liquidity mining, to attract attention and capital to their product. When we talk about “yield” in this context, it’s earning a token in exchange for providing liquidity. Yield in the context of traditional finance is cash flow you can generate on top of your principal.
The difference lies in how this yield is realized. With, say, bonds, you’re lending your capital to an external entity. They pay you interest periodically and return your principal when the bond expires. You earn a stream of cash flows in fiat through the interest, making the yield realized upon receipt. With yield farming, realizing your yield is dependent on selling the tokens you earn. As more people realize their yield, the price of the farmed token goes down, leading more people to sell it, and giving way to a negative feedback loop. We can differentiate the two types of yield by categorizing them as “pure yield” and “farmed yield.”
For the average retail investor in crypto, the only access to pure yield is lending coins on platforms like Aave, Compound, BlockFi, and others. Retail investors in TradFi can access yields by either depositing money in a savings account — and earning a trivial amount of money — or by buying bonds issued by governments and corporations.
Institutions have access to a variety of yield generating opportunities. One of those is holding an asset and selling call options of the asset to generate cash flow. This strategy is called selling covered call. It enables an investor to take part in the upside of an asset while selling calls and earning cash on top of it. If the call expires worthless, the investor keeps the amount they pocketed from selling it. If the call expires in the money and is exercised, the investor has to sell their asset at the call’s strike price.
Options selling comes with complexities and risks that are difficult for retail investors to understand. In fact, not many institutions understand it either. That’s why players who know how to sell options and generate yield create “structured products” to service other institutions. A structured product is any complex trading strategy baked into a single-faceted investment opportunity. These are accessible to entities with significant amounts of wealth — hedge funds, banks, and high net-worth individuals (HNIs).
If an average Joe went to Goldman Sachs and asked to invest in a structured product, they would be laughed out of the building (assuming they can even get in). But DeFi is shaking up this dynamic by bringing these opportunities to your friendly neighborhood web browser.
Open-Source Structured Products
Decentralized derivatives are in the first innings of a long ball game. But there are already new projects launching ambitious products to take on TradFi. Ribbon Finance is one such project.
Ribbon is, quite simply, an on-chain structured products provider that specifically focuses on yield generation opportunities in the options market. Ribbon currently has a options strangle vault live on mainnet. A strangle is a strategy where a trader simultaneously buys an out-of-the-money call (strike price > market price) and put (strike price < market price).
This strategy is a bet that the price of the the underlying asset will move markedly without taking a view on which direction it will move in. As long as price moves by a large amount in either direction, a strangle will be profitable.
Ribbon’s strangle taps into Hegic for liquidity, but there’s one problem there: DeFi options protocols cannot service a lot of demand yet. Liquidity provision models for popular DeFi options protocols are bit tricky. Hegic LPs hardly break even and rely on HEGIC emissions to actually make money. Opyn options are now just limit orders on 0x, and the orderbook is illiquid even around the few durations and strikes Opyn has. We have protocols like Charm Finance that have built options issuing infrastructure that is capital efficient and priced at par with the market. But Charm is still in the process of developing tools to make the UX for LPs much better. Overall, the DeFi options vertical is nascent and yet to develop the kind of liquidity DeFi spot markets see.
In the short to mid term, as ridiculous as it sounds, the scope for building DeFi structured products using options is larger than the scope for DeFi options themselves. Over the long-term, this will inevitably reverse. But this also means if Ribbon wants to scale they have to find a way around the lack of options liquidity in DeFi, and that’s exactly what they’re doing.
Ribbon is partnering with large options market makers to source liquidity for all of the new products they launch. These market makers will be the counterparty to all Ribbon vaults, taking the opposite position of the vault. For example, Ribbon’s next product is a vault where LPs can deposit ETH and the vault sells covered calls against it. Ribbon wouldn’t sell calls on Opyn or Hegic, but would instead sell it to these market makers who can then go and hedge their exposure on Deribit. As the DeFi options market evolves, Ribbon will pivot from using off-chain market makers to on-chain options.
Ribbon has several strategies up its sleeve, and this gives retail investors access to risky but lucrative opportunities to earn money. These strategies obviously aren’t ideal for every investor and varies per each person’s risk tolerance. However, thanks to DeFi, these opportunities are finally available to regular people instead of just wealthy individuals and institutions.
Unlike yield farming, this isn’t necessarily a zero-sum game. Put writers are selling insurance and, in return, they’re earning a yield for taking on future risks. So while one party ultimately wins, both are receiving a potential benefit and bearing a cost. With yield farming, there needs to be continued demand to buy the token at its perceived price for a farmer to actually realize their yield. Farmers also need to be mindful of the price risk they’re taking on the liquidity being provided. At the surface, earning 1% a day in a farm may seem too good to pass up. However, if you need to stake the project’s token to earn it, and said token’s price then falls 20% suddenly, the dollar value of your yield and principal just took a haircut that can quickly undue any expected profits.
Tranched instruments are another popular type of structured product. These are debt investment opportunities that are cut up into pieces, called tranches. Each tranche has its own risk / reward profile. The best way to explain this is with an example.
Let’s say an entire pool (senior and junior tranche) is invested in bonds yielding 8% per annum. The yield for the senior tranche might be something like 4%, while the junior tranche would earn around 16%. Those in the senior tranche could’ve just invested in the bond themselves and earned 8%, right? But they also could’ve lost all their capital if the bond issuer defaulted.
By investing in the senior tranche, investors lock in a stable 4% yield and use the junior tranche as insurance in the event of a default. This is a risk those in the junior tranche knowingly take because they want higher yields.
In DeFi, projects like Saffron Finance and Barnbridge are building the infrastructure for tranched lending. The mechanics work in the same way: more capital in the senior tranche increases the inherent leverage and thus yields for the junior tranche. However, given most people investing in DeFi are quite far up the risk curve, there isn’t all that much demand for senior tranches, making yields in junior tranches only mildly attractive at the moment.
But this could be a blessing in disguise, because it creates room for institutions to start using DeFi and earning yields in a senior tranche that are comparable to junior tranches in TradFi. This is of course a long way off but it’s important to keep in mind the target audience for senior tranches don’t care about DeFi yet.
Once again, tranched products are only accessible to wealthy folk. That is, until DeFi eradicated that barrier. Based on an individuals risk tolerance, they can gain access to sticky yields that beat anything a bank can offer. All while sitting in the comfort of a stablecoin like USDC.
The Beginning Of The End
Yield farming is cool, but sustainable yield generating opportunities provide more of a service than simply farming and selling tokens. By writing puts, you’re providing financial insurance to those who need it. By investing in tranched lending, you’re giving a borrower the capital to finance their operations.
Over the next year, I expect to see a proliferation of structured products across DeFi, in one form or another. As we start creating reliable, value-add products that benefit different sets of users, DeFi will make meaningful strides towards fulfilling its promise of a being inclusive, open financial infrastructure for all.