Conviction on directional crypto exposure remains low in our view, despite the fear and greed index returning to neutral territory and bitcoin breaking above its US$32-38k range. One way to mitigate volatility and directional risk in this space has been through yields from decentralized finance (DeFi) platforms like lending, liquidity pools and staking, which offer passive income.
But how best to distinguish performance among such yield investments in the DeFi sector, particularly when the trading regime for crypto markets seems to be in transition? We think it’s prudent for investors to take a systematic approach to determine which segments of the crypto market might recover faster depending on how liquidity in this space materializes.
For example, over recent months, we have seen total value locked (TVL) across lending platforms and decentralized exchanges fall, but as fresh capital from both VC and corporate sources start to be deployed, we think the inflow of liquidity into crypto markets could once again increase.
We think some of that value could accrue to yield generating crypto platforms, but DeFi growth may face competition from rising yields on traditional assets while depreciating liquidity incentives have reduced user demand. Neither of these were major issues for DeFi over the last two years, when global central banks were cutting rates aggressively and DeFi platforms were an attractive alternative for market players rotating away from fiat. This may position staking as a buffer on short term volatility for long term crypto holders.
As a simple metric for measuring over- vs undervaluation in the crypto market, we first look at market capitalization versus the total value locked (TVL) in various DeFi protocols and blockchains. Note that while we try to categorize different segments of the crypto universe here, we limit the level of complexity in our distribution method mainly to capture areas where there is a material difference in the macroeconomic drivers affecting their performance.
Over the last three months (November-January), decentralized exchanges (including Uniswap, Curve, Loopring, 1Inch, PancakeSwap and SushiSwap) saw a 45.2% decrease in their total market cap compared to a 11.3% decrease in total TVL. Comparatively, lending platforms like Aave, Compound and Anchor have had a 45.6% decline in market cap over the same period compared to a 1% increase in total TVL. Meanwhile, our subset of layer-1 (L1) blockchains offering staking opportunities had a 33.1% drop in market cap and 20.7% drop in total TVL. 
Interpreting TVL for active investing
From the perspective of active token investing (as opposed to passive income investing), lending platforms appear to be the most undervalued segment of the DeFi space as the sell off was comparable to DEXs (liquidity pools) and outpaced L1s but there was no actual fall in TVL. However, there are a few problems with this conclusion.
First, this is a very backwards looking analysis that doesn’t take into account potential changes in the macroeconomic trading regime. For example, the rise in TVL on lending platforms could be linked to more users looking for a safe haven from higher volatility in both crypto and traditional markets by swapping for stablecoins and collecting yield. But growth in lending activity was mainly recorded on Anchor, which offers interest of 19.5% on TerraUSD (UST), drawing away user activity from Compound and AAVE (which offer rates between 1-3% on other stablecoins) where activity has been steadily falling in the last four months (see chart 2.)
On the other hand, overall borrowing demand on Anchor has been falling as well (borrowing rates are c.13%), leaving Anchor’s reserve protocol to make up the difference in rewards paid to lenders on the platform. This may be one reason among others on why we have seen a decline in ANC’s market cap despite its higher TVL on Anchor in recent months.
Moreover, rate hikes are being priced across bond curves worldwide, and the global supply of negative interest bearing instruments are falling (see chart 3.) As yields on traditional assets rise while yields in the crypto space continue to fall, we think this could put a particular dent in the growth of the DeFi lending/borrowing sector as well as liquidity pools to a lesser extent, which has been coming from more traditional players rotating out of fiat instruments.
Finally, the example of Anchor suggests that TVL as a metric may be sensitive both to newer entrants as well as the period under evaluation. TVL in existing projects can potentially be reallocated to newer projects to chase higher yields, but independently this doesn’t give us much information about whether there is less faith in existing protocols nor more faith in newer ones. A high TVL coupled with the Lindy Effect (i.e. a longer history) may be a better way of making that assessment.
Thus, while the TVL ratio could potentially signal a mean reversion strategy for active investors, we do not think it is necessarily the best approach for identifying over- or undervaluation. More contextual factors are required to capture additional nuances in these markets.
Liquidity as passive investing metric
What about passive income investing? TVL can be useful as a means of tracking the flow of liquidity on these platforms, which we can compare to overall market performance to find patterns under different trading conditions. But how DeFi protocols respond to liquidity is not uniform.
Participants in the crypto lending/borrowing industry tend to benefit most from lower volumes (in terms of supplied tokens) and higher yields on these platforms, while higher supply volumes provided to liquidity pools – which are more likely during periods of crypto market strength rather than during sell offs (see chart 3) – tend to support better price discovery and help maximize DEX earnings. That value should ultimately accrue to the token holder.
However, historically we have seen the flow of liquidity on lending platforms often mirror the flow of liquidity on DEXs which may reflect relevant imbalances in the former. Thus, if crypto markets begin to stabilize in earnest, we think the increase in liquidity for these platforms are more likely to support DEX yields over lending pools within the DeFi space, which currently earn between 3-6% yield on stablecoin pairs.
Apart from yield, net earnings from passive DeFi investing can also include capital gains received from the incentive tokens rewarded by some of these platforms to stimulate activity. However, income from this source is more volatile as a number of factors can influence the price, including the circulating supply, trading volumes and general market performance. The recent crypto sell-off has negatively impacted incentive tokens like CRV (Curve) which has depreciated 50% since the start of the year. COMP (the governance token for Compound) has actually fallen more than 85% since its May 2021 peak. Such depreciation can lead to reduced volumes on these platforms and thus affect their yields.
Moreover, in a more stressed environment, investors who may have shifted money onto these platforms for passive income may be more inclined to lock their rewards in their fiat equivalent quickly, which would compel them to sell the reward token and add to the downside pressure - further reducing the total market cap.
That said, if borrower demand drops on lending platforms like Compound for example, then we may see a corresponding drop in COMP issuance, thereby limiting supply dilution to some extent in those periods of stress.
Rewards can also come from other sources, like how Curve and AAVE activity have in the past been driven by incentives provided by the networks hosting the platforms. Avalanche and Polygon are examples of how incentives are paid to DeFi users in the L1 tokens AVAX and MATIC to help scale their respective ecosystems in the hopes that activity eventually becomes self-sustaining. However, in these cases, rewards may only last for a fixed period of time.
Staking coins or tokens for passive income is different from either lending or liquidity mining and can be much more straightforward than the other DeFi sectors. Providing tokens to a lending or DEX platform physically transfers your assets to a borrower or liquidity pool, whereas with staking, you earn income while still retaining possession of your assets.
Staking rewards tend to be a function of the protocol’s policy on transaction and/or validation management rather than strictly a function of market supply and demand. In that sense, the rewards are more “stable.” That said, there can be risks as different protocols have different restrictions like withdrawal periods for staked coins. There can also be minimum staking requirements that may be a bar to entry for some or concerns about “slashing” if a validator fails to meet network standards, though such challenges can now be surmounted via delegated staking pools.
The biggest issue for staking as passive income is that it is not delta neutral with respect to the underlying, whereas our focus in the other DeFi sectors have been on lending or liquidity mining on stablecoins.
WIth staking, investors can still be exposed to market volatility in the form of both the tokens that have been locked in the protocol and the rewards paid in that native token. The idea of staking as passive income really only works if an investor already has a positive medium-to-long term outlook on the asset being staked. Otherwise, if that asset depreciates over the period in which it’s being staked, we think it’s more relevant to think about staking yield as a potential offset to a drop in the price.
For reference, table 1 looks at staking yields adjusted for supply inflation for various L1 tokens relative to their volatility over the last twelve months. This provides some guidance on potential breakeven values for L1s if staking income is incorporated.
Earnings from DeFi sources can vary even when the lending or liquidity pools function similarly, with some delivering greater or fewer rewards depending on the platform. This makes it challenging to interpret data like TVL both from an active as well as passive investment perspective.
With the recent downturn in crypto markets, yield from DeFi sources like lending and DEXs has arguably not done much to help retain token value, though staking does appear to have offset some of the volatility for corresponding tokens. As more L1 tokens are staked, that reduces the supply in circulation when those tokens are locked up, supporting returns and offsetting the impact of less TVL from the DeFi platforms on the network.
Nevertheless, while the size of the TVL for a protocol can give us a reference point about confidence in a project, the level of yield can skew that data and pollute the information we’re actually being given. That goes for staking rewards as well, which makes the period under observation particularly relevant - for example, if a coin offers higher staking rewards at inception, that can affect its liquidity and make comparisons to other coins less meaningful.
Still, if liquidity in the crypto markets pick up, staking seems like a better prospect for long term holders of digital assets looking for steady income to weather any short term volatility (or to earn something above the potential capital gains.) Meanwhile, we think yields from both lending and liquidity pools may come into direct competition with higher yields on traditional assets in the near future. However, higher volumes in the crypto ecosystem tend to support the latter over the former.