The various flavours of crypto yield

Broadly, crypto yields can be categorized into protocol-based, market-based, and real-world sources of yield. Each flavour of yield comes with its own mechanisms, examples, and risk profiles. As a sophisticated investor, it’s crucial to understand how yield is generated and what the risk trade-offs are. This month, we are going to dive into this crypto yield frontier. We will assess the various forms of yield, dig into the underlying mechanisms, how they are being adopted and the risks and rewards of earning yield in the digital asset arena.

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Protocol-based yield

Kicking off with protocol-based yield, this refers to the income generated by participating in the core operations and security of a blockchain network itself. This form of yield is fundamental to the integrity and decentralization of many crypto protocols, directly rewarding users for contributing computational power, validating transactions, or securing the network. The OG form of yield generation is proof-of-work crypto mining. Miners use powerful, specialized computer hardware to solve complex cryptographic puzzles. The first miner to solve the puzzle gets to add the next block to the blockchain and is rewarded with newly minted tokens and transaction fees. This form of yield generation has become unbelievably competitive and is now only really done by highly sophisticated mining professionals.

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The advent of proof-of-stake networks then led to the natural successor of crypto mining: staking. This is the most prominent form of protocol-based yield and a cornerstone of proof-of-stake (PoS) networks. Instead of relying on energy-intensive mining, PoS systems select validators to create new blocks and validate transactions based on the amount of crypto assets they “stake” (lock up) as collateral. In return for this service, stakers receive newly minted tokens and a portion of transaction fees. With staking, the APY for staking varies widely depending on the network, the number of stakers, and current network activity. For example, APY on Ethereum is generally 3-4% per year with 36m ETH staked out of a circulating supply of around 120m ETH. Solana offers higher returns ranging from 6-8% with Avalanche offering around 7% annual returns.

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Native crypto staking offers reliable returns, with the baseline rates rarely fluctuating in any meaningful way. Protocol staking can be thought of as a bond coupon in crypto, offering predictable yield for securing the protocol. Rewards are paid in the native asset (ETH, SOL, AVAX, etc.), compounding holdings. However, staking is not entirely “risk-free”. There is slashing risk if validators misbehave, potentially costing a slice of stake. In addition, there is the opportunity cost of locking up liquidity. This has led to the rise of liquid staking protocols.

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Liquid staking protocols issue a liquid staking token (LST) to users in return for staked assets. This LST can then be used in other DeFi protocols, allowing stakers to earn additional yield on top of their base staking rewards, albeit with additional smart contract risk. Ether.fi is an example of a decentralized, non-custodial liquid staking protocol. When users stake ETH with Ether.fi, they receive eETH. This eETH then accrues the base Ethereum staking rewards. Ether.fi leverages EigenLayer’s “restaking” mechanism. This means the underlying staked ETH, which backs eETH, is also used to secure other “Actively Validated Services” (AVSs). “Restaking” generates an additional layer of rewards beyond the standard ETH staking yield, making Ether.fi's eETH particularly attractive for yield maximizers. Ether.fi’s approach has attracted heavy inflows, with the protocol growing from under USD500m TVL in late 2023 to over USD11.7 billion today, making it one of the top five protocols on Ethereum.

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Market-based yield

For those looking for more volatile yield that can break into the double figures, we now move onto market-based yield. Market-based yield refers to the income generated by providing capital and liquidity to the various financial markets operating within the crypto ecosystem. This category mirrors aspects of traditional finance, such as lending, borrowing, and market-making, but executed through decentralized protocols. This category can be broken down into the three subcategories of lending, market-neutral trading and the crypto-native favourite pastime of “yield farming”.

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Crypto lending involves loaning out your digital assets to borrowers in exchange for interest payments. This can occur through centralized platforms (CeFi) or decentralized protocols (DeFi). In CeFi, an exchange will generally lend out assets to institutional borrowers or for margin trading, with interest earned shared with depositors. In DeFi, lending pools are governed by smart contracts. Borrowers draw from these pools after collateralizing loans with other crypto assets. Interest rates are usually dynamic, based on supply and demand within the pool. During market stress or high leverage demand, blue-chip crypto borrow rates can shoot up dramatically. For example, ETH borrow rates on Aave went over 15% APR in 2023, far above the base staking yield.

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Crypto lending is not without its risks. For CeFi, the risk is centred around platform insolvency or hacks. For DeFi, there are smart contract vulnerabilities (lending pools being hacked), liquidation risk for borrowers and the risk of the underlying asset's price fluctuations. While DeFi lending is almost always overcollateralized, sharp crashes can lead to shortfalls and in the worst case, protocol bad debt if liquidations fail. In summary, lenders must assess if the yield spread justifies the risk of borrower defaults or platform exploits.

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The second type of market yield is through market-neutral trading, which is itself a deep rabbit hole to fall into. Broadly speaking, we can break this down into active and passive strategies. On the active side, traders seek to profit from pricing inefficiencies or funding rate differentials between related crypto assets or markets. A common market-neutral strategy is the “cash-and-carry” trade. An investor simultaneously buys a cryptocurrency on a spot exchange (going long) and sells an equivalent amount on a perpetual futures market (going short). The goal is for the price movements of the long and short positions to largely cancel each other out, leaving the investor to profit from the “funding rate.”

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For example, Ethena is a stablecoin protocol that provides a “synthetic dollar” called USDe. Ethena generates its yield through a large-scale, delta-neutral strategy. When users mint USDe by depositing crypto assets (like ETH), Ethena simultaneously takes short positions on those assets in the derivatives market. The yield for USDe holders primarily comes from the positive funding rates earned on these aggregated short positions, combined with the staking rewards from the underlying ETH collateral. This offers a crypto-native yield source that is designed to be market-neutral in its primary operation. Ethena has proved popular with DeFi users, with USDe reaching a supply of USD13.2bn.

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Outside of crypto protocols, our Crest family of funds also utilize active market-neutral strategies to offer stable returns on USD and bitcoin. Our funds are allocated to a diverse set of strategies, including funding rate arbitrage, volatility arbitrage, statistical arbitrage, market making, lending, and DeFi strategies. While underlying risks can never be eliminated, in the case of Crest funds, we mitigate risk through the fund of funds approach and through our in-house OCRA (On-Chain Risk Alerts) system. Selecting the top 10-15 performing managers out of over 700 that we track ensures strong performance and derisks single-manager failure. Our OCRA system then continually audits onchain data, providing real-time risk alerts for exchange bank runs, mitigating in real time the counterparty risk from exchanges becoming insolvent, to prevent becoming victims of incidents such as the FTX collapse.

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In terms of passive strategies, a popular DeFi activity is liquidity provisioning and becoming a market maker. Decentralized exchanges (DEXs) like Uniswap and Curve rely on “liquidity providers” (LPs) to facilitate trading. LPs deposit a pair of crypto assets into a “liquidity pool,” allowing traders to swap between those assets without needing a traditional order book. Whenever a trade occurs in that pool, a small transaction fee is charged, and a portion of these fees is distributed proportionally to all LPs.

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Finally, market-based yield can come from the infamous yield farming. Yield farming is a sophisticated and high-risk strategy that involves combining multiple DeFi protocols to maximize returns. It often builds upon liquidity provision by “stacking” yield sources. For example, a yield farmer might deposit assets into a lending protocol, then use the borrowed funds to provide liquidity to a DEX, receive LP tokens, and then “stake” those LP tokens in another protocol to earn a third type of token (often a governance token for the farming protocol). This process often involves frequent monitoring and repositioning of assets to chase the highest available yields.

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The yield from farming comes from a combination of trading fees, lending interest, and additional “incentive tokens” (often newly minted governance tokens of the farming protocol) distributed to liquidity providers or stakers. Yield farming exposes participants to extremely high risk due to smart contract vulnerabilities across multiple protocols, impermanent loss, high gas fees for frequent transactions, and the potential for “rug pulls” or rapid depreciation of incentive tokens. It demands deep knowledge and active management.

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Real-world yield

For those less inclined to enter the yield farming arena, more traditional yield sources have been entering crypto in the form of real-world yield, where the income generated originates from sources outside the native crypto market. The process of tokenizing real-world assets (RWA) is rapidly growing and is where a real-world asset (e.g., a U.S. Treasury bond, a private credit loan, or real estate) is securitized and tokenized. A token is created on a blockchain that represents ownership or a claim to a share of that underlying asset. The legal framework for the offchain asset is crucial, while the token facilitates onchain transfer, fractionalization, and liquidity.

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While tokens sit inside the crypto setting, the source of yield comes directly from the underlying real-world asset, not from crypto market dynamics. In this way, there is true convergence between crypto and the real world, with crypto assets reflecting their real-world counterparts and providing superior financial rails and plumbing. These systems are not yet perfect. There are still legal and regulatory complexities, smart contract vulnerabilities, “oracle risk” (the challenge of reliably bringing offchain data onto the blockchain), and the credit risk of the underlying real-world borrower or asset. However, the trend towards real-world yield in crypto is strengthening. Investors burned by purely speculative yield schemes are now gravitating to projects that can point to an actual revenue source or real asset backing for the yield.

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Crypto has evolved to the point of sophistication where it is rivalling traditional finance in offering users an enormous breadth of yield opportunities. From low-risk protocol returns, to high-risk yield farming schemes, sophisticated investors can earn low single-digit returns from lending out stablecoins to making double-digit returns by offering liquidity to newer less tested DeFi protocols. At CMCC Global, we are constantly exploring the bleeding edge of this market, which we view as the future of financial markets. Within our Digital Asset Funds, we stake long-term positions such as ETH, SOL and AVAX, and have exposure to platforms offering yield opportunities like Genius, Accountable and Ether.fi. Our Crest family of funds provides institutional-grade market-neutral exposure and high-yield returns on USD and BTC.

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Ultimately, the ability to earn yield in a variety of ways is a testament to crypto’s financial ingenuity. It is also a powerful incentive driving crypto adoption and integration into the broader global economy.