The decentralized finance (DeFi) landscape is rapidly evolving. Yet the rising fear of recession is pushing investors into the arms of fixed yield strategies. These strategies are a world apart from the volatility of yields often found in DeFi. They provide consumers a more predictable and certain experience in an otherwise volatile market. This article dives into why we’re seeing the increasing adoption and popularity of fixed yield mechanisms. It lays out the big players—what’s going on, what’s at risk, what’s the upside versus variable yield options.
Fixed Yield Pioneers
In 2023, a number of groundbreaking fixed yield protocols made waves. Each one does this in very different ways, applying innovative strategies to provide consistent, reliable returns to their users. Yield Protocol, for example, allowed fixed-rate and fixed-term lending and borrowing via fyTokens, which operate like zero-coupon bonds. These tokens allow users to lock in interest rates for a certain period of time. This insulation provides them protection against the boom and bust cycles of the general market.
Unlike other money markets, Notional Finance is a fixed-rate money market, where lenders are directly matched with borrowers. And lenders receive the benefit of locking in their yield for up to one year. Because of this, they are able to distinctly illustrate their return on investment throughout that period. By creating more predictability for lenders and borrowers alike, this paradigm creates a more conducive environment for investment.
88mph explicitly offers fixed interest rates on crypto assets, providing a straightforward solution for users seeking predictable returns. DELV allows for fixed-rate borrowing through its DELV Fixed Borrow option. This feature directly ties the fixed yield environment to the yield of underlying treasury assets. For example, DELV offers 4.09% APY.
Yield Protocol’s “Hyperdrive One” allows users to buy discounted assets including stETH. Similar to zero-coupon bonds, it provides a defined yield with maturity. This fresh, user-friendly method benefits users by enabling them to obtain assets upfront for a fraction of the cost. In return, they’re guaranteed a low, steady return on that investment.
Variable Yield: A Landscape of Fluctuations
Unlike the predictability of fixed yield, variable yield is marked by volatility. Returns can often be wildly optimistic, dependent on the market situation, the success or failure of the protocol and a multitude of other variables. This built-in volatility requires active management, meaning users must be vigilant in monitoring holdings and dynamically reallocating resources to achieve the greatest possible return.
Assets can be staked in a proof-of-stake (PoS) consensus mechanism. Because of the mechanics of staking, it can provide very high return rates. Unlike other blockchains, such rates are dynamic depending on network usage and number of participants. That has made it almost impossible to reliably forecast future earnings.
Variable yield is a riskier choice than fixed yield. Variable yield is a much more unpredictable bet. As we’ve seen in cases where market conditions suddenly shift or where protocol parameters are changed, returns can fall off a cliff. The opportunity is vast, matched only by the uncertainty – both in the upfront costs and the operational needs.
Risk and Reward: Comparing Fixed and Variable Yield
Thus, fixed yield strategies are typically less risky than variable yield strategies. Locking in interest rates for a total of six months allows users to protect themselves from unpredictable swings in the market. This strategy ensures a constant and reliable stream of revenue. This low-risk nature of fixed yield makes it especially appealing to risk-averse investors who prioritize stability as they diversify their portfolios across DeFi.
In return, fixed yield is usually a lower return, although variable yield can be higher return. This potential comes with increased risk. Variable yield strategies are better aligned with investors who can more actively manage their positions and accept higher levels of uncertainty.
Which yield type an investor ultimately chooses will largely come down to their own risk tolerance, investment goals, and time horizon. Fixed yield is most effective for long-term growth and provides a steady, predictable stream of income. Conversely, variable yield is best suited for investors who want to focus exclusively on short-term return maximization.
APR vs. APY: Understanding the Nuances
A very important difference between APR (Annual Percentage Rate) & APY (Annual Percentage Yield) on fixed yield and variable yield strategies. Knowing this distinction is important when determining how to allocate your dollars. APR is the simple interest rate that would be earned over a year. APY includes the impacts of compounding. Knowing this difference is critical to comparably understand the risk-return profile of various DeFi products.
In fixed yield products, APR and APY are usually nearly identical. This occurs due to the fact that the interest rate is considered fixed over the life of the investment. Note that the APY for variable yield products is subject to large fluctuations. This difference varies based on the frequency of compounding on the interest and changes in the underlying market interest rate. Investors need to look at both APR and APY and what they mean for their potential investments.
Oracle Risk: A Potential Vulnerability
Though they provide more steadiness compared to fixed yield strategies, they have some inherent risks. Perhaps the biggest issue is oracle risk. This risk arises when bad or manipulated data inputs lead to improper performance of a smart contract, causing financial loss. DeFi protocols depend on oracles to deliver real-world data, including asset prices and interest rates. If these oracles are somehow compromised, the integrity of the entire system can quickly be thrown into doubt.
Protocols using fixed yield models should use strong oracle security processes to prevent this risk. This can involve requiring multiple oracles, building in data validation checks, and creating systems for detecting and responding to possible attacks.
The "Illusion of Fixed"?
"However, some consider this an “illusion of fixed” within DeFi’s volatile ecosystem." - nftevening.com
Compared to equity markets, fixed yield strategies are inherently more predictable. Yet, as many have pointed out, they produce an “illusion of fixed” in a very real, volatile world of DeFi. External factors outside of one’s control, like smart contract vulnerabilities or regulatory changes, could always affect how well these strategies do.
Even with this risk, fixed yield strategies are a huge advancement in the direction of DeFi’s evolution. Second, they provide a greater measure of stability and predictability in the investment climate. This user-first approach welcomes a broader, more diverse user base and leads to more overall adoption of decentralized finance.
