Erik Weijers, 9 months ago

What are DeFi interest rates?

Few things are as opaque as the interest rates you are presented with in Decentralized Finance (DeFi). To understand whether the 34% you are promised is sustainable, you must understand where the rates come from.

Interest rates on a "traditional bank account" have been laughably low for years. No wonder many people have been licking their lips at DeFi and have indeed moved their funds over in part or in full. What explains the difference in interest between Tradfi and DeFi? First of all, the money market in this crypto world is not suppressed by a central bank that sets a sometimes artificially low-interest rate. In crypto, it is a purely free market.

Enabling trade together

Secondly, DeFi does not have to pay expensive intermediaries. Much of the revenue generated by trading can be distributed to the users/holders of the coins. Instead of an exchange where a central party manages the order books, it is the users themselves who put their money in liquidity pools and thus make mutual trade possible. For that service, they are paid transaction fees: this is a just and natural form of 'interest', often in the ballpark of half a per cent per transaction.

There are other understandable sources of real yield, namely:

  • Transaction fees for services: think of bridges between protocols, which charge a percentage for shipping your coins between chains
  • Interest on lent money: the margin a DeFi platform takes: the difference between interest paid by borrowers and captured by lenders. For example, 1%.

Be careful with tokens

Where you have to be careful is that the percentages mentioned with above mentioned liquidity pools partly consist of 'farming tokens' that you get paid. These are governance tokens of the DeFi protocol in question. The payout often decreases over time ánd the value of the tokens can drop rapidly. After all, it's just a token, not a dollar or BTC. So the promised 235% on a yearly basis is usually not going to happen... Of course, it can be a profitable strategy to get in quickly after the launch of a new DeFi protocol and sell that initial glut of farming tokens quickly. But it is not necessarily a sustainable strategy.

So it is good to consider what the ratio of payout in transaction costs to own tokens is for a DeFi protocol. If it is only own tokens that are the payout, you need to be careful. On, you can see which chains/protocols are most in-demand, as measured by the transaction fees users are willing to pay. A nice sign of actual adoption/popularity.

Thanks to Shivsak for his explanation.

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