Using Yield Products and Protocols in the Digital Asset Space
Insights • Oct 20, 2022 • 3 min read
Bullish’s Justin Short joined managers from three leading digital asset funds—Alek Kloda, Founding Partner and Co-CIO, Nickel Digital Asset Management, Ren Yu, DeFi, BKCoin Capital, Jasmine Burgess, COO/CRO, One River Digital—in a webinar panel moderated by Gwyn Roberts, CSO, Global Fund Media, to discuss the state of yield products in crypto. The Hedgeweek and Bullish session titled, “Using Yield Products and Protocols in the Digital Asset Space: A Guide for Institutional Managers,” covered the basic types of products and challenges to institutional adoption. To learn more about the discussion, watch the recording or read our session recap below.
Using Yield Products and Protocols in the Digital Asset Space: A Guide for Institutional Managers
Crypto “yield products” offer investors income on top of the performance of the underlying token. Broadly speaking, there are three categories of yield product: lending-based, staking, and automated market making.
Lending is the most straightforward in its architecture across both CeFi and DeFi. Token holders lend their assets to borrowers in exchange for interest. CeFi products are offered through intermediaries, while DeFi products are decentralized peer-to-peer networks. Both models come with their own risks. With DeFi it’s a combination of the lack of transparency of the counterparty (potential to be a bad actor) and protocol risk stemming from potential issues with code. CeFi markets suffer from counterparty risk—potential defaults from borrowers and under collateralization by intermediaries facilitating the market.
Staking involves pledging tokens to a proof-of-stake blockchain’s nodes to contribute to governance and security. Token holders are rewarded for their contributions to the consensus mechanism with some percentage of yield on their assets. Staking comes with unique risks, namely “slashing” or asset seizure by the blockchain for validating fraudulent transactions, lockups, and protocol risk that comes with potential issues with code.
Automated Market Making
First found with decentralized exchanges (DEXs), automated market making is when a token holder deposits their assets in a liquidity pool to be used for market making. An automated market maker (AMM) uses a deterministic rule based on the ratio of assets in the liquidity pools to swap one asset for another. Asset holders are rewarded by fees traders incur when trading with the AMM. In effect, traders are paying asset holders. Risks associated include protocol risk (only with DEXs) and a phenomenon known as “impermanent loss” where asset holders may experience losses due to changes in asset price between the time of deposit and withdrawal.
Institutional Access: Bridging the Trust Gap
Crypto yield products are hampered by the same issues as the space faces writ large. Fund managers face challenges with the lack of regulatory clarity, cumbersome investor covenants, and the lack of defined investment processes in a nascent industry.
These factors combine to push funds along a similar path. Many covenants preclude funds from holding tokens, ruling out position taking in the spot market. Derivatives serve as a common entry point when spot markets are inaccessible. Many funds that can access the market begin by running arbitrage strategies on CEXs that are akin to those in fixed income or foreign exchange markets. These strategies are familiar to investors and easier to digest, while the usage of a centralized exchange mitigates some of the regulatory risks associated with playing in DeFi.
As funds move deeper into the space, they have to balance client needs, workflow tolerances, and risk concerns. Managers have to balance the types of yield products they use with the risk tolerances or compliance requirements of their investors. For example, staking conducted on-shore in the United States may be unsuitable for foreign investors who are wary of the tax implications.
Using DeFi is a more complex proposition, one that comes with compliance quandaries and a convoluted, ever-changing structure that makes identifying risks and opportunities difficult. The anonymity of counterparties makes DeFi highly difficult for regulated entities to use. So too does the labyrinth of protocols and opportunities make the hunt for alpha challenging. While the eye-wateringly high yields of some protocols can be enticing, they have the tendency to collapse with downward price—a fact witnessed over the past year.