Complementary strategies - Yield enhancement
Owning an asset is no longer enough. Perhaps DeFi’s greatest value proposition is returning capital efficiency to the owner of the crypto asset. While Hartmann Capital operates a number of core strategies, from catalyst trades to activist investments, we like to stack strategies that are complementary. Today we explore how we maximize yield on our entire book, through a number of strategies.
Securities lending in TradFi
Just as value investing and shareholder activism have their analogues in DeFi, so too does the common practice of securities lending - making productive use of owned assets.
In TradFi, income-generation opportunities through lending render equities and bonds productive assets. Borrowers generally are shorting the securities, either to hedge other long positions or to express a negative view on the asset. Securities are also used as collateral to fund dealer and hedge fund balance sheets - a form of leverage.
This yield enhancement market is enormous. Two of the biggest lenders, Blackrock and State Street, earn hundreds of millions of USD in passive income on their securities positions. The total market size in the US alone is measured in the trillions.
Productive assets in DeFi
In DeFi, tokens are in demand for the same reason as in TradFi: Lending to borrowers who wish to sell short or wish to finance positions. Tokens might also be borrowed to raise capital without selling and incurring a capital gains liability.
In TradFi, income derives from an interest or dividend stream, and sometimes additional borrowing costs (such as a standby fee). The yield compensates for liquidity, counterparty, credit and, sometimes, market price risks.
DeFi has several important nuances. Credit risk is generally not the prime driver of DeFi yields, for example.
The yield on crypto assets exists because someone has a need for the tokens as follows:
Pure borrowing to short or for funding/leverage (as in TradFi)
Attracting liquidity for decentralized exchange (DEX) automated market makers (AMMs) to facilitate token swaps
A need for protocol to restrict tokens to enforce certain behaviors, such as providing insurance (e.g. Aave’s and Nexus Mutual’s tokens get slashed if certain negative events occur), assuring proper validations on a proof-of-stake chain (staking RUNE, MATIC or bLUNA ensures aligned interests for the blockchain’s key guardians), or for governance (e.g. xSUSHi or veCRV vote on proposals to improve the protocol while also earning fees)
Earning income beyond the borrowing cost by “yield farming” in complex, income-enhancing strategies that combine some or all of the above.
We at Hartmann Capital are unafraid of the complexity in enhanced yield generation, and use yield enhancement as a strategy on top of our value, momentum and activist positions. We continually search the markets for the optimal yield enhancement strategy for each token we hold.
Yield enhancement can be broken down into the following strategies:
Yields of 20% - 80% (per annum) are available for those willing and able to do the work. Earnings come from:
Interest income (especially in the case of straight borrowings)
Trading fees for providing DEX liquidity.
Incentives to provide liquidity, to encourage even deeper token swap markets (especially high for new tokens through what is known as “liquidity mining”)
Incentives to use the protocol
Compensation for illiquidity (lock-in commitments)
Compensation for taking slashing and protocol risks
In the case of the lending example in the table (first, above), we would earn (1) interest income (denominated in the token we deposited into Aave, the lending protocol) as well as (4) incentives to use the platform, denominated in the platform’s token (AAVE). In the second example in the table, the interest rate paid is higher if received in NEXO tokens than in BTC, again demonstrating that the all-in yield is a combination of (1) interest rate and (4) incentives. Liquidity provision of BadgerDAO’s governance token, BADGER, in the Sushiswap DEX earns (2) trading fees plus (3, 4) both BADGER and SUSHI rewards.
Staking may sometimes also lead to airdropped token rewards. Occasionally, Hartmann Capital will stake with the expectation that non-yield rewards will come available. For example, LUNA stakers, as well as other tokenholders in the Terra system, have been rewarded with multiple airdrops of now-valuable assets such as ANC and MIR.
Yield enhancement risks, and Hartmann Capital’s approach
In DeFi, yields arise from compensation for five risks and for the resources expended as follows:
Smart contract and other protocol risks
Price risk, of the deposited tokens but also any tokens earned as rewards
Liquidity risk in some cases
Risk of impermanent loss, if yield farming as a liquidity provider in a decentralized exchange, and
Efforts required to search, analyze, execute and manage the strategies.
Protocol risk
Users of one or multiple protocols required for yield enhancement take the risks that (1) a malicious entity exploits security flaws in the protocol’s code, (2) the team drains value from the protocol (governance failure = “rug pull”), (3) the code fails to act as intended/expected, and (4) protocol inputs such as price feeds are manipulated to cause economic losses.
The longer, more used and tested a protocol is, the safer we feel committing tokens to it to earn out extra yield. Hartmann Capital requires audits, preferably several, from well-respected teams, and relies only on proven protocols. As importantly, Hartmann Capital mitigates the risks by limiting exposure to any one platform.
Token price risk
Owning a token of course exposes our investors to price risk, but yield enhancement has the potential to add in another source of volatility. Base yields are often denominated in the same token, yet the extra incentives may be earned in different tokens. Since May, base yields have fallen, so the rewards are an important component of the total return.
For example the chart below is indicative of the entire market, revealing that base yields on the USDC stablecoin have fallen from 10%-20% level to 2.5% of popular lending platform, Aave. Yields on BTC and other centralized lending platforms that pay only in the deposited token have recently again slashed rates to uneconomic levels for institutions: 0.5% per annum for BTC.
Source: Loanscan.io.
Promised yields in DeFi paid in reward tokens assume that those reward tokens do not fall in price. This is a decent expectation in a bull market, yet does add risk. We do not hold tokens for any other reason than as part of an explicit strategy. As such, weaker tokens will be sold as earned to minimize the risk that out yields are eroded through poor token performance.
High headline incentives are not attractive to us, if paid in highly-inflationary tokens held by weak hands and requiring a leap of faith to believe in the protocol.
The promise (on May 5):
The result, a 95% loss frpm the highs:
Soucre: Coingecko.
Liquidity risk
Yield enhancement sometimes comes at a cost of reduced liquidity. Staking, for example, to back layer 1 validators or to provide risk cover, often requires long lock-ins. Staking Ether to support a Eth2 node requires a lock-in until Eth 2 proof of stake comes on line, likely sometime next year. Other layer 1 chains (e.g. Terra) also reward stakers, but require lock-ins of various length. Hartmann Capital does lock tokens in from time to time.
Impermanent loss risk
Providing liquidity on decentralized exchange automated market makers for token swaps involves passively selling the rising priced token out of a pool and accumulating more of the one falling in relative price when prices move. This can result in “impermanent losses” (IL) to LPs, and these losses can end up being permanent.
IL can be mitigated by (1) focusing on token pairs or sets that are expected to have extremely high correlations (e.g. two US-dollar pegged stablecoins, or two or more variants of the same token), (2) actively managing the position, (3) depositing into protocols that offer IL protection (e.g. THORswap on THORchain) or (4) betting that LP fees and token rewards will more than compensate for losses.
Dedicating resources to yield enhancement
As some of our strategies are proprietary, the following example can be used to illustrate the complex analysis and execution issues involved in yield enhancement activities. If Hartmann Capital owned tokenized BTC, which is how Bitcoin is held on the Ethereum blockchain, the below is one possible strategy we could use to add yield. In this case, the Badger and Harvest vaults do all of the heavy lifting, but the overall strategy is representative of the important elements: Researching and identifying the optimal risk/reward profile, and managing a position by swapping out rewards tokens for those we want to hold (in this case, tokenized BTC).
Final thoughts
Enhancing yield on our portfolio is not an afterthought, but an important element of our overall fund management style. Yields on our productive assets plus the occasional airdrop adds alpha on top of our token selection strategies. The token is chosen first, and yield enhancement is the overlay.
What we do not do is choose a token because it has high promised yields. Token prices can be very volatile, and smart contract risks are very real. The highest yields are usually available on new (and therefore untested) protocols for tokens that do not (yet) have natural demand. A catastrophic failure, in price, or in the platform, can quickly erase all one’s hard-earned income and possibly one’s entire investment. Billionaire Dallas Mavericks owner Mark Cuban found this out the hard way with TITAN.
Yield enhancement is a complex process, and should be trusted to experts.