Most people in DeFi end up invested in yield bearing assets, but they usually don’t do much with them. What are the options once you hold your favorite yield-generating (or investment) token?

The typical role of capital is to be used productively, and generate a return. Obviously, most people want to optimize this return to earn more at the lowest possible risk. In DeFi, the main sources of yield are credit markets (Aave, Compound, Euler, …), DEXs (Uniswap, Curve, …), and farms (Convex, …). But once your tokens are earning yield from one of those sources, what can you do?

The investment tokens you get when earning yield have started to be gradually used in DeFi as collateral themselves to take out loans, typically on lending or debt-based stablecoin protocols. These loans can then be used to buy more investment tokens, and improve the returns on the original capital.

Imagine owning a EUR-denominated token generating a 5% APR, borrowing a EUR stablecoin like agEUR for 1%, and using the borrowed agEUR to get more of the yield-bearing token: this can easily multiply your yield.

You might be thinking “this smells a lot like 2008”, and you’d be right. Yet, strategies behind those investment tokens can have very different underlying mechanisms, making them more or less risky.

Let’s try to have a look at what using investment tokens as collateral implies in terms of risk/returns, and the main categories of protocols enabling this use case. Remember that the global idea is always the same: use yield-generating tokens as collateral to borrow an asset and generate more returns with the loan, usually by buying more of the the original investment tokens.

For Protocols

Using yield-bearing tokens as collateral bares two main risks for the protocols issuing the loans:

1. Liquidity risks: Can the collateral tokens be easily liquidated to the underlyings to pay back the debt?

2. Pricing: Can the collateral tokens be easily priced to evaluate how much debt can be drawn from said collateral?

For Users

On their side, users have other risks to watch out for:

• Is the underlying “strategy” of their collateral sound?

• How is their debt denominated vs their collateral, and how their relative prices are expected to evolve over time? In other words, is the position delta neutral or not? If my yield-bearing token is an ETH derivative (like wstETH) making a yield, and I am borrowing a USD stablecoin, then I’m not delta-neutral.

• How sensitive is their position to collateral/debt price changes? It usually depends on leverage.

• And finally, how much does the loan cost, and how profitable the strategy is?

Overall, many actors offer leverage on yield, but depending on the answers to the questions above, the risk/returns can be very different.

To offer leverage on yield, a protocol needs to be able to issue a loan against the productive asset posted as collateral. They can be split into two categories: debt-based stablecoin protocols like Angle, Maker or Abracadabra, and lending protocols like Gearbox, Notional or Sturdy.

Debt-based stablecoin protocols

The major advantage of stablecoin protocols is that they are able to charge low and fixed interest rates to borrowers, making the positions’ returns higher and easier to predict.

The borrowing rate can be very low because these stablecoin protocols have almost no cost to offer their product. They usually charge an interest rate on loans to cover for the risk of bad debt (ending up with unliquidatable positions).

It can also be fixed because the available supply of stablecoins is flexible as opposed to lending protocols.

Thanks to these characteristics, the cost to borrow agEUR from Angle can be as low as 0.5%!

Lending protocols

On their side, lending protocols have to find available liquidity to provide users with loans. This is usually coming from lenders expecting to earn a return in exchange. This means charging a higher and often variable borrowing rate for loans, making positions’ returns less profitable and harder to predict.

However, loans can typically be denominated in a bigger range of assets, making it more customizable for borrowers. For instance, on Gearbox, you can take delta neutral ETH, USD or even BTC positions, that consist in lending an ETH, USD, or BTC yield-bearing derivative (obtained on Curve for instance) and borrowing ETH, USDC or wBTC.

In some cases, these loans can have a fixed rate and limited duration. Notional is an example of a protocol providing fixed and limited ETH loans to borrowers to let them leverage their positions on the ETH/wstETH Balancer pool. The upside is that the interest rate is known in advance, and the downside that the loan has an expiration date.

Some protocols have found ways to decrease the borrowing cost by giving away a portion of the yield generated on the collateral to lenders. This is what Sturdy does.

There are many ways to earn more from yield bearing assets through different kinds of leverage. Stablecoin protocols offer fixed and lower rates, while lending protocols can denominate loans on more assets making it easier to get delta neutral positions but with potentially higher borrowing rates.

In the end, whether the loan is coming from a stablecoin or a lending protocol, it is very important to keep in mind the loan’s risks for borrowers: how the loan is denominated, how sensitive the position is to collateral price changes, and how much it costs.

This is what ultimately affects the profitability of the strategy. The underlying mechanism of the vault collateral tokens is the other aspect to watch out for, as it’s what can lead to a potential loss of funds. If you are owning a yield-bearing USD stablecoin but that this stablecoin depegs, then you may lose money.

While on the paper leveraged yield strategies are very promising, the UX is most of the time complex and involves often many different transactions just to be able to get in a position of entering in it.

We have been working to solve that with Angle and will have some big news in a couple of weeks from now 👀