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Income-ing!  — Digital Dives Vol. 51

May 2023 marks the one-year anniversary of the Terra/Luna collapse. Taking time to reflect on the events and contagion that followed provides a stark reminder of the volatility and interconnectedness inherent to the market. Leading up to the collapse, Terra's Anchor protocol offered seemingly stable yields in the 30% range, and asset managers with capital allocated there boasted high returns. These rates of return significantly exceeded the Aquanow DeFi Funding Rate (ADFR) and its companion, the Aquanow DeFi Funding Index (ADFI), which we believed was a clear risk indicator. It underscores the value of the benchmarks, whose composition is endogenous to the digital asset ecosystem. Both were launched a year ago and are available on the Bloomberg terminal. These tools provide investors with insights necessary to navigate the complex and volatile crypto landscape.

Source: Bloomberg, Aquanow

Institutional investors, such as pensions, insurance companies, and mutual funds, prioritize generating income to meet financial obligations and provide returns to stakeholders. However, the period between the Great Financial Crisis and the COVID-19 Pandemic was characterized by persistently low interest rates, so many institutions stepped out of the risk spectrum to achieve their return objectives. Sometimes this involved allocating capital towards assets with lower liquidity, longer duration, or lesser credit quality. Today, we’re seeing some of the consequences of these portfolio tilts play out in the headlines, but the principle of diversification has been upheld. Spreading risk across several return sources makes for a more resilient portfolio.

You can see the benefits of adding digital asset income to other yield-bearing assets below. It’s worth noting that the low interest rate environment was especially challenging for short term income mandates. A skillful allocator could have enhanced returns with different weights, but to highlight the importance of diversification we’ve illustrated the equal-weight portfolio. Even still, the benefits of uncorrelated sources of return are evident where the combined holdings achieve 71% of the highest return while assuming only a third of its volatility.

Indexed Returns of Various Income-generating Assets:

Source: Bloomberg, Aquanow

Participation in digital asset markets among institutions has been limited to date. However, professional investor adoption has increased with each passing cycle. It might seem hard to believe given the frequency of negative news flow, but even during the current bear market, traditional portfolio managers continue to evaluate adding cryptoassets to their holdings. In most cases, the investors are seeking substantial price appreciation, but income, derived from decentralized lending protocols and other mechanisms, provides diversification benefits as it has limited correlation with traditional assets like stocks and bonds. By incorporating digital asset yield into their portfolios, institutional investors can potentially enhance risk-return profiles and improve overall performance.

The Aquanow DeFi Funding Index (ADFI) and Rate (ADFR) play a crucial role in evaluating yields across the digital asset landscape because they’re built from the ecosystem itself. The ADFI is a liquidity-pool-value-weighted composite that captures the return generated from aggregate yields of stablecoin lending in top-grade DeFi pools. It allows investors to assess the performance of assets and portfolio managers allocated to the space, as nuances of protocol-based lending markets are incorporated natively. For its part, the ADFR represents the prevailing rate across decentralized pools for lending non-algorithmic stablecoins, serving as a reference rate for the cost of capital in DeFi loan pools.

By leveraging the ADFI and ADFR, institutional investors can gain a comprehensive understanding of digital asset yields. These benchmarks enrich investment decisions, help manage risk more effectively, and enable the comparison of DeFi yields across different protocols and market conditions. The built-for-purpose benchmarks enhance the income generation capabilities of institutional portfolios and we believe the number of mandates with exposure to decentralized finance will continue to grow.

Source: Fidelity Digital Assets

Let’s consider some ways to use Aquanow’s indices. We’ll begin with the comparison of returns from the Orthogonal lending pool on Maple against the ADFI. The latter represents uncollateralized loans while the DeFi pools underlying the Aquanow benchmark are all backed by pledged digital assets. In traditional capital markets, widening credit spreads are typically associated with heightened market risk. It’s fascinating to see the spreads of the uncollateralized Orthogonal pool expand relative to ADFR (and by association ADFI) ahead of eventual loan losses.

Indexed Returns of DeFi Lending Pools and Direct Uncollateralized Loans:

Source: Cicada Partners, Aquanow

Given the greater risk, you’d expect the direct lending portfolio to carry higher interest rates, but how much spread is sufficient? We don’t have enough of a time series for a robust analysis and there’s never any guarantee that what’s happened in the previous market conditions will repeat. However, in a recession, the spread of high yield bonds over the U.S. 10-year Treasury typically peaks around 700 – 800 basis points (with some outliers). Before the Orthogonal pool closed (due to reasons outside of the manager’s control) the spread was 700 bps. It’s too early to say if the digital asset markets have bottomed, but this might be an important metric to track in future cycles.

We can also gauge market stress through the ADFR. Due to the size of the alleged fraud, FTX’s collapse seems to have garnered more media attention than the disruption from curtailed banking rails and the threat to the bedrock of DeFi, stablecoins. Looking at Aquanow’s benchmark rate we can see visually what many digital asset participants have experienced – the threat of lost faith in USDC would be a massive shock.

Source: Aquanow

A rising ADFR shouldn’t always be interpreted as a sign of market strain. The recent appreciation is from an increase in loan pool utilization. Token prices have stabilized, so it makes sense that there’s a greater appetite for leverage. However, on a relative basis, borrowing activity has been concentrated towards USDC pools where it might be interesting to borrow an asset if another depegging situation is probable and the loan can be repaid at a lower value than when it was borrowed. We can’t say for sure how much of the borrowing is related to which kind of speculation, but with the proper tools, we can begin to ask the right questions.

AAVE V2 on Ethereum Utilization Rates

Source: Aavescan

Reflecting on the past year, the Terra/Luna collapse serves as a poignant reminder of the hazards in digital asset markets. It underscores the importance of tools like the Aquanow DeFi Funding Index (ADFI) and Rate (ADFR) in aiding effective risk management and decision-making. As digital assets' role in diversification becomes increasingly recognized, we expect more institutional investors to adopt instruments like the ADFI and ADFR. As we navigate the evolving investment landscape, built-for-purpose analytics will be paramount in managing risk and prudent capital allocation.

At Aquanow, we help institutions unlock the potential of digital markets, so if you or anyone you know are considering this functionality, then please get in touch. We’d be glad to leverage our expertise to help you outperform.

Do you want to contribute to the web3 movement? We're on the look for curious and motivated folks to join our team. Feel free to reach out directly or check out the current openings here.

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