Tokenization 101: Yield-bearing tokens, what are they and how do they work?

Cryptocurrency Mar 1, 2022

Introduction

With the development of DeFi, a new type of tokens was also born, yield-bearing tokens.

One of the most exciting characteristics of the Ethereum network is the composability it offers to projects building in the ecosystem. Teams are able to build new products and strategies on top of each other in innovative ways.

For this reason, many DeFi projects host a variety of vaults or pools in which users can deposit and receive a deposit token, called LP token, in return. These tokens are ERC-20 tokens that act just like all the other ERC-20 tokens and can be transferred or traded whenever there is a market for them.

Among the LP tokens, one type is yield-bearing tokens. These tokens represent a share of a yield-generating activity, and each carries a unique floating cash flow that can be realized in real-time. So, the question is:

What are yield-bearing tokens and how do they work?

As the name implies, yield-bearing tokens are LP tokens that generate yields. The pioneer decentralized lending protocol Compound introduced interest-bearing tokens, cTokens, in DeFi for the first time.

Simply put, cToken is the proof of ownership of the loan and can be used to claim your deposit. The value of cToken grows over time as the protocol collects payment from token borrowers. Compound requires users to deposit at least a certain amount of underlying tokens before getting cTokens at a 1:1 ratio.

If that’s still tricky to understand, here is an example of how it works.

Let’s say you supply 1,000 DAI to the Compound protocol, when the exchange rate is 0.020070; you would receive 49,825.61 cDAI (1,000/0.020070).

A few months later, you decide it’s time to withdraw your DAI from the protocol; the exchange rate is now 0.021591:

Your 49,825.61 cDAI is now equal to 1,075.78 DAI (49,825.61 * 0.021591)

You could withdraw 1,075.78 DAI, which would redeem all 49,825.61 cDAI

Or, you could withdraw a portion, such as your original 1,000 DAI, which would redeem 46,315.59 cDAI and keep the rest of the 3,510.01 cDAI in your wallet.

With Compound, the exchange rate for cTokens increases over time – guaranteeing each cToken becomes convertible into an increasing amount of its underlying asset, even while the number of cTokens in your wallet stays the same.

What can you do with interest-bearing tokens?

There are usually two things that everyone can do with interest-bearing tokens: 1) sell them in the secondary market, such as DeFi protocols like Uniswap; 2) Hold them and redeem funds by burning them.

As projects in DeFi develop, more use cases of interest-bearing tokens have come to the market. These tokens can be used as collateral to borrow funds, be shaped into structured products, be sent to the cold storage for safety, or be used to generate an extra layer of interest.

There are farms and vaults that are designed to accept yield-bearing tokens to do yield farming. Farm aggregators like Multifarm make it easy to find out which farms/vaults are available for a certain asset. Below shows an example of the search result for aUSD (yield-bearing token aToken from AAVE).

DeFi 2.0 protocol Abracadabra allows users to use their yield-bearing tokens as collateral and mint MIM stablecoins in multiple cycles. For example, if a user stake USDC on Yearn, the user will receive interest-bearing asset yvUSDC. The user earns rewards from Yearn for holding the yvUSDC but there were not many other applications for this asset. Now with Abracadabra, the user can stake this yvUSDC on Abracadabra, and mint MIM stablecoins. The user can buy more USDC with MIM in other platforms such as Sushiswap, stake on Yearn again to get more yvUSDC, and then stake on Abracadabra to mint more MIM, and do this cycle for up to ten times. This greatly increases the capital efficiency.

Closing

In summary, yield-bearing tokens are a type of ERC-20 tokens that can generate yields simply by holding them. The tokens can also be traded like all the other ERC-20 tokens. With more teams getting deeper with these tokens, more use cases have been developed for these tokens, such as using them as collateral or generating an extra layer of interest.

With yield-bearing tokens catching more eyeballs and attracting more applications, a new ERC standard is being developed to standardize solutions to integrate these tokens so they could be plugged into other applications with ease. As yield-bearing tokens develop, they are becoming a more and more important section for the DeFi Lego.

Read more on Tokenization series.

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