Yield is one of the most important primitives in financial markets. Alongside gains, it’s an expression of investment profits. But whereas gains come from changes in the price of an asset – and are only realized when the asset is sold – yield is a measure of cash flows generated and distributed to the asset’s holder. They are different things, but yield informs the price of an asset and vice versa.
For example, you can profit from an investment in a company’s stock by selling shares at a higher price (gains) or when the company distributes excess profits in the form of dividends (yield). You may then value the stock as a function of its cash flows, as is common in securities analysis. Similarly, the interest rate paid by a borrower in a loan contract is the yield earned by the lender, and the market value of that contract is a function of its expected yield. Yield is expressed in percentage terms: a division of cash flows by the size of the underlying investment (e.g. a $100,000 investment that produces cash flows of $5,000 per year, yields 5%).
Yield is how many DeFi protocols reward active participants. For example, decentralized exchanges like 0x, Uniswap, and Balancer compensate market makers and liquidity providers who stake in those protocols with income derived from trading fees. Credit marketplaces like Aave and Compound pay lenders much of the interest rate paid by borrowers, and “robo-advisors” like Yearn maximize yield across a variety of underlying strategies. You may also earn yield from Proof-of-Stake systems like ETH2 or Decred.
When you stake in most DeFi protocols you get back tokens that are redeemable for your initial deposit plus any yield generated throughout the duration of your stake. In Aave, these are “a-tokens”, in Compound “c-tokens”, and in most AMM dexes these are called “LP” tokens. But these come with capital-efficiency problems. First, the yield rates are usually market-based and thus variable and often volatile, so you have no certainty about the ultimate value until redemption. Second, your deposit is locked for the duration of your stake. It’s still yours, but you can’t use it elsewhere for the duration of your deposit.
For example, if you stake 10,000 USDC in Aave, the current annual yield (as of writing) is about 8.92% – but there’s no way to know if the next three or six months will yield more or less. You have no access to your principal (the 10,000 USDC deposit) while it’s staked in the protocol, which prevents you from leveraging that capital elsewhere.
Element is a protocol that allows developers and investors to harness the power of yield in their applications and strategies by addressing these two issues as a layer on top of yield-generating protocols. It works by separating the principal from the interest of a given stake into two separate, tradable tokens: Principal Tokens and Interest Tokens. At the end of a set term (e.g. 3 or 6 months) each Principal Token is redeemable for a proportional share of the initial stake, while your Interest Tokens are redeemable for the yield generated by the principal over the same time period.
For example, if you pursued the same 10,000 USDC Aave strategy through Element over a 12-month term, you would get 10,000 Principal Tokens redeemable for 10,000 USDC in a year, and 10,000 Interest Tokens redeemable for however much interest is generated on Aave over that year. If the average rate turned out to be 10%, then the interest tokens would have a terminal value of about 1,000 USDC (or 0.1 USDC per Interest Token).
It’s a powerful trick. Here are just a few things you can do once you separate the yield from the principal:
First, your principal interest is now liquid. Keeping our example, your 10,000 USDC is still locked in Aave for a year, but you now have an equivalent amount of Principal Tokens which you can sell at a discount to account for the lockup. The market might be interested in buying your 10,000 USDC principal tokens for 9,400 USDC, thus securing a fixed yield of 6%. This new instrument solves the problem of unknown yield.
Principal tokens trading at a market discount function like zero-coupon bonds and unlock a whole new asset class in DeFi. Many investors will gravitate towards fixed yield instruments, creating demand for principal tokens while their sellers gain access to most of their principal. These become naturally appreciating assets that provide exposure to stable interest, as an alternative to collateralized lending markets which can require constant movement of funds. If you are long the underlying base asset, it’s also an effective way to acquire them at a discounted price to market, further boosting your expected returns.
Liquid Interest Tokens give you a lot of flexibility as well. You can sell your principal tokens and hold onto your interest tokens, or you can sell your interest tokens and hold onto your principal tokens, accessing some of tomorrow’s yield today. Or you can sell both! New markets and compounding strategies are bound to emerge (for example, you can re-stake your principal to gain leveraged exposure to yield).
Element also makes it much easier to switch strategies. If you wanted to move your 10,000 USDC from Aave to Curve, for example, instead of un-staking from Aave and re-staking in Curve, you could just trade your principal or interest tokens from one strategy to another through a decentralized exchange, saving time and money.
What’s most interesting to me is what can happen once markets form around these new DeFi primitives. Just as every investor in the world pays attention to the national bond markets and interest rates, investors in DeFi can glean valuable information from the markets for principal and interest tokens. Higher or lower fixed yields on principal tokens provide certain kinds of information, as do higher or lower prices on variable interest tokens.
Higher discounts on principal tokens can mean investors expect higher risk-adjusted returns in the broader market, but it could also be a signal of higher principal risk in the underlying strategy (e.g. a potential hack and recovery). Growing prices for interest tokens on USDC deposits in lending protocols like Aave or Compound can mean the market expects interest rates to rise, while decreasing prices for interest tokens on LP stakes in an AMM DEX could mean the market expects trading volume and fees to decline.
In principle, increasing capital efficiency is key to scaling DeFi to the next order of magnitude, as it helps attract larger and larger pools of capital. Today, on the heels of its first public launch, we’re only scratching the surface of what’s possible with Element. We’re excited to see these ideas in practice and look forward to the many experiments this protocol will catalyze.
To dive deeper into Element, take a look at the construction paper at https://paper.element.fi and follow the team at @element_fi on Twitter.