Stablecoin Yield Spreads: Treasuries vs Protocol Returns

The focus of this article will be on the Stablecoin Yield Spread: Treasuries vs. Protocol Fees. We will analyze the DeFi yields of stablecoins generated from lending

Staking, and other protocol rewards and how these yields compare with the secured and predictable yields of U.S. Treasuries. Defining this spread will enable investors to assess the income potential versus the risk in decentralized finance.

Overview

The last few years have seen the development of stablecoins, which are digital assets used to keep a value consistent, either through a domestic currency like the U.S. dollar or an international one like the Euro.

These coins can be seen as an external finance and DeFi merger, and although they do act as a means of maintaining a stable value, the financial mechanics of stablecoins extend significantly beyond simple value stability.

The opportunity to earn a yield, which stablecoins offer, has been a more driving factor for many, including large institutional investors, than that of U.S. Treasury securities, which are considered risk-free.

Explaining the yield differentials between these two options—treasury yields versus protocol yields—requires sophisticated understanding of various domains including DeFi protocol evolution, associated risk, and market behavior.

What is a stablecoin Yield spread?

A stablecoin yield spread shows how much return you can earn on stablecoins via DeFi protocols compared to safe assets like U.S.

Treasuries. It shows how much more money investors can earn by getting involved in decentralized finance, where money is made via lending, staking, or getting paid by protocols.

The spread is a measure of risk compensation for the uncertainty of smart contract failures, liquidity risk, or de-pegging of stablecoins vs the safe, predictable, and regulatory clear risks of government bonds.

Why Compare Stablecoins To Treasuries?

U.S. Treasuries are viewed as the “risk-free” return benchmark because they are backed by the U.S. government. The baseline yield of U.S. Treasuries gives investors insight into the additional risk compensation offered by DeFi platforms.

These risks are related to the smart contract risk, sudden liquidity risk, and the risk of the stablecoins deviating from the $1 peg.

Comparing stablecoin yields against Treasuries allows investors to analyze the tradeoff between higher yields and the risk associated with DeFi.

Stablecoins: Not Just Digital Cash

USDC, USDT, and DAI, are examples of stablecoins that are hosted on blockchains and are pegged to fiat currencies, crypto collateral, or use some form of an algorithmic approach.

These types of cryptocurrencies offer individuals the opportunity to transact and participate within the crypto ecosystem without the risk of significant decreases in values of crypto assets like Bitcoin or Ethereum.

In addition to that, an individual can earn a passive income with stablecoins by lending, staking, or providing liquidity on different DeFi platforms.

The income that a user can earn on a stablecoin can fluctuate, and is expressed in Annual Percentage Yield (APY) and can be influenced by the supply and demand of funds in the lending and borrowing space, and the rewards that are provided by the lending platform in the form of tokens.

For example, lending platforms Aave and Compound can offer interest rates of greater than 10%, which is in stark contrast to the much lower rates of 5% in United States Treasury bills, no matter the length of the maturity.

Treasuries, The Standard of Claiming Returns with No Risk

U.S. Treasury securities have accurately represented the risk-free tier of the financial markets for a number of decades because they are backed by the “full faith and credit” of the U.S.

government, meaning that the government isn’t likely to default for any reason. Because of this certainty, investors typically accept lower, or no returns.

The interest rates that are provided by the Treasury on short-term Treasury bills often represent the monetary, inflation, and overall sentiments of the investors.

In times of high-interest rates, the rates on Treasury bills become more appealing compared to other risk-free assets, however, they still offer a lower rate than what is available in riskier assets such as DeFi.

The liquidity of treasuries and counterparty risk is zero. They are fully compliant with regulations and with complete certainty.

They can be used as collateral in traditional finance anywhere. Investors may be treasuries dissatisfied because the real return on the security is eroded by inflation and 60 percent of the revenue on the inflating dollar is a net positive.

Yield Spreads: A Comparison

The risk-adjusted return differential of treasuries and stablecoins is the yield spread. Treasuries are underwhelming because risk is extremely low and stablecoins are high because of interest, trading cost, and incentive to trade as it relates to decentralized finance (DeFi) protocols.

The example of a $1 million investment in USDC on an anchor lending protocol which yields 6 percent APY (annually, $60,000) will be compared to the same investment in a 1-year US Treasury which yields 4 percent (annually, $40,000). In this example, the spread is 2 percent.

The comparison is not completely accurate as the protocol yield poses the following risks: smart contract risk, governance risk, liquidity risk, and the risk of the stablecoin losing its peg. Treasuries are stable and limited.

The calculation of such spreads also depends on the time horizon. In DeFi, Protocol fees can vary greatly on a day-to-day basis, and in some cases, some platforms can provide additional token incentives that can temporarily increase yield significantly.

In comparison, Treasury yields, which are more time predictable, can be more sensitive to macroeconomic variables such and Federal Reserve policies and expectations of inflation.

Seasoned investors are likely to simulate these yields many times to isolate specific times when the spread makes it worth the risk of DeFi exposure.

Why Stablecoin Yield is as it is.

There are many variables that go in to determine yield an investor can make off of stablecoins. One of which is lending demand within the protocol. When borrowing demand is high, the interest to be paid also increases. Supply also affects demand, when the supply of stablecoins is high enough relative to liquidity, it can increase interest rates.

Additionally, through governance of the protocol, participants can increase the amount of yield earned through staking or liquidity mining, which is an added form of yield. Simple macroeconomics can also influence the yield indirectly by affecting the demand to borrow and the liquidity of the reward.

Another key element is protocol risk. Unlike treasuries, which have almost no chance of defaulting, DeFi platforms face the risk of smart contract bugs, attacks, and liquidity issues.

A good example of this is the collapse of Terra/Luna, which shows the risks of over-leveraging and reliance on algorithmic collateral. Ultimately, investors will need to consider the risks to determine if the potential return over treasuries is worth it.

Best Case Scenario

Both retail and institutional investors should consider the stablecoin-treasury yield differential. For investors who are risk averse, treasuries are still the best option, as they provide definite returns and regulatory clarity.

For those with a higher risk appetite, a portion of the capital can be placed in DeFi stablecoin protocols, as this will increase yield on the entire portfolio, assuming protocols are monitored for protection, liquidity, and the market.

The widening of yield spreads is becoming a key indicator of market behavior. A widening spread indicates appetite for risk in DeFi, while a narrowing spread indicates less demand for stablecoin lending or increased confidence in the so-called safe-haven assets.

It is becoming more common for portfolio managers to monitor risk-adjusted yield spread as part of a more comprehensive approach to liquidity and security. This indicates growing liquidity in the market and a decrease in risk relative to traditionally safe assets.

Comparison Table

The Spread Dynamics

When Treasury yields increase, stablecoin issuers benefit, reducing the motivation to pursue DeFi yield opportunities.

When there is a significant increase in protocol activity (like in bull markets), yields from fees increase, increasing the spread in comparison to Treasuries.

This situation often leads investors to arbitrage between the two, reallocating funds to where the spreads are most enticing.

Risks & Trade-Offs

Treasuries: safety comes at the cost of limited upside + exposure to issuer centralization

Protocol Fees: attractive yields + susceptibility to hacks, liquidity crises, and regulatory shutdowns

Hybrid Models: some protocols are beginning to tokenize Treasuries, combining safety with DeFi accessibility. This could lead to tighter spreads in the future

Conclusion

The conclusion yields spread shows the trade-off of risk versus reward. DeFi protocols yields are higher, but have risks.fetching yield involves interest, fees, and incentives.

In contrast, U.S. Treasuries have safety, and, return lock-in. Risk involve smart contract and liquidity issues. Analysing the spread enables the investor to make choices, and quantify the trade.

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