Thinking about Double Digit Crypto Interest Rates
Lets discuss another magic money tree..
Hi all,
I know, I know. *Interest Rates*. Super, super sexy topic to dive into? Right?!
Well, hold onto your hats as I share my thinking about (i) the MASSIVE gains that you can make by depositing into traditional bank accounts (sarcasm), (ii) how crypto companies get away with offering 3%+ and in many cases double-digit interest rates and (iii) my high-level thinking about crypto prime brokers offerings, where they get their edge from and why I think their businesses is a magic money tree…
Let’s dive in…
Tradional Interest Rates
With inflation hitting 8.5% in the US and 7.0% in the UK, it’s only natural to think “Hmm… I wonder what my money is doing for me.” Traditional banking saving rates are tending to zero. In fact, the best rates that I could find (from a quick google) were:
In other words, inflation is eating our money. Naturally, we turn to crypto.
Setting The Scene- Net Interest
Before we consider interest rates from a crypto lens, let’s think about net interest. When you deposit money to a bank or company, they can use your money and lend it out to other users. Your incentive (other than practical money management) is that you are paid an interest rate. The banks’ incentive is to subsequently loan out your money; for this, they are paid an interest rate from the loanee. The difference between the interest that they make on the loan and the interest that they pay you is called net interest. This is how banks make money.
Hence:
Net Interest = Interest gained from loans - Interest paid out to depositors
This may be off-putting for some that banks are “risking” your money. However, the FSCS (UK) protects up to £85k of your money should your bank become insolvent.
From this, we can reason that when we see rates in traditional finance or crypto of 0%, 1%, 5%, 10%…. it really is just the level that the bank/protocol can lend out such that they make money via net interest.
In Trad-Fi, loanees vary from normal people to small to medium enterprises, corporates, and in some cases financial companies. The latter bucket includes trading firms, market makers, hedge funds, and other cryptocurrency traders. Let’s call them “finance bros”.
Crypto Interest Rates
At this point, in crypto, it is trivial to find interest rates of 7%+. Both centralised finance and decentralised finance are in on the action.
Examples (not advice nor recommendations):
And this is just scratching the surface!
How do they get away with this?
Well we can think about this in two ways - crypto market size and cash demand.
“Cash is King”
The opportunity in crypto means you will have people/finance bros trying to trade it. This creates a demand for cash (stablecoins). The cash is typically used for creating liquidity pools, arbitrage purposes, market making, or leverage.
Crypto Market Size:
We can speculate that the market size of crypto lending markets is at a maximum c.$500bn. Money markets in the US alone are x10+ this and stand at c.$5 trillion. With this size disparity, the interest payout in traditional finance (trad-fi) is naturally lower. Similarly, with such new markets, there is more opportunity to generate profits/losses from crypto trading.
Hence, when we see these sorts of high rates in crypto, you would expect trad-fi firms to be all over it and arbitrage away the difference between traditional markets and crypto markets. As seen by the size disparity in the markets, there is simply not enough capital being deployed into crypto to close this gap.
Rates to the moon?
Such high rates are a consequence of the miss-match between this massive cash demand from crypto inclined finance bros and the lack of capital being deployed (so far - wink wink) into the space. It’s mind-bending but as the market matures, these rates may tend down. That said, anything > 2% will remain attractive.
Potential Downsides
Issues for Users:
Platform Risk. It may collapse/rug and you lose your deposit
FX/Volatility Risk: Exotic strategies may result in collateral being seized/wiped out
Simply not being able to pay back loans
Depositors typically receive interest rate payouts in crypto, should the value of the payout token decrease, the interest is no longer as interesting
Issues for the platform:
Say I deposit 1 $COIN ($100 value) but take out 1 $JOE ($50 value). What happens when $COIN goes down to $50 value while $JOE is now worth $60. Why would someone pay back their $JOE? They would be fine with liquidation
Depositors typically receive interest rate payouts in crypto, this creates a long tail downward selling pressure on the protocol’s governance token price (assuming they are not on an incentive programme such as AAVE and Polygon on AAVE)
Greatest Business?
So in order to take out a loan, you need to first deposit an asset as collateral. This is your commitment that shows you are good for taking out $X amount in loans.
Quick tangent: you may think, why do I need to deposit dollars if I want to take out dollars? You can use any crypto as collateral. Imagine you hold ETH. You want access to liquidity to do X, Y, Z with but do not want to lose the appreciation/deprecation properties of ETH. You can deposit your ETH and take out a cash loan.
Please note however that current tax law in the UK actually counts this as a disposal so you generate a taxable event. (As of Feb 2022). Not advice as ever, do your own research.
So you have now deposited collateral, you can now take out a loan. Great. But what happens if you cannot pay the interest rate on taking out your loan? What about if the value of your collateral drops to below the value of the loan?
That’s the beauty of collateral. Once you cannot pay the APY, or indeed the value of your loan approaches the value of your collateral, you will get liquidated and the protocol takes your collateral and sells it to make themselves whole. In fact, most protocols require you to be over collateralised, meaning you can only take a 1:<1 ratio of collateral to debt. In other words, $100 worth of collateral only allows us to take out less than $80 in debt.
This means that even if the value of collateral suddenly crashes in fiat terms, users will rapidly get liquidated (manage your debt closely!) and the protocol protects their users tightly.
I would add that it is down to the protocol to think carefully about what they allow to be used as collateral. A super volatile stock or one with thin liquidity pools/trading activity is not a wise choice. Uncollaterlised lending should be reserved for the true financial juggernauts of our age.
Oh, but there is more…
Remember this formula?
Net Interest = Interest gained from Loans - Interest paid out to depositors
Sometimes, the difference in interest rates for depositors vs gained from loanees can really jump. Often (lol), crypto markets become very volatile and there is a lot of trading activity. When this happens finance bros can try to take advantage of this. but they will need capital to do so. They can deposit the positions that they are happy to hold through the volatility and then take out debt to finance their latest crusade. When the demand for cash is pushed even higher in these periods, loanees will pay more interest, meaning that net interest indeed rockets. $$$$ for protocols.
What’s more, for the centralised finance companies that also offer this, have a magic money tree in their garden. They can do away with costs (transaction fees/blockchain gas fees / time delay / otherwise). It’s a material difference. The first movers in this space (think Genesis Trading) will be printing money as the institutions enter the space more. An acquisition is certainly on the cards for such companies.
From a protocol lens, they become income-generating and will one day (SEC allowing) be able to pay this out to people who stake the protocols’ governance token on their platform. The levels of genius here are quite painful/joyous.
Even more so DAOs surrounding these protocols may also eat from offering services to institutions directly but I anticipate that this is a much longer-term
To Close…
Moving on, I think the biggest challenge that the space will face is legality issues. Currently, these things are simply not defined but as it changes, we will get to a place that I think will be very exciting.
I hope that I helped you to understand crypto interest rates and why I use readily use these platforms to enhance my crypto activity. In the end, it is indeed a super super sexy topic!
Thanks for reading,
God bless.
Joseph