What to know about earning interest with crypto
Right now you can earn a lot of interest with your cryptocurrency through relatively simple means. There are many easy to use decentralized (Compound, Aave, Yearn) and centralized (BlockFi, Nexo, Celsius) options to choose from to earn yield.
Decentralized lending is attractive because it is transparent, i.e. you know exactly what your funds are doing and why you are earning yield. Moreover, the lending process is algorithmic — this allows you to develop a clear understanding of your risk profile. Lastly, there is a wider variety of options available since the entry barrier to creating a DeFi product is low.
Centralized lending options are more opaque, i.e. you don’t know exactly where the yield is coming from. This means the platform could be exposing your funds to large unknown risks. However, some of these institutions are regulated and this in turn provides the user with some form of protection.
DeFiRate.com does an excellent job collating what the latest lending rates are across a number of leading platforms. Let’s see what we can learn from scanning the table below:
- Stablecoins are funding at up to a very high rate of 10%, nearly 2x ETH/BTC. We will speculate on reasons for this is later.
- Centralized lending is paying significantly more than decentralized. We will also speculate on reasons for this is later.
- Fulcrum is the best decentralized platform listed. They are paying significantly better than Aave/Compound, but much of this is incentivized — essentially, they are paying to get users on their platform.
- Meanwhile, Nexo is the highest paying centralized platform.
Where is the centralized yield coming from?
Given that lending rates are so high, we were really curious, where does it come from and why?
Answer: Platforms exist that provide collateralized lending for institutional and high net worth individuals. Genesis’ business model is reliant on having cryptocurrency to lend, and that is where centralized platforms provide value. Essentially, they are matching retail funds with institutional lenders. For instance, Ledn.io is a centralized lending platform that explicitly states their source interest to be from a partnership with Genesis.
Concretely, Ledn earns interest by lending to Genesis who then lends to select counter-parties at an even higher rate. Genesis is a regulated company and therefore this is likely to be reasonably safe, but we have no guarantees in this process like we do with FDIC insurance in conventional banking.
Why are the centralized rates so high, and why are they higher for stablecoins?
We can only speculate here, but we believe that the lending rates are largely being driven by “the basis” or “the funding” trade. This is a non-directional trade that seeks to profit solely by providing leverage to market participants.
The trade works as follows: a trader can user stablecoins to buy one ethereum and then sell a future against it. Quarterly futures have recently been trading at a premium of up to 30% — this is profit that is more or less locked in by the trade (sorry the best we could do was a relatively old plot from Jan 2021).
Sophisticated traders can post their funds as collateral with institutions like Genesis to gain leverage. This in turn lets them run the trade at a multiple of their actual holdings and secure higher profits.
These traders are getting paid handsomely to satisfy a demand for futures that is likely being driven by speculative traders and miners who want to hedge future cash flows.
Because the trade is directionally neutral it cannot be financed by ethereum or bitcoin. Therefore, demand for ethereum and bitcoin is coming from a different source. We speculate that it is likely traders who want to cheaply finance a leveraged position.
Where is the decentralized yield coming from?
It is a little bit easier to answer this question at the surface level. We can simply go to Aave or Compound and compare the lending/borrowing rates that are algorithmically determined:
With Compound users deposit in one crypto and borrow against it in another. The interest received for lending and paid for borrowing is determined by supply and demand and is detailed here.
Looking at the rates, we see that there is clear oversupply of ethereum. We speculate that this is driven by users supplying ethereum to borrow stablecoins that are traded back into ethereum. I.e. users are again seeking leverage. Because of this behavior, stablecoins again pay a higher interest rate than ethereum.
What else is out there?
In future articles we will get into greater detail around more advanced strategies for earning yield in DeFi. It is currently possible to securely earn interest rates in excess of 10% on stablecoins.
Conclusion
Interest rates for cryptocurrency are currently very high. A low risk return of 10% is very hard to guarantee in the traditional financial world. Hedge funds are the only known vehicles in the world that can give similar returns without having volatility like a stock.
That being said, it seems difficult to understand exactly what risks are being taken when providing funds to centralized lending platforms. Hopefully there will be more transparency in the space sooner than later. DeFi rates are more tempered, but this is offset by the added transparency and security.
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We are working on building a regulated custodial solution that automates interest earning through DeFi, please visit ChainVault if this interests you
EDIT(S): 6/28 — Typo
