Cryptocurrencies, like physical currencies, can be used to earn a yield on your idle digital assets through a variety of ways.
The most popular way of generating yield is lending, and newer (but unsustainable) ways of generating yield have emerged, such as yield farming, which will be explained in a future post.
Crypto lending is a financial activity that exists similar to how money is lent in the traditional finance space (money market).
In traditional finance, debt – which originate from banks – is a motor that powers the economy. Banks collect deposits from savers like you and me, keep some of them in reserves, then lend the deposits out to borrowers.
Banks can technically lend more than what they have in their balance sheet, a phenomenon known as fractional reserve banking. Typically, banks only need to keep 10% of the deposit (or whatever reserve is set by the central bank), and lend out the rest, which helps to expand the economy.
Banking deposits are also guaranteed up to a certain amount usually by government institutions, such as the FDIC in the US and SDIC in Singapore. This is to insure on losses if a bank goes bust and is unable to pay its claimants.
Banking in the cryptosphere
In crypto banking, a similar lending and borrowing framework exists, but without regulation. The lending and borrowing framework exists either through centralized institutions like BlockFi, Celsius and Nexo or decentralized protocols like Aave and Compound.
There’s strong demand for lending and borrowing services as the market matures. Lending and borrowing makes crypto assets more capital efficient, and the blockchain serves as a uniquely powerful settlement layer with smart contracts, custody and zero downtime all in one.
Owners of digital currencies such as BTC, ETH and most stablecoins may want to earn a small yield on their digital assets. Instead of just holding them idle, they might lend them out to borrowers.
There might be large institutions or traders who might want to take large positions in trades or OTC desks who want to help execute an order. Borrowing allows them to source liquidity for crypto assets easily.
Another group of people who borrow can be those who want to short the underlying asset. They can first borrow the asset, sell it immediately, then buy it back hopefully at a lower price.
Lastly, some people might want to borrow cash using their crypto assets as collateral. This might be used to fund an expense without selling their crypto, or used to leverage long their position.
Centralized lending services
There are a couple of centralized lending services available that allow users to deposit cryptocurrencies and earn a yield. Centralized services have the advantage of helping you manage and custodize your crypto assets, but you risk losing them if they get hacked.
BlockFi is backed by the biggest investors Coinbase Ventures, Galaxy Digital and Winklevoss Capital. BlockFi pays interest monthly in any supported cryptocurrency of your choice.
Nexo (review) is another good contender that I use and recommend. Like BlockFi, Nexo allows you to earn interest on your crypto. But unlike BlockFi, Nexo pays interest daily in either your original cryptocurrency or in their own tokens (NEXO).
Celsius Network is another popular choice among netizens. They support a wider variety of cryptocurrencies with interest paid weekly. Similar to Nexo, you can choose to earn in-kind or in their native token (CEL) with no minimum balance required.
Holdnaut (review) is an up and coming lending platform based in Singapore, with more than 2000 users on their platform. Interest is paid in-kind every Monday.
Decentralized lending services
Centralized lending services might not appeal to everyone. For some, it might defeat the purpose of blockchain’s decentralization.
Instead, users can lend out their assets through decentralized lending platforms which is basically programmatic borrowing and lending through protocols (i.e. code/smart contracts) that allow trustless borrowing and lending.
Aave is an open-source and non-custodial lending protocol with more than US$5.6B locked in deposits across its V1 and V2 lending markets.
Being fully decentralized on the Ethereum blockchain, Aave manages liquidity through fully-audited smart contracts. Interest rates are set dynamically through demand and supply.
Interest rates on Aave are as attractive compared to centralized platforms. A governance mechanism manages the assets that can be listed on its platform.
Compound is another decentralized lending protocol with algorithmically set interest rates. Users can interact with the Compound protocol in a non-custodial and decentralized manner through its smart contracts.
When users deposit funds into the smart contract, Compound holds the tokens while giving users a representation of their deposits (cTokens) which automatically accrue interest and increase in value relative to the underlying asset.
cTokens are also composable, where they can be further used as collateral across decentralized finance.
Risks of crypto lending
Lending has risks, and even more so when done on the blockchain and crypto world and therefore you can earn a higher yield on your deposits than those held in a bank account.
For centralized lending services, risks include:
- Default risk – the company that borrows fails to repay
- Platform risk – the company gets hacked and users lose their funds
- Credit risk – the company becomes insolvent
- Custody risk – you no longer own the crypto assets since the private keys are held by the company
For decentralized lending services, risks include:
- Smart contract risk – bugs and errors in the smart contract may lead to loss of funds (e.g. bZx hack)
- Liquidation risk – for borrowers, the interest rate on collateral might quickly change over time, especially during peak demand periods, causing liquidation of your collateral if not monitored
Overall thoughts on crypto lending
Crypto lending is a new and emerging field that’s extremely promising. Digital assets will continue to grow and mature as a market while a new layer of the Internet (the blockchain) will be concurrently built to facilitate trustless interactions of value.
For lenders, crypto lending puts idle assets to work, earning an interest based on market demand. For borrowers, these platforms provide an opportunity to leverage, short, or raise capital easily (and even trustlessly).
It’s probably still early stages, but in the next decade, we will see even more interesting use cases on crypto assets rather than mere speculation.
In future posts, I’ll share more about my experience on these platforms.