mobile banking network.
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Cryptocurrencies, heralded as the future of finance, are finally catching up with the centuries-old idea of turning money into money. The global low interest rate environment is attracting professional and amateur investors alike to invest billions of dollars in high-yield crypto banking products. The burgeoning digital currency market is creating an alternative universe of finance, trade, investment and speculation that could fundamentally transform the global economy and disrupt industries. It’s beginning to reshape the way people borrow and save money, reshaping banking as we know it.
crypto banking
The fast-growing crypto financial market is making inroads into the traditional banking sector. Crypto banks provide interest-bearing accounts, term deposits, credit cards, secured loans backed by crypto asset deposits, and other services that are similar to traditional banks’ product offerings, albeit with much higher interest rates/yields. Crypto banking platforms lure customers by offering Annual Percentage Returns (APYs) that are orders of magnitude higher than returns from traditional bank accounts. APYs of 7 to 12 percent for coins like bitcoin and stablecoins are typical. Typically, niche coins and newer, higher-risk crypto projects offer the highest returns. The allure of generating above-average returns in a global, low-yield environment is also catching mainstream attention.
Why are the returns so high?
Traditional banks lend pooled deposits and in return pay their depositors a portion of the proceeds as interest. However, traditional banks are heavily regulated and obligated to protect consumer deposits. They must hold reserves for non-performing loans and refrain from highly speculative lending, resulting in subdued returns on capital and hence meager payouts on bank deposits.
Crypto financial platforms, similar to traditional banks, pool crypto deposits to provide credit and pay interest to depositors. They incentivize depositors/investors to provide liquidity in the crypto asset market by employing a cryptocurrency blocking process to earn rewards and lending services. Crypto financial platforms are primarily unregulated, have no reserve requirements and engage in opaque lending, i.e. lending to unidentified third parties and institutions that can make risky bets to earn outsized returns on crypto deposits.
The underlying crypto funding is crypto trading and speculation.
There is a strong demand for crypto lending as speculative trading in crypto assets can generate high returns. Primary borrowers include hedge funds involved in leveraged trading, as well as market makers or exchanges that need crypto liquidity or want to lend to their trading clients. Hedge funds and speculators are taking advantage of market failures to make highly lucrative bets on discrepancies between crypto market prices and crypto futures prices. These speculators pay the crypto banking platforms high yields on the crypto loans. Superlative payments, minus the crypto banking platform cut, flow as income to primary crypto holders, far exceeding what is available from traditional bank deposits. High returns are possible mainly due to existing market inefficiencies and increased demand for cryptos for speculation.
The burgeoning crypto banking industry spans a wide range of platforms; Centralized Finance (CeFi) platforms with roots in Traditional Finance (TradFi) and emerging Decentralized Finance (DeFi) platforms.
DeFi – decentralized finance or similar
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DeFi is a global peer-to-peer ecosystem of smart contract-based apps that enable algorithmic lending, savings, yield farming, flash loans, trading, and more, while incorporating human intermediaries such as brokers, bank teller, traders, and institutions such as banks or payment processor. The full approval process that oversees the financial transactions is performed via smart contract algorithms embedded in blockchains.
yield farming
Under the DeFi umbrella, yield farming, also known as liquidity farming, is an investment strategy to earn interest and other rewards in exchange for lending or staking cryptocurrency. On these DeFi platforms, users can borrow and lend any cryptocurrency at short-term rates set algorithmically. To optimize profits and increase yields, yield farmers employ complex tactics such as: B. moving their cryptos between multiple liquidity pools or lending platforms, constantly chasing after the pool that offers the highest APY. According to a Harvard Business Review article, “In effect, it mirrors a strategy in traditional finance – a forex carry trade – in which a trader seeks to borrow the currency that commands a lower interest rate and lend the one that that offers a higher yield.” The high yields offered in DeFi yield farming come with significant risks that are underestimated by novice investors, making the underlying risk-reward trade-off difficult.
flash loan
Powered by decentralized finance protocols, flash loans are unsecured loans with an obligation to repay immediately within the same block transaction. The smart contracts execute the instructed loan and repayment amount plus interest and fees within the same transaction. If the borrower fails to make the repayment, the original transaction is reversed. Flash loan is a unique, innovative and useful tool to create a higher level of liquidity for arbitrage trading and debt refinancing. It is a niche financial tool for tech-savvy DeFi users. Flash loans are also very vulnerable to smart contract exploits, fraud and hacking.
DefiLlama, a DeFi Total Value Locked (TVL) aggregator, lists the total value of crypto assets locked in DeFi protocols as $220 billion. Defi players include crypto banking platforms like Compound, Aave, MakerDao, MeanFi, and more, which are decentralized and use automated borrow-and-borrow systems. With nearly $7 billion in TVL, Compound uses different liquidity pools for each supported crypto asset and allows lenders to deposit cryptocurrency into these liquidity lending pools for borrowers to access. Aave has $14 billion and MakerDao has $15 billion in TVL. Powered by Money Streams, a real-time financial protocol that helps businesses set up payroll and banking in crypto, MeanFi.com is bridging TradFi and DeFi. “Mean DAO ushers in the future of real-time finance with the Money Streaming Protocol to power a new wave of real-time finance applications. We’re doing to money what Spotify did to music,” said Michel Triana. Founder and CEO, Mean DAO.
CeFi offers the yield benefits of DeFi with the added convenience and security of traditional financial services products. It offers the potential to earn much higher returns through crypto-based accounts and is functionally similar to a traditional savings account, offering crypto debit cards and more. The responsibility for safeguarding deposits rests with the CeFi platform, but without the support of traditional Federal Deposit Insurance Corporation (FDIC) insurance. CeFI players include major platforms like Nexo, Celisius, BlockFi, Genesis, and more that offer returns of 8% to 18%. These platforms manage billions of dollars worth of crypto assets, compete aggressively for capital, offer bonuses and token rewards, and are now facing regulatory scrutiny.
Is Crypto Lending Safe?
The complex revenue-generating strategies that DeFi and CeFi platforms implement do not highlight the underlying risks for crypto customers. Customers/depositors who contribute to the liquidity pools often have very little insight into what the platforms are doing with their crypto assets – opaque lending. Even though many lending platforms retain high levels of collateral, opaque lending in highly volatile crypto assets can expose depositors to significant hidden risks. In search of attractive returns, cryptocurrency investors can be caught unawares by the underlying risks in the largely unregulated crypto banking world, and be tempted to engage in extreme volatility and manipulative scams. Converting the crypto coins back to traditional currencies can incur high fees and reduce overall returns.
The cryptocurrency could experience sudden swings. While it is being held or lent, its price could fall or rise, creating temporary unrealized gains or losses, also known as impermanent loss. These gains or losses become permanent when one withdraws the wagered coins, and the interest and rewards earned may not offset the losses resulting from the price drops of the locked crypto. Yield farmers may unknowingly invest in fraudulent projects or scams. In a scam called Rug Pull, cryptocurrency developers raise funds for a project and then abandon the project without returning any funds to investors. The smart contracts that power DeFi lending platforms can have bugs, flawed protocols, or be vulnerable to hacking, putting the investment at risk. Finally, the risks of crypto lending can trigger serious regulatory oversight and a crackdown.
Institutional Participants
Crypto banking is an attractive alternative for return-oriented capital in the current near-zero global return environment. Risk-averse institutions like university endowments, insurance companies, pension funds, and more are starting to dip their toes into crypto. Traditional financial institutions i.e. Goldman Sachs, JPMorgan and Citi are starting to enter the crypto market. Both Visa V and Mastercard MA are partnering with crypto platforms to gain a foothold in the burgeoning crypto finance world.
DeFi and CeFi products are not made for traditional low-risk passive investors. These products offer alternative options for sophisticated investors looking for higher returns, albeit with an unquantifiable speculative risk. The crypto financial services space is a hotbed for innovation. If the traditional banking institutions used to operating in the highly regulated financial industry join in, crypto banking could expand its adoption and every household could have crypto assets working for them.
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