It’s hard to find a riskier investment than crypto lending, which has offered ridiculous returns of up to and even exceeding 20% APY to anyone who had deposited the crypto collateral to fund various decentralized finance (DeFi) systems.
It’s even more difficult to find a safer investment than three-month Treasury bills, which are highly liquid and backed by the full confidence and credit of the United States.
But at least those high risks came with potentially big rewards at a time when traditional investments, ranging from Treasury bills to savings accounts, offered tiny fractions of 1%. However, 3-month U.S. Treasury bills are now offering much better rates than crypto lending, with CNBC and MarketWatch listing just over 3.2% as of Sept. 13.
And crypto lending? Well, BlockFi, a centralized lender that was saved from bankruptcy by a timely loan from FTX CEO Sam Bankman-Fried, is now offering 0.1% to 3% APY on many tokens (although some dollar-backed stablecoins are still 6 % to 7% APY). .
See also: Crypto Basics Series: How Does Centralized Crypto Lending Work?
Top DeFi lending platform Aave is offering under 2% on dozens of tokens. Another top DeFi lender, Compound, is offering just over 1% APY on a single token — Tether’s USDT stablecoin — which is 1.44% APY according to DeFi Rate.
Continue reading: Crypto Basics Series: How Does Decentralized Crypto Lending Work?
That begs a pretty simple question: why on earth invest in extremely risky loan programs when the safest of all investments pays more? The answer, particularly from the hedge funds and institutional investors who have been getting a foothold in DeFi for some time, is that you wouldn’t.
“Two years ago, interest rates in crypto were at least 10% and in the real world rates were either negative or close to zero,” said Jaime Baeza, CEO of digital asset-focused hedge fund ANB Investments. “Now it’s almost the other way around because yields have collapsed in crypto and central banks are raising rates.”
According to Sidney Powell, CEO of Maple Finance, this has led to “an increased appetite for government bonds that has drained liquidity from crypto.”
A risky venture
In short, crypto lending/borrowing programs work like this: At their core, a crypto owner deposits or locks stablecoins and other cryptocurrencies in lending DApps in exchange for interest, commonly referred to as yield. Borrowers provide crypto collateral worth 125% to 150% of the amount they wish to borrow.
If crypto price volatility pushes that value close to the value of the loan, a margin call will be made and if it is missed – and this can happen very quickly while borrowers are asleep – the collateral will be liquidated to cover the loan and the owed to cover interest.
That last part can be breathtaking. One of the outliers currently offering far more than T-Bills on Aave is Wrapped Ether, which yields 15% APY. However, it is rented for 45% APY.
This is how it works on DeFi lending/borrowing platforms and this is how it should work on centralized versions like Celsius and Voyager Digital – both now in bankruptcy.
After the collapse of Terra/LUNA’s $48 billion algorithmic stablecoin ecosystem took down a high-profile crypto hedge fund called Three Arrows Capital, it emerged that many crypto lenders loaned it hundreds of dollars Millions of US dollars without collateral – which is driving more than half a dozen large companies into bankruptcy.
Learn more: Reckless crypto lending, opaque operations paved Voyager Digital’s path to bankruptcy
That has left hundreds of thousands of punters looking for interest rates between 2% and 20% or more in limbo, expecting big losses as the companies they invested in progress through Chapter 11.
Unstable
There are a few cryptocurrencies — notably stablecoins — that still yield high returns in the 6% range from some centralized lenders (although DeFi platforms built on algorithms, not optimism, offer well below 2.5% in many cases ).
One reason is that stablecoins are “the lifeblood of the DeFi” ecosystem, as Senator Elizabeth Warren — who is decidedly not a fan — puts it, as they are the currency of crypto lending and borrowing transactions and many DeFi investments .
See also: Sen. Warren calls DeFi the “most dangerous” part of crypto at Senate hearing
That’s the other part of the high-risk profile of crypto lending and borrowing. The vast majority of these loans are directly fed back into other, even riskier DeFi projects such as yield farming and liquidity mining. It’s a closed ecosystem in many ways, although the stablecoins that borrowers receive can theoretically be used for anything.
Related: DeFi Series: What is Yield Farming and Liquidity Mining?
It’s probably worth pointing out the irony of this situation: stablecoins have two main purposes at this point – to lubricate trading in crypto and DeFi investments – despite their growing popularity as a payment currency.
However, they are increasingly supported by short-dated government bonds as the “highly liquid assets” of choice, which the best stablecoins have embraced after discovering that their “$1-for-1 reserves” actually contained many corporate securities of questionable liquidity.
Additionally, much of the stablecoin legislation drafted in the European Union and proposed in the US stipulates that the collateral pools must be either currencies or government bonds.
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