Finding yield – Bitcoin, DeFi vs bonds and savings
Investors love to chase yield. Did you know that Bitcoin, Ethereum, and even DeFi coins earn yield? And the yield on these cryptocurrencies is far greater than the yield on savings accounts, bonds, and even real estate? But how can you leverage crypto and DeFi to yield better results? In this post, we’ll explain just that.
Yield – what is it?
Yield or more specifically yield generating assets have a special place in a portfolio. So, before we get into what yield is, we have to differentiate between investments that have a yield element and investments that don’t. Investments, in whatever form, whether equity, bonds, or even crypto can be of two types – growth and income.
Growth assets are those investments that increase in value over time. What you pay for it today will hopefully be less than what someone else pays for it tomorrow. You’d want to own growth investments in the long-term. However, these investments do not give you any periodic return in the short-term. Meaning, in order to realize the returns you’ve made on the asset, you’d have to sell it. But what if you want assets that give you some money?
Income assets are those investments that give you regular payments. By simply owning these assets, you receive money. However, the downside is income-generating assets do not have high growth potential. This is the trade-off between the two asset classes. The income generated by this asset is referred to as yield or the earrings an asset gives out over a period of time.
Yield – what went wrong?
Yield is dependent on interest rates. Especially for the most popular income-generating assets like savings bank accounts and bonds. But what are interest rates?
The Fed Funds rate is the rate at which a country’s central bank lends money to commercial banks. Based on this, the commercial bank determines the rate at which they lend to you (as loans) and the rate at which you lend to them (as savings account deposits).
From a yield perspective, all you need to know about interest rates is – decreasing interest rates lowers the savings bank account rate. This means that the rate of interest you receive by leaving money in the bank will decrease. When interest rates go down, people hesitate to leave money in the bank because it will give them low returns. Hence, low yield.
In March 2020, as the pandemic sent stock markets into a spiral, interest rates were slashed. The Federal Reserve cut interest rates to near zero. This was less than a year after it cut interest rates twice in succession for the first time since 2008. Regardless of the political or economic nature of the rates cut, yields plummeted.
The rates cut pulled down bond yields. The US 30-year bond yield (which measures the yield generated by a US bond with a 30-year duration) dropped to less than 1%, its lowest point ever. This means the earnings on holding a 30-year bond were less than 1%. Similarly, banks decreased their savings account rate as well. The annual percentage yield (APY) on savings accounts for most US-banks is less than 1%. Is this yield worth holding onto?
With two traditional sources of yield – bonds and bank accounts offering record-low yields, where else can investors turn?
Yield – what can crypto and DeFi offer?
We’ve seen that yield is necessary, and traditional sources have little to offer. There are several reasons for low bond yields and savings bank account rates. Most common among them are an unlimited supply and centralized control. Since Bitcoin and the larger DeFi (or decentralized finance) ecosystem do not have these drawbacks, they offer a higher yield. However, they come with risks.
Ranging from volatile cryptocurrencies to stablecoins with prices tethered to fiat currencies like the US-dollar, the cryptocurrency world offers double-digit yields. Let’s look at a few ways to maximize yield using these investments.
Lending simply means lending out your idle BTC or ETH and generating a return on it. This works in the same manner as a bank account. The bank requires you to have a minimum balance, which is used to give out loans. Similarly, you can lend your Bitcoin or Ether and receive an interest on it.
Companies like BlockFi offer a 6% APY on lending Bitcoin. This is much higher than the sub-1% bond yields and savings accounts interest. A small side note, APY is the rate of interest calculated compounded every month. Meaning, you receive your principal + interest at the end of the month and reinvest both immediately.
Exchanges like Gemini, also offer lending on a variety of cryptocurrencies. Investors can also lend stablecoins like DAI or US Dollar Coin (USDC), these coins are collateralized and hence the safety is enhanced. DAI is backed by a higher amount of ETH to protect against volatility. USDC is backed 1:1 by a US dollar locked and audited in a bank account.
Several DeFi protocols like Compound, and Aave, facilitate lending to earn yields. This is done in a completely autonomous and decentralized manner. These protocols allow lending through peer-to-peer (P2P) loans, or via a lending pool. In P2P loans or P2P lending, the borrower and lender collectively decide an interest rate. However, in the lending pool, the rate is determined by the supply and demand of lenders and borrowers. Either way, the yield generated is higher than traditional finance.
Staking is another means of earning yield on idle crypto. However, you do not need to lend the coins out to an external party, you simply need to lock them. Staking is a process of validating transactions of a particular cryptocurrency.
If you have the same crypto, you can stake your crypto to validate transactions. Since you’re participating in the staking process you receive rewards. These rewards accrue to you in the form of the same cryptocurrency that you staked. This is how you generate yield while staking.
Staking, unlike lending, usually does not compel you to part with your cryptocurrency. You maintain custody, but use it to participate in the cryptocurrency’s particular blockchain network. Think of this as voting for network validation. But the weight of your vote is equal to the coins you hold, or coins you stake.
A small note, staking is only possible for proof-of-stake or PoS cryptocurrencies. Cryptocurrencies like Ethereum and Dash work according to a PoS network. Bitcoin works on the proof-of-work or PoW validation system. Different PoS blockchains have different staking requirements. Protocols like Staked, Compound, and Aave offer staking. Cryptocurrency exchanges like Coinbase and Gemini also have staking functions.
Staking, simply put, is the self-custody and self-lock in of idle cryptocurrencies to help support the network. This is a micro-version of another yield-generating avenue- mining.
Mining, in crypto, is an incentive cycle. An important part of this cycle is finding yield. Mining is the process of generating crypto through computational effort, known as Proof-of-Work (PoW).
The reward for mining cryptocurrency is newly mined cryptocurrency. Think of these newly mined cryptocurrencies as a form of yield that’ll accrue income to you over a period of time. However, it comes at a cost. Mining requires intensive computational effort.
The process of mining is essentially several high-powered computers racing against each other to solve a mathematical problem. This problem adds transactions to a block and chains them together (hence block+chain). Once a block is added to the blockchain, the miners involved in processing the transactions and the block receive a reward. This reward is the yield. The cost for this reward is the hardware (miners), and the immense electricity to mine the coins.
We’ve discussed how mining is creating an incentive structure here.
Yield – what are the risks?
Like every form of finance, finding yield in crypto and DeFi has its set of risks. Each of the above forms of earning yield has a single or a combination of the below risks.
Price or volatility risk is the risk of holding volatile assets. Every major cryptocurrency is subject to this. However, with the development of price-neutral stablecoins and their association with DeFi, this risk is diminished. You can use a USDC or DAI token across various DeFi protocols. Since these are stablecoins, the price won’t fluctuate wildly and yield can be generated at a higher rate than traditional dollar-based investments in bonds and savings accounts.
While lending is straightforward, staking and mining are not. This requires those unfamiliar to understand the technology behind it. This is technology risk – the risk that you’re venturing into an unknown technology. Since everything from the coins to the infrastructure required know-how, there are other technology risks like understanding the nature of private-keys, wallets, custodians, exchanges and more. In addition, several exchanges get hacked, and protocols compromised. However, once the know-how is established, this risk is reduced.
Several forms of yield procurement require investors to give up custody of assets. For instance, lending requires you to give your cryptocurrency to a borrower, or a decentralized pool which in-turn gives it to a borrower. Here, you’re undertaking a credit risk. A good way to secure against this risk is to check the collateralization ratio (or the loan-to-value ratio) of the lending protocol. Further, you can insure the smart contract, or the infrastructure that facilitates the transaction on the blockchain. These can be done through DeFi protocols like – Nexus Mutual and Opyn Protection.
Yield – what to expect
“DeFi’s high yield that doesn’t exist in the traditional financial space is certainly alluring,” said Martin Gaspar, research analyst at CrossTower. His research pointed that just three DeFi protocols (Compound, Uniswap, and Sushiswap) generated over $1 million in daily fees in February 2021. These are common mediums to generate yield using cryptocurrencies and DeFi.
The gulf of difference between traditional finance and decentralized finance is evident in the yield offered. However, it’s important to note that with higher yield comes higher risks – namely in price, technology, and credit. One way to safeguard yourself through all these risks is education. We, at Interaxis, aim to educate financial advisors and investors on the intricacies of crypto and DeFi.
We’ve got a course for financial advisors here.
Check out our videos on YouTube here.
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