Digital Currency Lending - Do Rewards Justify Risks?
DeFi yields are substantial, but are they sustainable and justified by the risks?
A recent development in the digital currency markets is the ability to lend long-term digital asset positions for an interest-like return. Various platforms exist for facilitating lending, including traditional companies such as BlockFi and blockchain-enforced contracts such as Compound and Aave.
As of September 2020, the rates payable on most major cryptocurrencies are multiples of the rates available on government bonds (see below courtesy of www.defirate.com/lend, accessed 24-Sep-2020):
Accordingly, it's reasonable for investors to ask whether these returns are:
- sustainable; and
- subject to hidden or less transparent risks.
To answer the first two questions, it’s important to understand where the demand for crypto borrowing comes from. We believe that crypto borrowing demand comes from short sellers, tactical positioning / market-making, and derivatives arbitrageurs. Given these target markets for borrowing, it seems reasonable that demand is coming from independent user bases, which may indicate a diversification of demand type which could be more durable (and thus support lending rates) in times of market stress.
What risks should investors consider before lending digital currencies?
To answer the risk question, investors should consider the drivers of the risk of loss associated with the lending itself. The first and most important concern is counterparty risk - specifically, the amount of overcollateralization (or, conversely, the “haircut”) required for the loans. Second, investors should consider the financial backing of the lending agent, who may be incentivized to stand in for failing borrowers. Finally, investors should consider whether their incremental income from lending their digital currencies is worth the risks of its underlying price volatility. The income generated (for example, 0.02% per day) may be quickly eroded by a large downward move in the market which may come without warning, leaving investors unable to trade while their currency is out on loan.
Based on the above, we believe potential lenders of digital currencies should:
- Be committed to holding their coins even in the face of occasional large downward market moves;
- Be comfortable with their lender’s financial backing and collateral requirements; and
- Believe that the demand for borrowing their coin is stable or increasing even in times of market stress.