Ordinarily, and historically, the way you made money with digital assets was by buying them and then watching the price go up. Most still expect the prices of many digital assets to continue rising for years, but that’s no longer the only way to generate profits from this new asset class. Today, you can also earn interest on your coins and tokens, too.
Fixed income is, of course, a major part of any diversified portfolio. Now, thanks to the emergence of DeFi, decentralized finance, crypto has a place within the broader fixed-income category. As of January 2022, DeFi protocols held over $230 billion in assets. Financial advisors call that AUM, for Assets Under Management. In the DeFi world, it’s called TVL, for Total Value Locked. TVL is the total dollar amount of digital assets locked into DeFi lending smart contracts.
Dozens of platforms facilitate the process, and if you deposit your coins or tokens with them, they’ll pay you annual yields, of anywhere from two to 12%. And if you’re earning 12%, the borrower is paying even more, because the lending platform is taking a cut of the interest.
Why would a borrower be willing to pay 15% or more for this loan? Well, I’ll give you 5 reasons to do this.
First, you might simply need the money – you can’t borrow from any other source, so you’re willing to pay high interest rates to get the cash you need.
Second, you might just be using the common strategy of leverage – amplifying your investments so you can increase the size of your investment portfolio. Instead of investing $100 and buying $100 worth of investments, you invest $100 and get $200 in investments – you’ll grow wealth much faster, right?
Third, do the exact opposite –short the market. Borrow someone else’s crypto and sell it. Wait for prices to fall and rebuy at the lower prices.
Or, just play the arbitrage game – you can exploit the fact that digital assets sometimes trade for different prices at the same time on exchanges around the world. Shares of IBM are the same everywhere, but that’s not always true for bitcoin.
And finally, maybe you just need some liquidity. You own crypto but have unrealized gains. So instead of selling and paying the taxes, it’s cheaper to borrow someone else’s coins or token, and sell those. You’ll get the liquidity you need without having to sell – meaning you avoid taxes triggered by incurring capital gains.
Any light bulbs going off? You might now realize that some of these ideas make sense for your situation. Suddenly, you’re more interested in borrowing bitcoin than you were a few minutes ago. We’ll get to borrowing soon, but for now, we’re still talking about lending.
Let’s talk about how lending works. You can lend your assets through two kinds of crypto companies – a centralized company, or a decentralized company – CeFi or DeFi.
Both platforms require that borrowers post collateral. This is key to reducing the risk of default. To get the loan, each borrower must deposit either fiat currency or crypto. If you’re using a CeFi company, the borrower has to comply with Know Your Customer procedures – the same as when you open a brokerage account and seek to do margin. KYC provides consumer protections – but remember, there’s no SIPC to protect you.
DeFi platforms don’t adhere to KYC. Instead, borrowing is done via smart contracts. You learned about Ethereum in the book, so I won’t get into that here, other than to say this: Smart contracts let transactions get carried out between anonymous parties, without the need for a central authority, legal system, or external enforcement. For example, when borrowing on a DeFi platform, a borrower can draw down a certain percentage of their deposit, usually up to 75%, and pay interest at either a fixed or variable rate. All this is entirely operated by blockchain technology, and so, as you know, the transaction is cryptographically proven – trust is not required. So, instead of having to trust the borrower that they are being honest when responding to all the KYC requests, the smart contract lets you cut out the intermediary (the CeFi exchange). In other words, you get to act as your own bank. You save money, and you avoid all the hassles associated with opening and maintaining a traditional account at an exchange.
So, want to lend out your crypto? Consider these questions:
- Do you want to use a CeFi or DeFi platform?
- Once you choose the platform, what interest rates are various companies on that platform offering?
- Does the company require borrowers to post collateral?
- How long do you have to commit to loaning your crypto?
- What are the risks? We’ll talk more about risks later.
One final question: Which crypto coin or token will you lend out? There are more than 10,000 coins and tens of thousands of tokens and NFTs. My advice? When it comes to lending, the best approach is to lend stablecoins. As of this book's publication date, the most popular stablecoins are the Circle USD Coin (USDC), Tether (USDT) and Gemini (GUSD).
Each of these are considered to be fully reserved digital dollar stablecoins — redeemable 1 to 1 for US dollars. Interest rates range from 2% to 10%.
If all this sounds a bit too good to be true, because firms are paying out so much more than traditional banks, there’s more to the story. So let’s look at the business model.
Crypto companies are expanding their activities into financial services. Here are 6 ways that companies make money by lending digital assets:
First, they charge fees for issuing and redeeming stablecoins in exchange for underlying fiat collateral.
Second, they engage in market-making on exchanges.
Third, they make money on the bid/ask spread, and the exchange volume that’s facilitated by the issuer’s trading desk.
Fourth, they invest a portion of their collateral in short-term Treasuries and money market funds.
Fifth, they make money on the basis trade. (If it’s been a while since you played in the commodities space, that’s the difference between the spot price and the price of the futures contract.)
And sixth, they issue credit cards. The consumer gets rewards in crypto. As the card issuer, they get annual fees, late payment fees and, of course, interest on unpaid balances.
So, it’s easy to understand why crypto companies are getting involved as lenders – we all know how much money banks and credit card companies make. Now, crypto companies are getting in on it, too.
What does all this mean for you?
Start with determining whether crypto lending is suitable for you. What is your experience with digital assets? What is your risk tolerance? What is your financial capacity for risk? (Risk tolerance and risk capacity are two different things – just because you’re willing to take risk doesn’t mean you can afford to!)
Next, review your emergency funds. How many months’ worth of spending do you have in cash and cash equivalents? Be sure that, if something goes wrong with your crypto lending at the same time you lose your job, you will still be able to pay your bills for a year or more.
Next, and this is maybe the most important part, manage your expectations. Keep in mind the risks associated with crypto lending. Remember that digital assets have a volatile history, and you need to be willing to tolerate this. If collateral and margin calls are involved, you need to be able to handle it – financially as well as emotionally. And even if you can handle it, can your spouse handle it? Let’s not set yourself up for marriage problems!
Now let’s talk about borrowing. No doubt about it, the world of traditional loans is being disrupted by this new ability to lend and borrow digital assets.
Think about the traditional bank model. When you borrow money from a bank, the money they’re lending you is other people’s money – money given to them by depositors. When you’re trying to borrow from a bank, if you don’t have hard assets of your own (a house, car, or investments), the bank won’t give you a loan. But when you try to borrow with crypto, you use your own crypto assets as collateral. And if your crypto is a stablecoin, you can borrow against it so you can invest in bitcoin, Ethereum and other digital assets.
When you borrow, there’s nothing more important than fulfilling the loan repayment obligations. If you default, of you fail to repay the loan, the lender gets full possession of your collateral. And sometimes your collateral is twice as much as what you borrowed – in other words, because crypto is so volatile, you have to post $100,000 worth of bitcoin in order to borrow $50,000. And when smart-contracts are involved, your collateral will be automatically liquidated immediately when your loan-to-value breaches the threshold. Forget about a nice phone call from a banker who you might negotiate with. Bam, your collateral is gone.
So with all that in mind, let’s look at the five risks of crypto borrowing.
Like I just talked about, the first risk is price fluctuation. You’ve got to post collateral, and if the value of that collateral falls, you have to post more collateral. This could force you to use up some of your cash reserves – and that can create a problem of its own. You might have to sell other investments to come up with the extra collateral, and that could trigger capital gains taxes for you.
And if you’d can’t post more collateral, you get hit with the second risk: liquidation risk. If you get a margin call, you generally have 24 hours to post the extra collateral. Depending on your lender’s rules, you might get no notice. If you don’t get the chance to post collateral, or if you fail to post collateral, the lender will liquidate your collateral to cover its loss. This gives you 2 problems. First, you lose your collateral. That’s bad enough. But even worse, you could wind up with taxes because the liquidation might trigger a capital gain. Losing money and having to pay taxes? Doesn’t get much worse than that.
The third big risk is, of course, investment risk. You might be interested in investing in some new coin or token that’s getting a lot of attention, but you don’t want to use your cash reserves, and you don’t want to sell other investments to come up with the cash. So, you figure you’ll just borrow and then return close out the loan after the asset rises in price. Nice idea – if it works. But you could find yourself owing more than the collateral is worth. And that could take us back to the margin call. And let’s remember – with all margin loans, you pay interest whether you make money on the account or not.
There’s also platform risk. When you open a margin account at Schwab, you don’t have to give a lot of thought to Schwab’s ability to deliver on its side of the deal. But when you borrow crypto, you’re using a lending platform that you might not know much about. Will they deliver on their side of the bargain?
If the lending platform is hacked or goes bankrupt, you could lose your collateral. Remember, there’s no SIPC for crypto exchanges like there is for brokerage firms and the NYSE. So you have to pay attention to this risk, and work to reduce it. That means doing some due diligence on the lending platform – does it have good security measures in place to protect against hacks? Does it have the financial ability to reimburse account holders if it’s hacked? Are its systems robust enough so that it can stay open during massive demand? Keep in mind that demand will peak during massive price declines: at the very moment you try to log in to close out your trade, you won’t be able to get in, and the price decline busts your margin limits, triggering a margin call and busting you out of your positions, despite the fact you were ready and willing, and trying, to post more collateral to prevent that from happening. This has happened at many exchanges many times. Make sure this won’t happen to you.
One way you can minimize this risk is the tried-and-true strategy that you know so well: diversification. Spread your collateral across several lending platforms. This way, if one platform fails, you won’t lose everything. You’ll end up with several accounts, and that’s a bit of a hassle, but it could well be worth it.
Related to all this are our final two risks. Tax risk and regulatory risk. We’ve already touched on both of these. Depending on how things go, you might end up incurring tax implications you weren’t expecting or didn’t want. Even if things do go well, the interest you earn from lending is taxable – but don’t expect to get a 1099 from anyone. They’re not yet required to issue 1099s, although that will soon change. For now, the burden or recordkeeping and tax reporting is all up to you. This is why I recommend you use a crypto tax tracker service – you can find a list of them at coindesk.com.
In today’s low rate environment, it’s vital that we consider alternative ways to generate income for income-oriented clients, and crypto now offers something new for you to consider – with the opportunity to earn double-digit interest rates. If you own crypto and need liquidity but want to avoid capital gains, the lending and borrowing platforms could be a solution.
The business model for lending and borrowing digital assets is similar to traditional brokerage firms and banks, but the crypto community is still in the early days. Crypto lending and borrowing platforms are still evolving but they already offer passive income strategies that can help you.