The lending sector seems to be blowing up right now...and here's why.
We’ve covered lending in crypto on multiple occasions in the past. However, before we only had a few key players that drove that sector. Today, we see major platforms like Binance getting into the game with competitive rates. It should be no surprise that this sector can be very lucrative for the service provider as well as the client.
The interest rates are unbeatable.
First, lets take a look at the traditional financial sector and interest rates they offer on your cash. We know that major global economies are currently racing to the bottom with cutting interest rates. The current Fed target rate is 2-2.25% in the U.S., and the EU recently announced another cut in rates which brought them into the negative territory.
What does this mean?
This is the interest rate at which banks and other depository institutions lend money to each other, usually on an overnight basis. The law requires banks to keep a certain percentage of their customer's money on reserve, where the banks earn no interest on it. Consequently, banks try to stay as close to the reserve limit as possible without going under it, lending money back and forth to maintain the proper level.
How is this rate used?
Like the federal discount rate, the federal funds rate is used to control the supply of available funds and hence, inflation and other interest rates. Raising the rate makes it more expensive to borrow. That lowers the supply of available money, which increases the short-term interest rates and helps keep inflation in check. Lowering the rate has the opposite effect, bringing short-term interest rates down.
So, how does this relate to savings? At the moment, U.S. banks offer 0.05 - 2.25% APY interest on your dollar. Meanwhile, the inflation rate in the U.S. is 1.7% annually. This means that you are actually earning 0.55% APY from banks that offer the top rates.
This is how it compares to what's available in crypto.
First, let's look at USD stablecoins for comparison. At the moment, you can get between 8-12% APY on stablecoins like USDT, GUSD, PAX, USDC, and TUSD. How is this possible? Lending platforms use your deposited funds to give out loans that earn interest from borrowers. These entities then take a spread between what they offer to lenders and borrowers.
Example of a Crypto Interest Account through Blockfi
Example of a Crypto Backed Loan through Blockfi
Who are the borrowers? There is a mix of users who take advantage of borrowing cash for crypto. The most obvious one would be BTC miners that don’t want to liquidate their holdings for cash to pay electricity bills. They would rather put up BTC as collateral and get cash in the short term while having a BTC long position in their portfolio. Makes sense right? Now, let's get a bit more creative. Let’s say you are holding $100k worth of BTC and by the end of the year, your portfolio grows to $200k. If you liquidate that position, you will be subject to short term capital gains (35% in the U.S.). This means that you are paying $35k to cash out your investment. Instead of closing your position, creative investors choose to put up BTC as collateral and take out cash. This way, they are not closing their position in BTC and taking out cash while being subject to 35% capital gains tax. Yes, this also means that their portfolio is subject to price volatility in BTC. Obviously, I’m not a tax expert and you should not be using this as a way to avoid capital gains tax. However, it is interesting to discuss the influx of users on lending and borrowing platforms that chase different goals. Some traders can even borrow coins and then sell them in the market as a way to go short.
It will be interesting to see how LTV (loan to value) and interest rates will change as this market matures and volatility slows down. Instead of depending on traditional credit scores, with lending platforms it all comes down to the LTV ratio. The more you can offer as collateral, the better the interest rate you can get. This also lowers the chance of a margin call.
Let's look at an example: If you put down three times the loan value ($100,000) in crypto, you will pay only 6.95% (interest rates are subject to change) and you’d have to face a margin call if your crypto lost 20% of its value. Given the volatility in crypto, 20% isn’t much wiggle room. Therefore, it is important to keep the LTV % as low as possible for favorable interest and more room for volatility. Platforms like Celsius will notify clients if their LTV ratio reaches 65% due to a market price drop and will allow you to manage your loan before a margin call occurs.
As we see this sector heating up in competition and it is important to perform your own due diligence before lending your coins. Some of the key factors you should look for when evaluating these companies should include LTV ratios, margin call process, total assets, custody of assets, active wallets, and regulatory compliance in the jurisdiction this entity operates. Some of the top respected players in this sector are Celsius, Blockfi and Binance.
And, as always, do your own research.