Stablecoin Lending: A Lucrative High-Yield Opportunity for Debt Investors
Written by Alan Fan, Stably Summer Intern
Abstract
In today’s fast-growing decentralized finance (DeFi) industry, stablecoins have been successfully applied to collateralized lending and their yields have become a very lucrative opportunity for alternative debt investors. Due to the increasingly high demand for liquidity from institutional traders, crypto payment processors, and miners, interest rates being paid to borrow stablecoins on crypto lending platforms are substantial, with the average yield being four times that of top savings accounts and twice the rate being offered by fiat-based lending platforms. This phenomenon may continue to persist as long as the crypto economy continues to grow faster than the mainstream economy. Additionally, the potential boom in enterprise stablecoin adoption signaled by Facebook’s Libra and Walmart’s stablecoin patent could signal mass consumer adoption of both stablecoin lending and borrowing in the near future in lieu of uncompetitive rates from banks, as well as today’s low interest rate environment.
A brief history of lending and borrowing models
Historically, the facilitation of lending and borrowing has primarily been the role of banks. Banks act as an institutional intermediary between those who want to deposit money and those who want to borrow, although in practice there is no direct connection between the lender and borrower. This is because banks use a fractional reserve system, so it is only required that 10% of their deposits are held in cash or within the central bank. With a fractional reserve, banks can lend out up to 10 times more than their reserves. While banks have more capital available to them with this system, the accompanying increase in risk can cause bank failure if a bank run occurs or if a high volume of loans is defaulted on, such as with the 2008 Financial Crisis.
In the mid-2000s, a new alternative has emerged: peer-to-peer lending. Peer-to-peer lending platforms match lenders directly to borrowers, charging a loan origination fee from borrowers and a service fee to investors. After a decade, the peer-to-peer lending industry grew to be $231 billion in 2017, and popular peer-to-peer lending platform LendingClub has amassed over $47 billion in total loan issuance since its inception in 2007. The peer-to-peer lending model offers greater returns to investors and lowers interest rates for borrowers by reducing the high overhead costs of the banks that use legacy IT systems and branch networks.
More recently, cryptocurrency lending has expanded on the peer-to-peer lending model, allowing for greater borrower transparency. Because transactions on the blockchain are publicly auditable, borrowers’ full transaction history could, in theory, be assessed to provide a more accurate credit rating than peer-to-peer fiat platforms, many of which mitigate default rates by specifically target prime consumer borrowers. With smart contracts, the fees normally taken by peer-to-peer platforms can be circumvented. Crypto lending also offers superior rates for users. However, due to the volatility of cryptocurrencies, borrowers using crypto lending platforms must collateralize large amounts of crypto, making borrowing inaccessible to the average person. For example, on SALT Lending, one of the most popular crypto lending platforms, a borrower must post cryptocurrency collateral worth twice the value of their loan on a 50% loan-to-value ratio. Stablecoins solve the overcollateralization problem because they have a stable price, so there is a negligible risk of the stablecoin collateral dropping below the value of the loan. By utilizing stablecoins in crypto lending, lenders enjoy the high returns associated with the low operational cost of smart contracts, and borrowers can post a reasonable stablecoin collateral to get a loan with low interest rates.
Lending returns across different lending-borrowing models
For banks, the counterpart to people who borrow from the bank are the people who deposit money in savings accounts. Savings accounts are a low-risk investment, as many are FDIC-insured. However, the highest interest rates for savings accounts as of August 2019 are 2.15% APY, which matches the annual change in the consumer price index. Therefore, although there is no risk of losing money by investing in a good savings account, the investor’s purchasing power will stay relatively the same over time.
Lending returns on peer-to-peer platforms outperform those of bank savings account by over a factor of two. On LendingClub, portfolios with an age of 12–18 months had a median net annualized return of 4.5%. Funding Circle, another peer-to-peer lending platform, states that its average returns for all loans, from February 2013 to March 2019, was 5.3% per year.
Finally, there are crypto lending platforms. Although interest rates on popular non-stablecoin cryptocurrencies are approximately 4% on Celsius Network, stablecoin lenders can earn 8% on Celcius Network and Nexo, and on decentralized crypto lending platform Compound Finance, the lending APR for Dai and USD Coin is 12% and 9%, respectively, although this figure fluctuates based on the lend and borrow supply.
Why are returns on stablecoin lending so high?
In a peer-to-peer lending and borrowing model, regardless of if fiat or crypto is used, the interest rates for lending and borrowing are influenced by the supply and demand. If there is a high volume of loans and a low supply from lenders, then the return for lenders will be high and the interest rate for borrowers will be high. On the other hand, if there is a low volume of loans and a high supply from lenders, then the return for lenders will be low and the interest rate for borrowers will likewise be low. The idea of supply and demand in a peer-to-peer loan market helps explain why stablecoin lending can provide double-digit annual returns.
Stablecoins have a relatively low supply from lenders. Stablecoins are still a nascent industry within the greater cryptocurrency landscape and comprise only about 2–3% of the total market capitalization of cryptocurrencies. A disproportionately high amount of the lending supply comes from stablecoins, likely because people buy stablecoins just to lend them on crypto lending platforms, but stablecoins still make up far less of the supply than the top cryptocurrencies. For example, on Compound Finance, Ether has over 50% more gross supply than both of the stablecoins they offer combined, being Dai and USD Coin.
Secondly, there is a massive demand for stablecoin loans. On Compound Finance, the gross borrow demand for Dai is nearly 40 times that of Ether. This demand is largely driven by large institutional traders and cryptocurrency payment processors. Institutional traders such as hedge funds and market makers use crypto loans for speculation, using the capital to increase their leverage on certain cryptocurrencies or to arbitrage trade between different exchanges. And for crypto payment processors that take in large amounts of cryptocurrencies from businesses using their processor, crypto loans are necessary for them to reimburse businesses within a short timeframe. These processor companies may not be able to find enough volume on exchanges to liquidate their cryptocurrencies, and by selling large amounts of crypto they may be lowering the market price for themselves. Therefore, by borrowing fiat money with their crypto as collateral, they can pay their clients back quickly and also afford themselves the time to liquidate their currency at market price.
Crypto lending in the future
The question of whether stablecoin lending interest rates will stay as high as they are today or even increase is dependent on the lending supply and loan demand, with many factors having the potential to influence them. The biggest factor in determining whether the crypto lending supply will grow, lowering lending interest rates, is an increase in awareness about crypto lending. With stablecoin interest rates being over five times greater than that of high-yield savings accounts, it is only a matter of time before people start investing on crypto lending platforms. Lending returns will increase if the demand for crypto loans continues to grow, and it does not look like it will stop anytime soon. Custodial crypto borrowing platform Genesis Capital grew by 48% in total loan origination over the first quarter of 2019, with an acceleration of new loans as crypto prices rallied. With the current bull run, crypto loans are only set to increase in demand, especially because institutional traders and whales will use crypto loans to gain capital without selling their crypto assets. Finally, as stablecoin technology progresses to have greater retail utility and other built-in features, demand for both stablecoin lending and borrowing will increase because stablecoins will be more widely used by everyday consumers who need both functions. The current bull market and underutilized lending platforms make crypto lending, specifically stablecoin lending, a prime opportunity for investors. A stablecoin-based lending-borrowing industry featuring the low operational costs of a peer-to-peer blockchain system and the low collateralization of a stable collateral price could very well be seen in the not-so-distant future.
About Stably
Stably is a venture-capital backed startup. Our vision for the future is to build an alternative digital bank powered by stablecoins — faster, cheaper, transparent and globally accessible.
What is USDS?
USDS is a stablecoin created by Stably and issued by Prime Trust, a Nevada-chartered trust company that is also the regulated administrator for USDS. Stablecoins are cryptocurrencies that are equivalent to national currencies — i.e. digital cash. Regulated, fiat-backed stablecoins are backed by physical reserves of cash and can be redeemed at a 1:1 ratio.
USDS virtually eliminates the crippling price volatility of traditional cryptocurrencies like Bitcoin and Ethereum, while still retaining many of their useful characteristics.
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