Is the Risk/Reward worth it on Crypto Lending?
In Part 1 and Part 2 we discussed the risks of lending your cryptoassets on decentralized and centralized platforms. In this final part on crypto lending we’ll attempt to price the risk/reward by comparing it to traditional financial assets.
Risk/Reward
Risk/Reward is defined as “the relationship between the amount of return gained on an investment and the amount of risk undertaken in that investment.” The spectrum generally follows this progression, starting from lower to higher risk/reward:
Short-term debt — Long-term debt — Property — High-yield debt — Equity
It’s fair to assume that any crypto-related investment activity would fall on the far right of the spectrum, this includes lending. Investing in cryptoassets is typically viewed as high-risk, but most do it under the expectation of extraordinary returns, especially when looking at the past 10 years — there’s seldom been an asset class that has outperformed the crypto market. This fact alone has driven many investors/speculators to chase for a “moonshot”. However, this market behaves no differently to others, cycles are constant and in times of uncertainty investors will turn to safe havens/low-risk alternatives for returns. During the 2018–19 bear market, lending platforms were seen as providing exactly that, but is the risk/reward truly worth it? Let’s examine below:
The above chart illustrates a wide variety of securities with some of the most popular crypto lending markets. You may notice that crypto lending is on the far right, with a riskier profile than cryptoassets — this is because of the added element of counterparty risk. To understand how rates are determined on crypto lending platforms I highly recommend reading this Medium by Roy Learner. Essentially, rates are determined by supply/demand and thus far due to the speculative nature of this activity we’ve seen a wide range of Annual Percentage Rates (APR) depending on the cryptoasset. Stablecoins and Bitcoin have benefited from higher rates ranging from 6% — 10%, with the exception of special circumstances where the rates will go up considerably (DAI is currently~12% APR on Compound, was at 15% last week). Rates on other cryptoassets such as ETH, BAT, REP etc. have ranged substantially lower from 0.1% — 2% (anything higher should be considered rather suspect).
By taking the above figures and comparing them to traditional fixed income securities we can attempt to price the risk/reward. For example, US treasury bonds — the 10 year currently yields around 1.75%. These bonds are generally perceived to be risk-free because it is debt backed by the US government — the chance of default is very low. You can even earn around the same just by keeping USD in a money market account that pays interest based on current rates. Going by that rationale, is 2% APR or lower enough to justify lending your cryptoassets and being subject to counterparty risk? Clearly not, one would expect much higher returns. Another example are high-yield (junk) bonds which currently have a yield of around 6% — even though they carry a greater chance of default, most are still backed by solid companies with assets that bond holders are entitled to in the event of a default. So, an investor would get 6% with more security for his/her principal, in comparison with crypto lending platforms where the risks are much higher and undefined. Again, the risk/reward doesn’t seem reasonable for 6% APR or lower. Referring back to Ari Paul’s article, crypto lending should be treated similarly to start-up loans and therefore should come with much higher yields (upwards of 20%) to justify the risk/reward. So far, only the Compound DAI market has gotten close to that number, during its peak reaching around 18% APR. But since it is a stablecoin it limits an investors exposure to the upside (and downside), effectively creating an opportunity cost.
Because borrowers want to limit their exposure to volatile cryptoassets, the largest loan originations we’ve seen on crypto lending platforms have been in stablecoins — higher demand = higher yield (~8% and above). Because this is significantly higher than what most banks offer nowadays, it’s evident why there’s been a large influx on the supply-side. But what’s the opportunity cost of keeping your majority portfolio in stablecoins to earn around 8% per year?
As we can see in the table above, there’s been a notable turnaround in prices for the crypto market since the beginning of the year. Just looking at Bitcoin — year-to-date it’s returned around 220%, so for any investor with a portfolio allocation in cryptoassets these are the type of returns one would expect. Since investing in this space carries a lot of risk, it doesn’t seem logical to take on additional counterparty risk and opportunity cost to earn 8% per year, especially since there are less risky alternatives available in the traditional financial markets that bear similar returns. Although the “hodling” strategy has its drawbacks, it also has its merits in generating the largest returns for investors who are patient and keep custody of their own holdings. Ultimately, everyone has their own investment strategy and risk appetite, but investors should be a lot more cautious with the concept of “risk-free” income in crypto lending.
This equally applies to lending markets in volatile cryptoassets. For example, if you lend your BTC to some unknown counterparty for an extra 6% per year, but your funds are victim to a hack or default by a borrower, the supposed gain on that investment can turn into a 100% loss. If blockchain and the crypto market achieves even a fraction of disruption on various industries, the return on investment should be more than enough to satisfy the ambitions of any investor. The largest opportunity cost would be to miss out on such returns for a couple extra percent a year.
Final Thought
Now one could argue that crypto credit and lending platforms have numerous advantages over legacy finance. Notably more accessibility (no KYC/AML, credit checks etc.), liquidity, transparency (on decentralized) and simplicity for anybody who’s interested in generating interest income. I’m in full agreement with the above, the advantages of these platforms (especially decentralized ones) cannot be denied and it will be very exciting to see what the future holds for projects innovating in this space.
Thank you for reading. Please don’t hesitate to reach out if you have any feedback or corrections.
