DeFi, banks, and the future of savings

MakerDao recently launched a product called Dai Savings Rate (DSR), a smart contract that pays interest to account holders like a traditional savings account. Shortly after, the cryptocurrency exchange OKEx announced that it will allow users to put their DAI deposits in the DSR, earning DSR interest plus an additional MakerDao funded subsidy.

What does this mean for decentralized finance and the cryptocurrency ecosystem more generally? On the surface, the interest payments are just another strategy to lure lucrative customer deposits. Coinbase launched a similar product in October, and Gemini has a similar arrangement via BlockFi. What’s more, many exchanges have propped up or supported stablecoins in one way or another including Coinbase’s USDC, Binfinex’s Tether, Gemini Dollars, and even OKEx with their own not-at-all-sketchy stablecoin called USDK. Although these interest programs have varied rates, and these coins have different properties and uses, there’s nothing new about an exchange supporting a stablecoin.

So what is going on here, and why is it interesting?

For those of you who don’t know, MakerDao is a foundation with financial products including the DAI stablecoin. DAI is a cryptocurrency, specifically an Ethereum ERC-20 token,whose market value is pegged at $1 USD. The stability of this peg relies on a carefully designed smart contract mechanism, and the active and ongoing governance of MakerDao. The newly launched DSR product is just the latest DAI stability tool created by MakerDao, an additional knob which can increase or decrease demand for DAI as necessary.

First, we should be paying attention because MakerDao is a large and complex part of the DeFi ecosystem, comprising just over 50% of all DeFi wealth. It’s incredible to see so much financial infrastructure being built on chain, and I am excited to see how the DSR evolves.

Second and more important, this push to offer high savings rates parallels a general trend in consumer finance, and points to a convergent future between the traditional and decentralized consumer finance worlds.

Banks and depository institutions earn significant portions of their revenue through “Net Interest Income”, the difference in interest earned through loans and other assets compared with the interest paid for consumer deposits. For example, JP Morgan earned ~22% of its Q32019 revenue from consumer and business lending, the bulk of which came from net interest. Since such a large portion of their revenues come from consumer deposits, banks compete fiercely by constantly changing and advertising their savings rates, and by convincing customers to move their funds to non-interest bearing accounts, like checking and investments.

Although cryptocurrency exchanges also compete for deposits, the incentives look quite different. While banks earn net interest on customer deposits, crypto exchanges earn their revenue from transaction fees. Customers deposit money in banks because they demand safety and stability, while exchange users generally want the complete opposite, an opportunity to speculate or “invest”. As a result, crypto exchanges have mostly competed on access (more currencies), legitimacy, user experience(simpler or more secure site design), and lower fees. As crypto markets have stabilized and cyptocurrency has gone mainstream, exchanges have begun finding new ways to encourage deposits: Coinbase’s USDC rewards, OKEx’s DAI savings interest.

Everyone is fighting for the same thing: consumer deposits. Banks want consumer deposits to shore up their balance sheets and offer more loans. Crypto exchanges want deposits so they can…. well let’s not worry quite yet how exchanges plan to make money longer term (I’m not even sure they’ve figured that out). Suffice it to say that exchanges are starting to look a lot more like traditional banks.

What does this mean for the future of decentralized finance? I believe it’s actually a really good sign. DeFi has introduced consumers to new points on the risk-reward tradeoff curve that sit close enough to “riskless” to be considered “safe”, but far enough above to offer competitive rates. Rates that consumers are finding increasingly difficult to get.

Interest rates world wide have been decreasing for decades. According to the New York Fed, this trend is the result of increasing demand for safety and liquidity, and a slowdown in global economic growth. These forces seem unlike to reverse any time soon, so we should expect to see interest rates remain low or decrease. Interest rates in DeFi, however, have been consistently higher than those of savings accounts. As they should be, even simply holding DAI brings essentially uncalculable risk: If MakerDao has a bug in their smart contracts, the FDIC is not going to rescue your DSR account.

Soon bond yields will be negative, mortgages will cost 2% APY, and everyone will desperately need consumer deposits. Who will get them? Right now, it’s the banks offering the highest savings rates and cryptocurrency exchanges offering DeFi interest rates. In the medium term (3–5 years) it will be the institutions that can convince customers their deposits are safe, despite small but unknown risks. Risks like DAI collapsing, Ethereum failing, or MKR owners collectively goldfingering the entire system. Difficult to calculate, unlikely, but possible.

DeFi will go mainstream from the bottom up. We will see a traditional bank offering something like DSR to consumers before institutional investors start buying MKR, CDPs, or holding DAI. This will probably start outside the US, or at a crypto focused bank like Silvergate. I’m not sure exactly what the product will look like, or how long it will take, but banks that can’t compete with DeFi savings rates will eventually lose consumer deposits to companies like OKEx and Coinbase.

Thanks for reading. In my next few posts I’ll be discussing more about how MakerDao works, going in depth on the stablecoin ecosystem, and reviewing interesting whitepapers.