On-chain Banking Part 3: Capital Efficiency

Welcome to this multi-part series showcasing on-chain banking and its potential to transform the nature of finance globally.

This installment looks into the concept of capital efficiency.

For those not familiar with it; capital efficiency is a measurement of how hard your money is working for you. Low capital efficiency is when you have your money in your bank account and it earns you no interest. High capital efficiency is when you deploy your money -in a safe way- and you generate a high yield. Risk is also a factor in understanding capital efficiency.

The basic idea is that your money should always be working for you. Especially when you sleep. You want to put your money —not spend it — somewhere that it will generate your more money. In the good old days of the 80’s that would have been your bank’s savings account at 10%. This is more than good enough for most people and businesses. If you are earning 10% then that capital is being used efficiently.

But today through a combination of hostile governmental regulation banning paying interest —looking at you New York— and banks slowing making interest rates lower then introducing fees that wipe out any interest you might get, the age of earning interest form your saving account is over. Today you get headlines if someone offers 4% interest when in reality the banks and other institutions that manage their own money are earning more. The result is that in traditional fiat finance retail users like you and I have terrible capital efficiency.

When thinking about capital efficiency and putting your money to work, risk and time are two key elements. First with risk, all investments or actions you do with your money come with risk. From keeping it under your bed to investing it your nephews new tech startup, everything comes with risk. What we are looking for is not the lowest risk, but some way to give people individually the information and choice to decide for themselves. Secondly, we have time, very often if you lock up your money for longer periods of time, you can get a higher yield or return. If you lockup your money then it’s effectively gone and the most unfavorable situation. The opposite to investing into a lockup position is investing into a liquid position.

So, to summarize, we want a low risk way to not lock up our money and generate a yield greater than 5%. For large companies and high net worth individuals there are lots of options such as various types of bonds and funds… and for the rest of us, there is crypto.

While there are many limitations to offering normal users yield in the traditional financial world, there are no limits in crypto. Anyone that owns crypto can generate a yield whenever they want to. That yield can be in tokens like Ethereum or Cardano but it can also be in stable coins like USDC and USDT. As a result, having a non-custodial wallet and putting your USDC to work will give you that low risk, no lockup 5% yield. But there are many other ways to generate a yield in crypto.

This is where the on-chain part of on-chain banking shines. If you keep your assets on-chain, or in your crypto wallet then you can generate a yield or do anything you want with your funds. All while remaining on-chain, exclusively in control of your money.

With on-chain banking you keep all of your funds on-chain where they can be be quickly deployed to earn a yield, making it capital efficient. Then, if you’re in need of sending a SWIFT transfer or paying for something with a debit card, the assets are automatically transferred to your bank account and spent. In this model you get the best of both worlds.

Yielding

What are some of the ways you can earn a yield on-chain today? Here is a list of just a few starting with the simplest and ending with more risky with higher returns (and some lockup).

sDAI — This is a saving mechanic for DAI, the stable coin. It is at the time of writing paying out 10% APY.

hyUSD — This is a real world asset token that provides a simple yield of greater than 8%. In addition to that, hyUSD can be staked in different protocols to generate yields north of 20% APY.

ETH — Ethereum is a layer 1 blockchain coin that can be staked to earn yields of about 3.5% and if you lock it up then you can earn up to 60% APY.

AVAX — Avalanche is similar to ETH but the base yield is more than 7%.

MELD — The MELD tokens—shameless plug — can be staked and generate 5% and if you lock it up for a period of time then you can earn up to 18% APY.

Currently most of the yielding assets are either stable coins or they are layer 1 blockchain coins but with the rise of real world assets (RWAs) the number and type of yielding assets are growing daily. Soon we will see high yield dividend ETFs, municipal bonds and other RWAs that will both yield about 10% and be able to be sold on DEXs.

Market Making

The other way to make your capital efficient is to market make. Market making is the act of using your money or supplying your money into a market to make sure that market has enough liquidity to operate properly. When market making you will typically earn a base yield on the amount of transactions.

To be clear, when you deposit your money into a bank, you are market making. You are giving the bank your money so they can lend it to other people and make the lending market. But in this case, you don’t earn anything from it. Only the bank earns from your money.

In crypto, most of decentralized finance (DeFi) is built on normal people being market makers and earning from this. It is democratizing the market making activity. One of the great things about market making is that you can supply and withdraw at any time, no lockups. The simplest types of market making in crypto are lending and borrowing protocols like MELD, AAVE and decentralized exchanges like Uniswap and Pancake Swap.

In the case of a lending & borrowing protocol you are supplying your assets, just like depositing into a savings account and then the protocol allows others to borrow that assets, earning you a yield in the process. You can think of this as performing similar activities as a bank, but removing the bank from taking all of the profit.

When someone borrows the assets you supplied, they pay an interest on it and most of that interest is passed on to you and the others that have supplied assets. You are earning from making that market.

In the case of a DEX, users typically supply two assets and then every time someone swaps from one asset to another a small fee is taken for that service and you earn that fee, called a swap fee. The more swaps the higher yield you can earn.

Capital efficiency is hard to achieve as a normal user in the traditional banking world, banks take all of the profit and leave you with your principle only. On-chain, users can generate a yield on the assets they hold through several means as well as access to these assets 24/7. Making on-chain much easier to be capital efficient, but it’s ultimately up to you and what risk appetite you have. You are in control when building your wealth with on-chain banking.

As the founder of MELD, me and my team have been building an on-chain banking system for the past three years. Part of the reason for this series is to share our experiences and discuss how it will shape the future of finance in the next decade and beyond.