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Passive Earnings in Crypto: DeFi Lending and Staking in a Zero Interest Economy
The COVID-19 outbreak has had a profound impact on the global economy. The Bank for International Settlements (BIS), which monitors central bank policy rates in 39 economies, reported that 29 of them had cut their rates since the virus began to spread in January 2020.
While the United States Federal Reserve cut interest rates to zero in March, maturity yields of sovereign bonds across the world fell rapidly, with a few officially entering the negative interest rate range.
Falling yields majorly impact those who seek passive income via savings, since parking capital in banks does not deliver much in the way of returns. Typically, savers bought bonds, deposited money into saving accounts or directly lent money for interest. However, with traditional opportunities dwindling, the crypto space has the potential to emerge with viable alternatives, gaining traction and encouraging wider adoption of digital assets in general.
In this piece, OKEx Insights introduces crypto lending and staking as offerings that can potentially attract new users seeking passive returns and boost global acceptance for blockchain-based digital assets and financial systems.
Passive income opportunities in the crypto space
Bitcoin (BTC) popularized the concept of being your own bank. While BTC paved the way for digital assets to be recognized as such, other, newer protocols have managed to diversify crypto use cases and facilitate entire ecosystems. One of these is the decentralized finance (DeFi) space, built on top of the Ethereum (ETH) network.
DeFi essentially represents a broad category of financial applications built on public blockchains. It combines protocols, tokens and smart contracts to provide financial accessibility to individuals, (mostly) without the need for traditional banking channels.
Some of the services currently offered in the DeFi space include payment processing, custodial services, collateralized loans and lending/borrowing. Given the decentralized nature of these financial services and products, they aim to be permissionless (anyone can use them), transparent and censorship resistant. The use of blockchain technology and smart contracts also significantly reduces counterparty risk.
While lending your crypto assets within the DeFi ecosystem is one of the simplest ways to leverage your coins and tokens for passive income, staking is another method, particularly for those who are tech savvy and want to participate in maintaining the blockchain networks they use.
Staking is the process of actively participating in transaction validation on a Proof-of-Stake (PoS) blockchain. As opposed to the typical Proof-of-Work (PoW) protocol (like Bitcoin’s), in a PoS consensus mechanism, holders of a minimum-required balance of a specific cryptocurrency can validate transactions and earn rewards for doing so.
Presently, as per Staking Rewards data, there are 14 PoS protocols that support staking, with a network value of over $100 million.
DeFi lending explained
As is the case in traditional finance, lending remains the most straightforward method for earning passively in the crypto space. DeFi services that support lending and borrowing allow investors to earn steady returns leveraging their digital assets instead of leaving them dormant in wallets.
As per stats provided by DeFi Pulse, the total value locked — or held — in DeFi applications currently stands at $1.01 billion, out of which $769.9 million, or more than 75 percent, is locked in lending services.
Maker, the leading credit platform on the Ethereum network, represents nearly 70 percent of the total value locked in DeFi lending. The MakerDAO smart contract allows users to borrow DAI, a stablecoin pegged at $1, against $1.50 worth of ETH as collateral. Maker’s system calls this a Collateralized Debt Position (CDP). Users can also deposit their DAI and earn the DAI Savings Rate (DSR) using a separate service called Oasis Save.
While Maker is unique in its mechanics, especially as it functions to maintain the 1 DAI = $1 peg, other decentralized lending platforms like Compound allow for more traditional experiences, where lenders start earning interest as soon as their capital enters a pool.
On most platforms, the lending and borrowing rates are determined algorithmically, according to supply and demand. When a large amount of funds in the pool is lent out, interest rates rise accordingly, thus depressing loan demand and attracting user deposits to replenish the pool. On the contrary, when the use of funds is reduced, the interest rate will be reduced in order to stimulate demand.
As shown in the chart above, large-volume DeFi lending platforms have high stablecoin demand, as opposed to Bitcoin and Ethereum (ETH) due to their volatility. While the highest rate, at the time of writing, is around 8.58 percent, there has been a general downturn in DeFi interest rates recently.
Just last quarter, Fulcrum, for instance, was offering an interest rate of 14.33 percent on DAI loans, while Compound was offering around 8.5 percent for the same. The rate hike was a result of large-scale borrowing and the resulting shortage of funds.
Compared to traditional banking rates, DeFi lending projects offer much higher passive income yields, especially for developed countries. But they are not without their unique challenges and opportunities which need to be overcome and realized before adoption can be expected.
Challenges and opportunities for DeFi lending
While DeFi projects offer attractive passive income streams, they still lack liquidity and are not quite battle-ready yet in terms of security. Protocols such as lendf.me and bZx have recently been the subjects of severe security lapses, denting market confidence.
Moreover, DeFi projects are not without their barriers to entry — users must first buy a supported cryptocurrency, generally using a traditional bank account and an exchange, before they can use the decentralized, crypto-only platforms.
However, the recent surge in stablecoins, driven by financial and geopolitical crises around the world, indicates a shift towards digital assets as their potential is realized. The byproduct of this drive is an interest in passive income opportunities linked with stablecoins, which can bring users to DeFi services and products.
Ultimately, as we transition further towards a digital economy, DeFi products are likely to attract users, and potentially improve crypto acceptance and adoption rates around the world.
Staking rewards as passive income
Staking is another popular avenue for passive income in the crypto space. This method is set to gain more attention as Ethereum, the second largest cryptocurrency by market cap, shifts to a proof-of-stake protocol later this year.
To earn staking rewards/earnings on a PoS blockchain, you need to "stake" your coins (typically any amount) either by locking them into your wallet or subscribing on an exchange that supports staking. By staking your coins, you participate in block validation (similar to what miners do for Bitcoin) and earn a set percentage of your stake as a reward.
Given how staking is older than DeFi products, the total staking market cap is over $18.5 billion with over $9.9 billion locked in staking as of June 4, as per Staking Rewards data. This is nearly 10 times more than the value locked in DeFi, which stands at $1.01 billion at the time of writing.
When it comes to staking rewards, however, different coins offer different yields, as shown in the chart below.
At first glance, staking rewards appear very attractive compared to DeFi lending rates. But there are inherent risks involved, especially since you will be staking coins, which are very volatile in terms of price, and even your rewards will be paid in those coins, adding more risk in the event of a market slide.
Moreover, as new coins are minted, their supply is diluted, resulting in inflation, which also impacts the actual returns you get (reflected by adjusted returns in the chart above).
While it is safer to stake coins with larger market caps and low volatility, their returns are typically much lower than those offered by small cap, but riskier coins — as shown in the scenarios discussed below.
A performance overview of the most popular staking coins
We took a closer look at some of the most popular coins for staking to examine their performance over the past year. Returns are calculated based on daily compounding, with 365 periods per year.
Tezos has a staking reward rate of 5.7 annual percentage yield (APY). One year ago, the price of XTZ was $1.58. If an investor put $1,000 in XTZ, they would have bought 630.99 XTZ tokens. After one year, based on the APY, the number of coins in the investor's wallet would be 667.89 — worth $1,799.54 since XTZ’s price grew to $2.69.
With these figures, the investor would be looking at an annual profit of 79.9 percent. However, there was a period when the market dropped, around October 2019, and the entire worth of this investor’s XTZ holdings was only $488.38 — they stood to lose $511.62.
As you can see from the chart below, changes in token price determine the entire return of this investment. Earnings from staking would only show up in the final stages of the investment due to compound interest.
On the other hand, some tokens, such as IOST, have very high staking rewards. IOST offers 10.35 percent APY, but is highly volatile and has depreciated sharply over the last year.
If an investor put in $1,000 one year ago, when the price of IOST was $0.013688, they would have gotten 73,057 IOST tokens. After one year, the number of coins would have accumulated to 80,999, but they would only be worth $361.09 since the price of IOST dropped to $0.004458.
This scenario marks a 64 percent net annual loss for the investor, even though the staking rewards percentage was very high and attractive.
While the examples above demonstrate its inherent risks, staking remains attractive for those seeking passive income and is easier to explain to non-crypto users, who can compare it to stock dividends.
On the flip side, critics believe staking reduces market liquidity since it encourages "locking" coins, which are then taken off the market, and may also hinder the use of decentralized applications, which are part of DeFi.
The road ahead, Ethereum and increased scrutiny
The next big milestone for staking and DeFi is Ethereum’s upcoming upgrade. Their PoS protocol is already live on a testnet and Ethereum 2.0 validators can expect to earn between 4.6 to 10.3 APY as rewards for staking.
For Ethereum 2.0, however, you need to hold at least 32 ETH in order to run a validator node, or stake. As such, we are observing a growing interest in ETH accumulation in anticipation of the network's switch to PoS.
Cao Yin, Founding Partner of Digital Renaissance Foundation, expressed optimism about the network’s transitions to PoS and its impact on ETH's price. He told OKEx Insights:
“Staking can have a big impact on the price of Ethereum. We have seen big Staking projects like Tezos performed very well in terms of price. The Staking mechanism reduces a big amount of tokens in circulation.
We estimate that several millions of ETH will be locked into a variety of staking nodes, which will have a significant impact on the supply in the market. In the simplest terms of supply-demand economics, with supply decreasing and demand increasing, the price of ETH should rise.”
With the introduction of ETH staking support, we will also see increasing competition between DeFi lending and staking yields, as investors have the option to choose the most lucrative method.
However, this added visibility and attention can also hasten regulatory restrictions. United States regulator the Commodity Futures Trading Commission (CFTC) has warned in the past that PoS tokens could be treated like securities in the U.S.
Jason Williams, partner at Morgan Creek Digital, touched upon such a possibility in his comments to OKEx Insights. He likened the risk of staking to the initial coin offering (ICO) bubble that burst in the face of regulatory pressure:
“If PoS tokens are treated like securities the CFTC would create an ICO 2.0 event like we faced historically dramatically changing the course of adoption. If POS tokens are treated as registered securities and survive that test, we could treat them as we do DRIPs (Dividend reinvestment plans) from an accounting and tax perspective.”
Given staking’s potential to attract mainstream users, the Proof of Stake Alliance (POSA) is taking proactive measures to ensure that regulators are properly informed and educated about the phenomenon. The POSA aims to have an open dialogue with the U.S. Securities and Exchange Commission (SEC) in order to reach a mutual agreement on standards and rules impacting the space. If successful, dialogues between the two entities could result in concrete rules, paving the way for growth and wider adoption of cryptocurrencies and their associated ecosystems.
Disclaimer: This material should not be taken as the basis for making investment decisions, nor be construed as a recommendation to engage in investment transactions. Trading digital assets involve significant risk and can result in the loss of your invested capital. You should ensure that you fully understand the risk involved and take into consideration your level of experience, investment objectives and seek independent financial advice if necessary
OKEx Insights presents market analyses, in-depth features and curated news from crypto professionals.