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Why Are Crypto Interest Rates So High?

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Whenever I recommend friends and family sign up to BlockFi, Voyager, or another crypto interest account, the first question that always comes up is, “Aren’t these interest rates too good to be true?”

It’s a fair question. After all, you’d be lucky to earn even 0.25% interest in your traditional savings account from your bank.

So when we see crypto companies advertising you can earn interest rates up to 10% on USD, we assume there must be a catch.

In this article, we’ll explore where the yields in crypto come from and why they’re so high. As with everything in investing, there are, of course, risks.

Just know that over time, as adoption grows and more supply of USD enters the market, yields will fall. So while I believe there still is plenty of runway ahead, these opportunities won’t last forever.

Why Are Crypto Interest Rates So High?

Fundamentally, there are two reasons why high interest rates in crypto exist:

  1. Working capital inefficiencies
  2. Rewards

Both reasons have their justifications and likely will not go away any time soon.

Working Capital Inefficiencies

Unlike in the traditional finance world where prime brokers allow you to borrow money and settle cash later, in the crypto world transactions have to be settled immediately given the trustless nature of the space. You therefore need to have sufficient collateral at all times, which creates a constant demand for cash.

In addition, because the crypto world is still very fragmented, large players like institutions need to be setup across a number of exchanges and OTC desks. All of which require sufficient collateral.

Token Rewards

Rewards in crypto are essentially a customer bootstrapping method. By giving your early users rewards in the form of the platform’s native tokens, you turn them into early adopters and stakeholders.

These tokens are essentially a form of equity in the platform, and incentives are one of the most powerful forces in the world. It is in these early users’ best interest to help promote / grow the platform, create communities, and drive increased adoption.

Note that this is how DeFi platforms obtain supply in the early days and also how early liquidity providers can earn extremely high interest rates.

How Do You Earn Interest in Crypto?

Lending

When it comes to lending, centralized finance crypto companies like BlockFi operate in much the same way traditional banks do.

You deposit money onto the platform, they lend out that money to a borrower at a certain interest rate, and then pay you a portion of that rate while taking the rest as a cut.

Ex. You deposit $1,000. Platform lends it out to a borrower at 12% interest. Platform pays you 8% while pocketing 4%.

The difference is that traditional banks charge a much lower rate to borrow, and of that amount will pay you even less. It’s all very opaque, but the end result are the low interest savings accounts you see.

There are two main reasons why are people are willing to borrow at such high rates in crypto.

1. Lack of fiat dollars in the crypto ecosystem

This might surprise you, but there is a constant shortage of fiat dollars or stablecoins within crypto, relative to other tokens. Most crypto natives, including whales, prefer to hold BTC or ETH.

As a result, there is plenty of btc and eth available for borrowers, but much less USD. This is why you can earn much higher interest rates by lending out stablecoins compared to btc or eth.

2. It’s financially beneficial

Ultimately, traders and institutions borrow at relatively high interest rates because they can make profit doing so. Borrowing USD at 12% annual interest to purchase tokens that increase by 50% or 100% in a few weeks – which isn’t uncommon in crypto – is a winning trade any day of the week.

These traders are employing leverage in order to magnify their returns and are happy to pay the rates they do. The more bullish the crypto market is, the higher the rates traders are willing to pay for stablecoins.

Along with leveraged trading, people also borrow crypto to take advantage of arbitrage opportunities. For example, you can borrow USD from BlockFi, then deposit that USD onto a DeFi platform to earn much higher yields.

These people are compensated for the risk they take for providing supply to a new, unvetted platform. We’ll get into some of these platform incentives later on in the article.

Staking

While most people are familiar with Bitcoin and Ethereum’s current Proof-of-Work (PoW) consensus mechanisms to secure their blockchains, the Proof-of-Stake (PoS) protocol has become increasingly popular. Ethereum plans to migrate to PoS eventually, while others like Cardano already utilize it.

Unlike Proof of Work mechanisms, Proof of Stake systems require much less computational power and energy. Instead, miners secure the network by staking their tokens as collateral. They are then rewarded by receiving block rewards and transaction fees.

You don’t necessarily even need to be a whale to stake. With mining pools, anyone can deposit their tokens into pools to help secure the network.

The current ETH 2.0 staking reward is about 5-6% annually. Not bad for a historically appreciating asset.

Providing Liquidity

Another way to earn crypto yield is to be a liquidity provider to a platform. When you deposit onto a decentralized exchange like SushiSwap, you receive a cut of the transaction fees for any trades in your pool. You can see in the image below liquidity providers earn a 0.25% fee on SushiSwap.

Along with transaction fees, liquidity providers can also earn rewards that serve as interest. You can see in the image below you can earn SUSHI and MATIC by being a liquidity provider for the following pairs.

What’s exciting is that you can then stake the rewards into their own pools, compounding the interest you earn. Some platforms like Autofarm automatically compound the rewards for you, making it truly passive income.

The yields above range from 10%-44%, which is already extremely high compared to traditional rates on bonds or dividend stocks. Generally, the less liquidity in the pool the higher the interest you can earn, which is why the AVAX/WETH pool’s APR is currently so high.

While these rates may seem great, it’s not uncommon for new DeFi platforms to offer 100%+ or even 1,000+% APYs. They do this in the early stages to bootstrap the marketplace and attract new users.

Be warned, though, that because these rewards are from the platform printing their own token, the future price will likely plummet once people that farmed it start selling in mass quantities.

Are Crypto Interest Rates Too Good To Be True?

Now that we know where yields in crypto come from and how to earn them, the question remains: are these interest rates too good to be true? And if so, how long can these yields last for?

The good news is these high rates will likely persist for a long time. Fundamental aspects of the crypto environment like its decentralization and trustless nature are not going away, which is why working capital inefficiencies will always exist.

Likewise, new DeFi platforms and new tokens will always emerge, creating more and more rewards programs that spit out high interest rates.

As for whether crypto rates are too good to be true – a lot of it comes down to common sense. If you see a platform advertising rates of 1,000%+ APY, just know that it’s a very temporary thing. If you can get in early enough and not risk too much capital to participate, by all means go for it.

But you need to have an exit plan and be very short-term focused on capturing profits. Holding these rewards long-term generally doesn’t make sense because the supply outweighs the demand for the tokens. Also, you run the risk of the platform rugpulling you or getting hacked.

If you want to participate in safer farms, avoid the new platforms and super high APYs. Stick to established platforms like SushiSwap, PancakeSwap, Compound, Yearn, CRV Finance, etc, and be a liquidity provider for lower volatility pairs.

Being a liquidity provider for stablecoin pairs like USDC/USDT or USDT/DAI is one of the safest ways of yield farming.

Lending your coins on CeFi platforms like BlockFi, Gemini, Coinbase, Voyager, Celsius Network are also good ways of earning crypto interest without too much risk. The more established the company is, the lower the interest you’ll earn but the less risk you’ll face.

Younger, smaller companies like Hodlnaut, YouHodl, Ledn generally offer higher interest rates because they have to compete with the bigger players.

Wrapping Up

We’ve explored why interest rates in crypto are so high and where these yields come from. Understanding these concepts will help ensure you participate in good projects that will stand the test of time.

Earning interest on crypto is one of the most underlooked aspects of building financial wealth right now. If you believe in the long-term future of crypto and specific coins you believe will appreciate over time, being able to earn anywhere from 6% to 20%+ interest holding your tokens is an amazing opportunity.

For those worried about the overvaluation of equities but also aren’t satisfied with the pitiful yields that bonds offer, you can also earn 8%-10% interest rates just by holding USD stablecoins.

Whatever your investment style or preference, everyone should do themselves a favor and explore the opportunities available in the crypto ecosystem to earn passive income through yield.

My recommendation if you’re looking to get started is to sign up to a trusted crypto provider like BlockFi, Ledn, or Gemini, and allocate some of your bank account savings to start earning interest on your cash. Once you get comfortable with this, you can start playing around with more advanced strategies like yield farming on DeFi platforms if you wish.

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