In traditional financial markets, interest rates reveal significant information about the health of the economy and form the basis for almost all asset valuation models. Whether it be for calculating expected return or present and future market value, the interest rate is a key variable based on the lending and borrowing of assets.
Lending and borrowing cryptocurrencies is becoming an increasingly important sub-sector of crypto finance, one that may end up shaping how the underlying assets themselves are valued and priced in the markets.
While still in its infancy, the growth of crypto lending platforms has given birth to a new type of measuring metric: interest rates, which has the potential to draw in new investors while encouraging the movement of crypto capital out of storage and into markets.
When individuals or businesses want to take out a loan, they normally have to agree to pay a percentage of the original amount borrowed back to the lender on top of the principal amount. This is what is called the interest rate.
Interest rates for cryptocurrencies incentivize users to loan out their crypto assets because users can earn a higher return lending their assets than they can storing them in a personal wallet or device. Rates for lending cryptocurrencies coupled with strong demand for borrowing would free previously idle balances of capital for investing, trading and generating new market activity.
For all the benefits to investors and market activity growth that an active lending and borrowing sector would generate for the cryptocurrency industry, the sector is still in early stages of development. Less than 0.01 percent of the total market capitalization of crypto was deployed in the third quarter of 2019 for collateralizing loans, according to figures by Credmark and Messari. To the nearly $1.5 billion in trade volume being generated daily, only $16 million was generated in crypto loan interest in the third quarter of last year, according to the most recent data from Credmark.
Other signs of sector immaturity besides low volume are high interest rate variance and volatility.
Interest rate variance
Interest on crypto deposits can vary by up to four percentage points, depending on the lending platform. This variance exists in large part because of the difference in business models between lenders.
Service providers such as Nexo borrow cryptocurrencies from primarily retail customers and lend in fiat. Others, such as Genesis, service large institutional clients and process loans in either crypto or fiat. Decentralized finance (DeFi) lenders such as MakerDAO facilitate loans strictly financed in crypto and paid out in crypto. Each one of these lenders incurs different costs for processing and custodying funds. They also attract different client segments with varying expectations of fees and service levels.
Over time, companies with unsustainably high interest rates on lending cryptocurrencies will go out of business, as will other companies with uncompetitively low interest rates that fail to attract lenders. The natural dynamics of the free market as applied to any industry weeds out inefficient business models and promotes standards of practice through competition. As the sector grows and consolidates, interest rates are likely to converge to sustainable levels.
Until then, borrowers and lenders will have to endure a high variance of rates, even within a platform.
Interest rate volatility
Interest rates on loans backed by and earned in crypto tend to fluctuate frequently, making any extrapolation of future value unstable. For example, interest rates on deposits for ether (ETH) paid to lenders have declined sharply from 1.3 percent to 0.01 percent on DeFi lending platforms Compound and dYdX in 2019. Interest rates for ETH on centralized lending platform Celsius also saw a decline from 4.5 percent to 2.75 percent in the same year. This could be a result of low demand for ETH loans propelled by poor spot-market performance of the asset. Between June and December, ETH’s market price fell from a high of $334 to a low of $128.
Volatility in the lending and borrowing sector of crypto is not surprising given the high risk associated with the underlying assets. Data from woobull.com shows the annualized volatility of bitcoin (BTC), the cryptocurrency with the largest market capitalization and trade volume, is 17 percentage points higher than U.S. stocks as of Feb. 21.
However, price volatility for bitcoin has declined over time through increased demand and investor participation. As the number of loans either financed or earned in cryptocurrency grows, interest rate volatility is also likely to decline.
Asset range variance
It’s not just rates that vary widely from one provider to another, there is also considerable variance in the number of assets supported. In general, decentralized lending platforms such as MakerDAO, Compound and dYdX support a narrower range of cryptocurrencies than centralized ones, primarily due to the technical restrictions of decentralized finance protocols. These operate entirely on-chain, therefore any assets supported by the protocol must also be supported on the underlying blockchain network. This limits the number of options for a lending platform to only ERC-20 tokens if the platform is built on ethereum, for instance.
With new infrastructure facilitating blockchain interoperability and seamless asset transfer from differing chains, DeFi lending platforms could eventually support as many cryptocurrencies as centralized ones. DeFi lenders Compound and Nuo already support lending on wrapped bitcoin (WBTC) tokens, which are virtual representations of bitcoin on ethereum. Projects like Polkadot and Cosmos are actively building out functionality to support instantaneous transfer of all assets between blockchains.
Such technologies to support inter-blockchain activity are likely to pave the way for greater asset diversity on decentralized lending platforms and help reduce the asset range variance between cryptocurrency lenders. Without a large variance between lenders, there is greater opportunity for competition on the basis of loan terms and conditions rather than the number of supported cryptocurrencies. This will further drive convergence of variable interest rates, as well as solidify standards of business practice.
Currently, the cryptocurrency lending sector is immature, with variable and volatile interest rates across platforms as well as among different sets of supported assets. However, the sector is developing and growing rapidly. In the most recent Credmark report, the total amount of crypto borrowed by users of crypto lending platforms increased by 23 percent to $900 million in the third quarter of 2019. Interest generated on these loans increased by 24 percent from $12 million to $16 million in the same time period.
Through increased competition, consumer demand and technological innovation, variable interest rates on cryptocurrency loans have the potential to converge. As a fundamental valuation metric in the traditional financial markets, industrywide interest rates would be game-changing for the cryptocurrency industry.
Interest rates present a wide audience of investors unfamiliar with crypto with a compelling and straightforward metric to evaluate the digital asset class. In addition, interest rates would also encourage the movement of idle capital away from personal storage into use for generating more market activity.