How Do Crypto Interest Payments Work?
I use at least one crypto lending application that takes crypto deposits and then pays interest in the same cryptocurrency deposited — for example, I deposit bitcoin and I earn interest paid in bitcoin. Some platforms pay between 6–8% interest in crypto. So I asked myself, how do these platforms manage to pay interest in crypto, particularly at such high rates?
After a fair amount of digging through the FAQs of a few of these interest-paying platforms, such as BlockFi and Nexo, the best answer I can come up with is that these platforms lend customer deposits to other users and to third parties, in the hope of making returns greater than the interest they have promised on deposits.
Ok, that is what banks generally do. Much of banking is about borrowing deposits from customers at, say, 3% and then lending the money out at 6%. But with non-crypto banks paying annual interest rates on U.S. dollar savings of less than 1%, it is pretty clear that crypto lending platforms have to significantly outperform their dollar-lending counterparts. That almost certainly means that they need to take more risks in their lending, i.e. of loan non-performance. They address this by overcollateralization when lending to platform users — so far so, good. But what of the risks when lending to third parties? It does not appear that these loans are necessarily overcollateralized in the same manner. In some cases, the “loans” are really investments in third party products. There appear to be somewhat significant risks in these third-party transactions.
And there is not just the risk of these platforms losing money on their third-party transactions and thereby being unable to meet their interest obligations (much less return of principle), there is also the volatility risk presented by their agreements to pay interest in crypto to their depositors. Their loan portfolios must require very skillful management to hedge against the risk of bitcoin gaining say 12% in a month, which would cause the cost of returning crypto interest to depositors to skyrocket.
Given all of this, it will be interesting to see if the crypto lending platforms can avoid blow-up. Here is a video from Blockfi on risk management, which discusses some of these issues.
