Op-ed

The Paradox of Staking in Decentralized Finance

Crypto lending still promises a 5-10% yearly return. How is this possible?

Decentralized lending and staking are the most rapidly growing sectors of the booming DeFi ecosystem, and the latest trends in the crypto industry. Lending means users giving their crypto holdings via loans and receiving interest payments (usually in the same numeraire). Exclusive to the cryptocurrency world, staking implies users locking their cryptocurrency to receive rewards. 

Having started after the peak of the Bitcoin bubble, today this crypto debt mechanism is in full bloom. Just like bank deposits, it offers passive income, allowing anyone to post the asset and to collect interest. Most accounts offer very competitive interest rates, especially compared to the traditional banking system. At a time of rapid money printing, with negative interest rates becoming the new normal, DeFi lending and staking rates of 10%+ look like a great deal.

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Here comes the paradox. Usually, debt pays interest because it is invested in a concern that will generate actual returns. It makes money and repays the debt, including interest and the principal amount. Today the average interest rate in the real economy is close to zero for the simple reason that we are in the mother of all contractions, due to COVID-19. Yet, crypto lending still promises a 5-10% yearly return. How does this work? 

The price of a crypto asset is usually derived from the supply and demand in the exchanges. Cryptos have no endogenous cash flows, and as such holding the asset (as opposed to selling it), is the one thing that can push

Marc Fleury, Ph.D. Two Prime
Marc Fleury, Ph.D. Two Prime

the price up. The principle of HODLing is elevated to the status of a mantra in crypto for this reason. Everyone HODLs, all the time. That is why staking is such an integral part of the blockchain ecosystem: it is an incentive for people to hold the asset.

Here is the trick. On the face of it, this is an unbeatable deal. Who can resist this kind of return when the real market is not paying anything? It is a play taken from the classical markets: corporations take cheap debt which they use to buy their own equity. The debt drives equity. This cash for equity loop fuels the mother of all rallies. 

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We are essentially trying the same in crypto. Debt in BTC can be used to buy more crypto products, so the interest really serves to smooth the volatility of the underlying equity asset. Follow this math: a company pays out 8% interest a year for 5 years, that is 40%. If the asset you buy with it rallies 100% (BTC 20k within 5 years is probable – look at the recent spike in price), you can keep the difference. 

Of course, magic is the illusion, but the illusion only works until it does not. If the underlying asset performs above the rate of return of the loan then you are all good, on both sides (the equity and the debt). If not, you are in default. So basically, the debt carrier is carrying debt type returns for an equity-type risk. 

But hey, it is debt, even deposits! (“My bank account does not offer 5% on deposits” – well that is because the product you hold is not a deposit but a proxy play to more equity). 

The thing is, this staking DeFi approach inevitably will not work in many cases, since crypto, the primary asset bought with the proceeds, does not always go up. Just like debt in the public markets is repaid if the underlying equity is working above the real rate of return. It might, and then everyone is happy. If it does not, oh well, tough luck right? 

Or, is there another way for crypto than a bet on non-stop growth, which one may call naive and shortsighted? There is: blending features of asset-backing with a finite supply, as the new stable growth asset class is doing, is a much more effective way to HODL and grow wealth safely.

 

Marc Fleury, Ph.D., CEO Two Prime

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