Digital Nugget: January 2021
Investing for growth or income - crypto wins on both counts
Investors have been attracted to crypto assets for the high upside potential and the tremendous growth opportunity of the new technology. But while zero and negative interest rates have become commonplace for deposits in most major fiat currencies, cryptocurrency holdings can increasingly be structured to offer a yield in addition to the exposure to growth.
As the debt based economic model is fracturing and central banks seek to provide fuel by keeping interest rates artificially low, cryptocurrencies are increasingly evolving to apportion real economic benefits to holders also in the form of yield.
Income (in addition to gains from price increases) may be earned on digital asset holdings in the following ways: 1/ staking, 2/ liquidity provision, 3/ lending, 4/ profit sharing tokens.
Staking for income involves committing tokens to validators on proof-of-stake chains, for which a fee is paid to the token holder.
Liquidity provision involves locking up tokens to provide capital reserves to decentralised exchanges/automated market makers in return for a share of transaction fees and/or receiving tokens.
Lending platforms share the interest earned on loans with the tokenholder, and may also offer other rewards such as distributing governance tokens.
Profit sharing tokens send income from revenue generating applications to tokenholders.
Although holders of digital assets can engage in the above activities directly, this requires time, effort and expertise, so various services are offered that aim to help maximise token holders’ income – such as staking-as-a-service or staking pools such as Rocket Pool, yield farming or liquidity mining such as Curve or Uniswap, lending pools such as Compound, as well as attaching income to crypto banking and investment products. Some of the yield generating methods carry a risk of loss, others do not.
Income from staking and revenue sharing can only ever be positive. Lending may involve losses in theory but in practice this risk is very small as loans tend to be fully collateralised or even overcollateralised. Liquidity pools carry a risk of loss if the price of the assets traded moves adversely in a significant way – the risk depends on the correlation between the assets in the pool, and in some cases the risk is very small (eg stablecoin only pools).
There is also a risk of hacks and bugs in the code used to execute the income generating activity – for mature projects this risk can be negligible, but smart contract risk can be an issue especially in the case of younger, smaller DeFi projects.
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