Digital Nugget: Generating income in the crypto market
The crypto market offers numerous opportunities to earn a yield. Some opportunities parallel the traditional markets (such as a market for borrowing and lending yields, or for yields resembling dividends), and some are unique to the crypto market. In this Digital Nugget, we summarise the various yield-generating strategies
Crypto interest rate market
There is an active and liquid crypto interest rate market where the rates are set by market forces. As market participants lend and borrow crypto assets, the rates are determined by supply and demand. Unlike fiat currencies, where interest rates are subject to political considerations, interest rates are never negative and represent an economic value for the lender.
The crypto lending market offers an attractive opportunity to investors looking for income. When lending stablecoins, there is no market risk relative to fiat currencies. When lending other cryptocurrencies, the crypto/fiat risk can be hedged, allowing the investor to earn income without market risk.
Currently crypto lending is fully collateralised or overcollateralised, and, in most cases, is backed by further safety reserves or insurance, reducing borrower credit risk to an extremely low level. The risks associated with crypto lending are primarily related to the technology.
There are two ways of accessing this market: one is from centralised entities that offer this service, and another is by providing liquidity to decentralised finance (DeFi) lending platforms.
Centralised finance (CeFi) entities such as Celsius or Nexo offer interest rates on crypto deposits based on the rates that they earn by lending those deposits out. The rates offered by CeFi lenders are more stable as they are set through a business decision by the company, while the rates earned on DeFi lending platforms such as Aave, Maker or Compound fluctuate constantly with demand.
CeFi lenders have typically offered higher rates; but as they do not offer the transparency of the decentralised finance platforms, there is a risk due to business practices or the stability of the company.
As DeFi platforms innovate (for example, to accept credit delegation, offer undercollateralised or uncollateralised loans or offer fixed rate products), holders of the project’s governance token make the decision with full transparency. Equally, governance token holders can decide on the fees and spreads the platform charges, and how much of this should go to liquidity providers versus the platform.
Users of DeFi platforms bear a risk from the quality of the smart contract code. Both CeFi and DeFi lending platforms have suffered hacks, however, to date the losses have most often been covered by the platforms. There are insurance products available to cover smart contract risk.
Other strategies related to crypto lending
Beyond simply providing liquidity to DeFi lending pools, it is possible to earn an income by contributing funds to certain protocols’ safety reserves that are used to cover bad debts. For example, the Aave protocol’s safety module pays some of the fees as well as additional incentives to those contributing. If there is a need for the safety module to cover a liquidity shortfall due to bad debts, 30 percent of the funds may be slashed.
Another lending strategy is providing fiat loans to crypto traders who trade on margin. These loans are also collateralised, but there is a small degree of credit risk if the price of the crypto collateral falls very rapidly, leaving the loan undercollateralised.
Crypto yields with market risk
Proof-of-stake blockchain protocols pay a staking yield to token holders for locking their tokens into the protocol’s validation module. The yield typically includes transaction fees plus newly minted tokens as an incentive. To earn the staking yield, the directional risk on the price of the underlying token (and, unless immediately sold, the earned tokens) has to be accepted. This is somewhat akin to earning a dividend yield on stocks.
Another market-risk-related strategy is providing liquidity to the trading pools on decentralised exchanges. Liquidity providers earn a yield by receiving a portion of the trading fees. They, however, take a risk on the price movements of the token in the market making pools they contribute to. This is called impermanent loss.
Other income generating strategies
Decentralised insurance is a fledgling DeFi subsector. As with DeFi lending and decentralised exchanges, those that contribute to the insurance cover pool earn a portion of the insurance premia charged. In return they carry risk on the amounts that the cover pool is required to pay out.
Mining proof-of-work blockchain protocols is another income generating strategy. This requires an investment in hardware and has a running cost to cover the energy requirements of the transaction validation process. Transaction fees and newly minted (“mined”) tokens generate income for miners. The risk is on the income relative to the investment and costs.
Projects, especially when they are early stage or when they face heated competition, occasionally offer additional tokens as incentives to liquidity providers. This increases the yield that liquidity providers earn and attracts more liquidity to the platform.
If the tokens received are immediately sold, there is no market risk involved. Such incentives are temporary to entice liquidity providers, therefore, targeting them is not a stable strategy on its own. It can, at times, be used to boost the yield earned from other strategies.
Crypto arbitrage is not exactly an income strategy, but it can be used to earn stable returns with very low risk. Arbitrage opportunities in the crypto market are richer and more lucrative than in the traditional markets, due to the early-stage nature and inefficiencies in the crypto market.
Funding arbitrage is the closest to other yield strategies as it is based on earning the implied funding rate on crypto futures or perpetual swaps, with the market risk fully hedged. The strategy can suffer mark-to-market losses at times.
Other types of arbitrage strategies can also be used to earn further income, such as cross-exchange arbitrage (taking advantage of a difference in prices for the same asset on different venues), triangular arbitrage (where the prices of three assets do not align exactly), or options arbitrage. None of these involve direct market risk, but options arbitrage, in particular, has a complex set of risks that need to be expertly managed.
The crypto market offers a rich set of opportunities for earning yields far in excess of what is available in the traditional markets. Some of the strategies are pure plays on the crypto interest rate market, carrying only technological risks and potential vulnerabilities relating to the platforms. Using yield funds that perform thorough due diligence on the quality of the protocols can mitigate this risk, as can various insurance products. Some of the income generating strategies involve additional risks, which can be hedged in some cases.
This document is purely for educational purposes and has been issued by Sygnum Group. It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a marketing communication. It does not constitute an offer or a recommendation to subscribe, purchase, sell or hold any security or financial instrument. It contains the opinions of Sygnum Group, as at the date of issue. These opinions and the information contained herein do not take into account an individual‘s specific circumstances, objectives, or needs. No representation is made that any investment or strategy is suitable or appropriate to individual circumstances or that any investment or strategy constitutes personalized investment advice to any investor. Therefore, you must verify the above and all other information provided in the document or otherwise review it with your external advisors. Some investment products and services, including custody, may be subject to legal restrictions or may not be available worldwide on an unrestricted basis. The information and analysis contained herein are based on sources considered as reliable. Sygnum Group uses its best efforts to ensure the timeliness, accuracy, and comprehensiveness of the information contained in this document. Nevertheless, all information indicated herein may change without notice.