In this review, we evaluate the mechanisms behind the decentralized finance protocols for generating stable, passive income. Currently, some savings interest rates can be as high as 20% annually, payable in traditional currency values such as US dollars. Therefore, one can benefit from the growth of the cryptocurrency markets, with minimal exposure to their volatility risks. We aim to explain the rationale behind these savings products in simple terms. The key here is that asset deposits in cryptocurrency ecosystems are of intrinsic economic value, as they facilitate network consensus mechanisms and automated marketplaces. Therefore, savings in cryptocurrency are associated with some unique advantages unavailable in traditional financial systems. We will go through the implementations of how savings can be channeled into the staking deposits in Proof-of-Stake (PoS) protocols, through fixed-rate lending protocols, and staking derivative tokens. We will discuss potential pitfalls, assess how these protocols may behave in market cycles, as well as suggest areas for further research and development. We end by discussing the notion of decentralized basic income – analogous to universal basic income but guaranteed by financial products on blockchains instead of public policies.
Hakwan Lau (Center for Brain Science, Riken Institute, Japan) and @Stephen Tse (Harmony.ONE)
Published on 29 Jul 2021 https://arxiv.org/abs/2107.14312
As of year 2021, the interest rates for savings in traditional ‘fiat’ currencies such as the US dollar and the Japanese yen are at historic lows, at around 0.07% and 0.01% respectively 1. Because of the large national debts held by these major economies, some may anticipate that interest rates may remain relatively low for the near future. At low interest rates, the traditionally lauded act of regular household savings becomes less rewarding. This may have a particularly strong impact on aging populations which rely on saved money as pension income, for the long-term sustenance of quality of life after retirement 2.
Meanwhile, during the pandemic triggered by COVID-19, major governments have printed large amounts of money to support their economic stimulation efforts 3. This has led some to worry that inflation, i.e. the rising of nominal prices of goods, will eventually become inevitable. Although modern economists have disputed the basis of this worry 4–6, historically this has been the consequences of excessive increases in circulating currency, such as in the cases of Germany in 1923 7 and Argentina in 1989 8. To many, these dramatic cases likely reinforces the pessimistic narrative about inflation as a source of potential concern. As of 2021 May, the US inflation rate for consumer goods was reported to be 5% for the past annual period, considerably higher than anticipated 9.
These may be some of the reasons why, somewhat paradoxically, despite the obviously negative economic impact of COVID-19, stocks and real estate prices have generally gone up since March 2020 10,11. As investors lose confidence in the future value of savings in fiat currencies, they look for options that would give higher expected returns. Accordingly, the cryptocurrency market has also flourished during this time 12–14.
However, this puts the common household savers into an unfavorable position. To the socio-economic groups who may have the most need to hedge against possible inflation, fixed-term saving and government bonds have historically been the major go-to options for the steady accumulation of wealth. To the average saver, the stock market may seem like a rather complex and potentially risky place. While real estate may be perceived as a relatively stable asset, the threshold for investment entry is higher. Above all, cryptocurrency remains very far from a mainstream investment option. Importantly, the perceived risk is in fact supported by the evidently high volatility of the market.
But what if one can benefit from the staggering growth of the cryptocurrency market without ever ‘investing’ into it? That is, what if one can sidestep the financial risks directly associated with the acknowledged volatility of the market, and yet generate stable income via interest rates on the order of several hundred times higher (i.e. 20% annual rate) than what the current traditional financial market can offer? What if this can happen even when the market is contracting instead of growing, at least to some extent?
This possibility is obviously of strategic concern for those who are already invested into cryptocurrency technology, who see mass adoption as a desirable and necessary next step for the development of the industry. But more importantly, there is also a moral **argument behind this consideration, even for the technologically uninitiated. Given the current economic context, the widening gap between the rich and the poor may increasingly turn into a gap between savvy investors and traditional savers. The former group can afford taking higher risks due to larger initial capital, while the latter may lack the means and the know-how to truly benefit from anything other than the anemic fiat saving rates.
Fortunately, certain existing cryptocurrency protocols may be able to help us bridge this gap. To anticipate, the general rationale behind is simple: in many modern blockchain systems the integrity of the ledger is supported by the Proof-of-Stake (PoS) consensus mechanism 15,16, rather than the Proof of Work (PoW) protocol used in e.g. Bitcoin. This means that to validate a transaction, one does not need to dedicate an excessive amount of energy and computational power to solve a cryptographic puzzle, to ‘mine’ a coin. Instead, in PoS networks, a validator needs to show that one holds a sufficient amount of the currency (i.e. stake) within the system such that it would be against one’s interest to act maliciously. By lending money to validators, one is allowing them to qualify to do their jobs. This process, sometimes called ‘staking’, means that putting money down for a fixed term can be of intrinsic economic value, as staking is key to the financial efficiency, security, and guaranteed integrity of the blockchain bookkeeping system. As long as a PoS ecosystem is able to derive utility and value with decentralized finance applications, e.g. for trading, there will be demand for staking. As such, savers can be rewarded in a sustainable way, as they support the generation of financial services and products provided by the PoS network - not entirely unlike why bankers and corporate lawyers are paid good salaries in the traditional financial system, even during downturns.
Besides the existence of PoS blockchain systems, the protocols for the generation of stable interest assumes the availability of several instruments and decentralized finance (DeFi) products 17. The most basic of these include stable currencies (sometimes called stable coins) pegged to real-world fiat currencies. Examples include Tether (USDT) 18, MakerDAO’s DAI 19, Binance’s BUSD 20, Terra’s UST 21. These are all pegged to the US dollar. There are also stablecoins for other currencies, such as Korean won 22, British pound 23, etc . The different mechanisms for how the peg is achieved have been reviewed elsewhere 24,25. One interesting fact is that they do not necessarily have to be backed by real-world fiat assets. Some are backed by other cryptocurrencies, yet others maintain their value by algorithmically adjusting the supply. Accordingly, they come with varying degrees of absolute stability. Nevertheless, overall, for the major stablecoins including the ones mentioned above, the stabilization mechanisms have been shown to be generally effective over the past couple of years, withstanding considerable market volatility. Also, insurance options are now available to mitigate the risks of unpegging 26,27.
Stablecoins are important for our purposes; for the stable interest rates to be meaningful to the typical household savers, both the savings and the interest have to be in terms of everyday currencies. With them, one can already earn savings interest without exposing oneself directly to the volatility of the cryptocurrency market. Protocols like COMPOUND 28, Maker 19, and AAVE 29 allow loans to be provided to borrowers who put down cryptocurrencies as collateral. Savers can deposit money into these protocols to form a pool for the loans. Because borrowers have to pay interest on their loans, part of that translates into the interest to be paid back to the savers in return. These interest rates are determined by market mechanisms 30, reflecting the expected values of future assets.
In part due to the semi-anonymized nature of financial engagement with cryptocurrency, with few exceptions 31, long-term loans tend to be overcollateralized, meaning that one has to put down a higher amount of ‘collateral’ in order to borrow. This overcollateralization ratio is typically up to 150% to 200%, meaning that for every $1 borrowed one has to put down as collateralization something worth up to $1.5 or $2. This way, if a borrower defaults, the lender would be protected. Also, the collateral itself is typically in a cryptocurrency that fluctuates in price. Should the worth of the collateral diminishes so that the expected overcollateralization ratio cannot be maintained, the lender can seize the collateral (in accordance with prior agreement) and sell it immediately to avoid a loss. With overcollateralization, even slippage during a flash crash should not lead to a loss on the lender’s part. If the process of liquidation is achieved more efficiently and quickly, some lenders can even afford to offer a lower overcollateralization rate e.g. at just 110% 32. Accordingly, ‘bad debt’ as we traditionally understand it does not really occur as such in decentralized finance. Given the nature of contracts in advanced blockchain systems (known as Smart Contracts 33,34), theoretically they are completely binding and frictionless to execute.
In terms of economic incentives, some borrowers may be willing to put down collateral because they expect the value of them to go up in the future. So they do not want to sell the collateral at the current price. And yet, while ‘holding’ the cryptocurrency for the longer term, if the asset is deposited as collateral, the loan gives them instant liquidity, which may allow them to reinvest further into the market via leverage. This is part of the reason why they are willing to pay for the loan interest. In this sense, at least part of the savings interest ultimately comes from the expected growth of the cryptocurrency market, even though the savers do not have to partake into the market speculation directly in order to enjoy the interest as income.
However, as of the time of writing, the interest rate for borrowing and lending tends not to exceed 10% annual rate 35. This is already far higher than current fiat interest rates. In fact, this is on par with, or just outperforms in some cases, most other major forms of low-risk investments, like national bonds, pension accounts, etc. And if one is to be paid back in stablecoins, the risks involved are likewise relatively small. However, one caveat is that it is unclear if borrowers would be willing to pay high interest during a bear market. Importantly, as we will discuss below, it may also be possible to generate stable interests at as high as 20% annual rate, by capitalizing on other sources of revenue besides anticipated market growth.
One other issue in treating lending interest as stable income is that until recently, in decentralized finance, borrowing and lending interest rates tended to fluctuate flexibly according to market conditions. However, fixed-rate lending protocols are now available 36. The key idea here is that we can trade the value of a loan on the market. That is, if a token is to give its holder the right to be paid $100, as a settlement of a loan, at a certain future date, then the token itself could be traded at a certain price. Assuming one generally prefers money right now over money in the future, one could probably only be willing to buy this token at a discount. How deep that discount is, in turn, should depend on when the loan matures. For loans that are to be settled further in the future, buyers may be willing to buy such a token only at a deeper discount. That is to say, the interest for longer-term loans should be higher. By setting up automated markets for these tokens 37, one can work out the general interest rates for loans for different durations - what is sometimes called a yield curve 38. This curve is not entirely fixed in the long run. But it can allow relatively stable predictions to be made within a certain timeframe.