Where Does Bitcoin Interest Come From?

Where bitcoin interest come from?

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In a world of high inflation, low-interest rates and falling wages, more people are forced further out of the risk curve. If you’re simply saving in cash or holding it in an interest-bearing bank account, you’ve probably noticed that it’s not getting you very far. While the nominal figure does increase year on year, the purchasing power of those currency units continues to decrease.

In an environment like this, it’s only natural to seek alternatives; for me, that alternative was bitcoin. Holding bitcoin in self-custody allows me to take control of my assets, and I enjoy the deflationary benefits of its number-go-up technology. The asset was created with the intention of de-risking yourself from the current state of credit-driven financial markets, but it seems very few have yet to grasp this concept and are suckered into risking their bitcoin in the market.

Instead of holding their own keys, many bitcoin owners would hold IOUs on exchanges or fintech companies, hoping to “get out” when the price is right, out of laziness, convenience, ignorance or greed. Greed is not a bad thing if you’re working hard to stack sats, but if it’s leading you to let go of signing rights for your bitcoin, then you’re going to end up having a pretty humbling experience in the future.

During the last five years, bitcoin interest accounts have become quite popular, with several centralised services willing to pay you a fee so they can grow their assets under management.

If you do some research via search engines or hit up social media looking for information on interest-earning opportunities, you’ll come up short. Most content will focus on where you can net interest by handing over your bitcoin, but very few, if any, will tell you where the interest is coming from and how it all works.

As someone who is planning to engage in a financial contract with an entity, don’t you owe it to yourself to learn about the inner workings of the system? If you provide your capital to a service provider, wouldn’t you like to know what they are doing to earn that money?

Leveraging the familiar

A bitcoin interest account is generally a fintech company or financial platform’s offering that lets you earn interest on the funds you’ve sent over into their custody. You agree to lend out bitcoin in exchange for interest.

This is similar to how savings accounts work at banks, or so many are led to believe. If you ask anyone who does have a “bitcoin interest account” or “bitcoin savings account” and ask them how it works. They’ll probably tell you that they don’t know or that You deposit money, then the “bank” lends it out and pays you back plus interest.

The agreement to pay interest should run in perpetuity, and you can end it at any time and generally take your money out and redeem those funds. It’s a familiar experience that retail has gotten used to via the banking system.

In the traditional banking system, interest is earned through banking fees facilitating transactions, interest rates set by the central bank, interbank lending, and banks’ ability to create credit in the form of home loans, car loans and credit cards and tack on an interest payment. As long as banks can continue to lend, they can continue to expand the money supply and provide account holders with interest.

But bitcoin doesn’t work like that; there is a fixed supply, there is a tiny credit market built on top of it, and there is a fee market for facilitating transactions, but it’s not owned by one entity but distributed. There is no central authority setting the interest rate policy, and it’s a floating rate made up to entice customer deposits.

If bitcoin doesn’t have the key components of interest creation, where does this “yield” come from and is it sustainable?

Where does the interest come from?

There are several ways these exchanges make money, and it’s not just fees from trading, deposits and withdrawals.

Market making

Centralised exchanges don’t only make markets and actively trade against their customers but also leverage these automated market makers (AMMs). We’ve seen plenty of reports that large liquidity providers for smart contract platforms are centralised exchanges.

Instead of losing out to trading fees outside their platform, they provide liquidity on these on-chain trading apps that rely on algorithms to determine prices based on the real-time supply and demand of each crypto asset in the market.

In many cases, these centralised exchanges even provide the oracle fees for these permissionless trading platforms too. Hence, it benefits them to participate in providing liquidity and capturing fees from trades.

Yield farming

The search for returns on cryptocurrency is called “yield farming” and takes shape on several new lending platforms. We’ve seen reports of several centralised exchanges taking customer deposits and locking them into these DEFI Ponzi scheme lending platforms, where users can now borrow and lend any cryptocurrency on a short-term basis at algorithmically determined rates.

Yield farming is a game of musical chairs; you’re putting your money in hoping to earn most of the subsided return by the creation of new inflation that was intended to bootstrap this market. You then sell that inflation to new users as the price appreciates in the early stages before the market becomes oversaturated with the coni.

Staking

This one might rub a few bitcoiners the wrong way, but since bitcoin doesn’t pay interest, some institutions would rather sell your bitcoin for a proof of stake coin instead. They can then stake the capital in that protocol with minimal effort and try to farm as much inflation into their coffers. As long as they can earn enough APY from the staking service and the price holds up as they sell that new inflation, they can keep repurchasing bitcoin to pay you your interest.

Arbitraging

There are thousands of bitcoin to fiat and altcoin pairs today, so there is always a market to exploit. The size of these opportunities varies and requires skill, speed, precision and capital to execute. Trading desks are constantly looking for market repricing, be that between exchanges, traditional markets, DEX markets or P2P markets.

Anywhere there is a price mismatch, where the exchange can buy low in one market and sell high in another before someone else does, is the name of the game.

Leverage trading

Even if the exchange you’re using doesn’t offer derivates products, they probably have an open agreement with platforms and trading firms that do. The exchange lends your funds to these platforms or trading desks for leverage trading. A market that is wildly profitable for the house as most traders lose money.

As traders blow up their accounts trading, a portion of funds can be funnelled back to you as an interest payment.

Subsidies

When these service launch, they need to attract customers to build up assets under management. To attract customer deposits, they need to pay out a yield even when business operations aren’t generating enough fees. Raised capital is then used to purchase bitcoin and funnel it towards customers as an early way of bootstrapping the demand for their product.

These subsidies are seen as a marketing and customer acquisition cost that will pay itself back over time once the company’s balance sheet is large enough to generate considerable fees through market operations.

Accounting tricks and credit creation

In some cases, if subsidies are still required, and the service cannot generate capital through traditional debt markets or equity sales, they could be forced to leverage their balance sheet. We’ve seen a couple of CEFI lenders go bust using this strategy.

They would create their own exchange token, make a market for it and then revalue their holdings based on the current trading value of the float. Even though there is no real demand for the asset and it’s held up by an artificially created market, the service provider then uses those tokens to borrow either from other institutions or even riskier from DEFI protocols.

That additional capital can then be used to repurchase bitcoin from the market and pay you interest.

The risk-reward mismatch

Each strategy mentioned above has its risks and depending on the combination used by an exchange, you don’t know if the 2-6% is fair compensation for the risk. You have no insight into what they are doing with your funds; you’re none the wiser.

Regardless of how glossy the website is, how wonderful the PR is, how prestigious the venture funding is and the team’s credentials, these fintech companies are operating in an unregulated space that is the wild west.

A space where customer deposits are not afforded the protections traditional banking systems provide and a space where you aren’t too big to fail.

No deposit insurance

Bitcoin interest accounts are not insured by any government or insurance company, so if a firm goes bankrupt, there’s no government guarantee or offsetting default insurance protection that you can get funds (including interest) back.

Default risk

What if a borrower can’t pay you back? A centralised exchange takes your money as an unsecured creditor and promises to pay you back with interest. If exchanges default on their loans, you won’t be the first to stake a claim on the remaining funds. Sure, you’ve provided funds they can use to trade, but the service has also likely raised debt through capital markets, and that debt will take priority over yours.

Only once the company debtors (debt the company has with other entities) are paid in full will the remaining funds can be divided up to unsecured creditors like the retail customer.

This might mean a partial repayment or, worse, no repayment.

Digital assets can lose value, and some can go extinct

There are more than 20 000 shitcoins, according to market research websites CoinMarketCap and CoinGecko, and it’s highly unlikely they’ll all go up in value over time. Most of them will die and take with them any remaining bitcoin liquidity. Altcoin markets are extremely thinly traded, and many have bitcoin trading pairs

If the firm you trust with your bitcoin trades an alt pair and gets cleaned out by another firm or large holder that dumps the made-up token and takes all the bitcoin on the buy side. One party will be sitting with a useless token worth nothing while the other managed to extract all the bitcoin on the order book.

If that bitcoin shortfall is large enough, the firm will have a mismatch in assets and liabilities and, in this case, could not meet redemptions if customers were to ask for their funds back. In a case like this, traditional banks can get bailed out; in the bitcoin market, there are no bailouts. If there are, they become increasingly expensive depending on the size of the balance sheet deficit and the current float and bitcoin trading price.

You can lose more than you make

Bitcoin interest accounts sound great, you get to hand over your bitcoin, sit on your arse and collect monthly payments while it works, and you can redeem the funds you’re in the driving seat, but what has happened in the past doesn’t translate to a fact that it will continue into the future.

Let’s say you’re handing over 1 Bitcoin and netting a premium 6% APR, which is on the high end of the bitcoin interest payment spectrum. Are you going to risk handing over your 1 BTC for an entire year for a payment of 0.06 BTC/6 million satoshis?

If the company goes bust within that year, you’re losing 16x what you could have earned in that time. Does that risk-reward match up to you? Most retail investors who hold bitcoin interest accounts don’t tend to sweep the interest payments into cold storage and would rather compound it, only increasing your exposure.

In a case like this, when losses occur, they are far greater.

Short-term gains might turn into long-term pain

I realise it can be tempting to consider handing over your bitcoin to net an interest payment; that dopamine hit of seeing additional satoshis hit your account each month is an intoxicating feeling, but you need to consider the long-term pay here.

Yes, you could earn more sats in the short term, but if you cannot redeem or only partially redeem your deposit in the long term, you risk losing out on massive price appreciation.

Do you have an interest in earning interest?

So do you lend out your bitcoin or not? Why do you do it? How do you size your allocation and risk? Let us know in the comments down below.

Disclaimer: This article should not be taken as, and is not intended to provide any investment advice. It is for educational and entertainment purposes only. As of the time posting, the writers may or may not have holdings in some of the coins or tokens they cover. Please conduct your own thorough research before investing in any cryptocurrency, as all investments contain risk. All opinions expressed in these articles are my own and are in no way a reflection of the opinions of The Bitcoin Manual

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