It is not just the outlandish returns that some bitcoiners are bragging about these days. There is also the yield.

At a time when interest rates on conventional bank deposits are pinned to the floor — often below 0.5% — financial technology companies are offering to pay owners of bitcoin and other cryptocurrencies annual percentage yields of 2%-6% and sometimes more. You can deposit your coins with a few taps on one of their smartphone apps.

What’s the catch? There are several, actually. In addition to the risk you are already taking in owning crypto, the earnings are paid in cryptocurrencies, too. Token prices could easily fall in value as sharply as they have risen in the past year, wiping out whatever yield advantage you are getting, if you are comparing it to what you could have made investing dollars. And you are essentially lending companies your crypto without many of the protections that come with a bank account, such as coverage from the Federal Deposit Insurance Corporation (FDIC).

Some of the companies hawking yield accounts have websites that look more than a little like an online bank’s. Crypto lender Nexo uses the tagline “Banking on Crypto” and touts the $375m of insurance it carries on custodial assets. What that policy covers, however, is not like FDIC insurance, which protects savers from losses. On a separate page on its site, Nexo says the insurance is in place to protect users against “commercial crime” which includes “physical and/or cybersecurity breach, and/or employee theft,” not losses that may be incurred from its lending activities.

Shadow banking system

Yields are part of a surprising turn in the crypto market. Bitcoin and its descendants, such as dogecoin, ethereum, and countless other tokens, are often seen as a way to avoid the established financial system. Some “hodlers” (crypto slang for long-term holders) are wary of yield accounts because they would have to entrust the service with their private keys, the alphanumeric strings that grant control of a digital asset. But alongside that world has sprung up a complex, interconnected market that looks a lot like a wilder version of Wall Street — complete with financial derivatives, arbitrage, borrowing, and a panoply of middlemen. Some have called it a shadow banking system for crypto.

At the lower end of yields is the 2.05% being paid on bitcoin by Gemini Earn. The product is part of the Gemini crypto exchange, founded by the billionaire twins Tyler and Cameron Winklevoss. Deposits made into an Earn account leave Gemini and go to another company called Genesis, which in turn lends to institutional and high net worth clients. These clients may want to borrow cryptocurrency for financial trades.

For example, a trader might want to short a cryptocurrency, or bet that its value will drop. One way to do this is to borrow it, then sell it, and pocket the difference if the price falls. But borrowing for big speculative shorts on bitcoin is comparatively rare these days. Another reason to borrow bitcoin could be to construct an arbitrage trade that takes advantage of discrepancies in market prices. Some crypto-based businesses and exchanges also borrow bitcoin for liquidity, such as to quickly make a payment in crypto or settle a trade.

But all of that is happening behind the scenes. Customers depositing their crypto with Gemini Earn ultimately have to trust that Genesis is doing a good job vetting its borrowers and controlling its risk — and that it is maintaining a strong enough balance sheet of its own to pay back Gemini Earn customers even if some bets go wrong. “At the end of the day, if anything would go wrong on the borrower side, that risk is on Genesis,” says Roshun Patel, vice-president for lending at Genesis. “Since inception to date, we haven’t had a single default or capital loss.” Still, as with other crypto yield providers, the frequently asked questions section of Gemini Earn’s website notes that accounts are not insured by the FDIC.

BlockFi, perhaps the most visible nonbank ­cryptocurrency firm, offers 5% on a deposit of up to half a bitcoin and 2% on additional deposits above that amount and up to 20 bitcoins. It too mostly depends on lending to pay its depositors, says CEO and co-founder Zac Prince in an e-mail. Prince says the firm also engages in its own trading.

After the 2008 financial crisis, US legislators were concerned enough about banks doing their own trading that they restricted the practice with the  Volcker Rule. BlockFi is neither a bank nor subject to such regulations, but that rule points to the fact that trading can be risky. Prince says the company’s activities can be better described as “market making”.

In addition to borrowing and lending, BlockFi runs platforms for trading cryptocurrency. “For example, when a retail or institutional client trades with BlockFi, they are facing BlockFi directly for the trade, and we are not matching the order before confirming it for our client,” Prince says. So BlockFi can potentially make or lose money if prices change after the trade. But Prince says the company is not trying to make bets on the direction of prices. “Everything we do at BlockFi is sized and managed relative to all risk considerations,” he says, adding that the firm has “maintained a perfect track record in high bitcoin volatility environments” and that the “vast majority” of BlockFi’s loans are ­overcollateralised — meaning they’re backed by assets worth more than the loan.

Staking yields

Coinbase, the largest cryptocurrency exchange in the US, does not offer a yield product for bitcoin. It does offer staking yields of up to 6% for some less well-known cryptocurrencies. Staking yields are another kind of beast altogether, with no close parallel in the rest of finance. In a stake-based cryptocurrency, owners can allow some of their tokens to be used in the process that verifies transactions. Those who do can earn a reward. Coinbase does the staking and passes the rewards onto customers. If that is all a bit baffling, the thing to focus on is the key risk trade-off: to earn a fat yield, you have to bet on a crypto you might not otherwise be interested in, with a future at least as uncertain as bitcoin’s.

Antoni Trenchev, co-founder and managing partner of Nexo, echoes many crypto enthusiasts in dismissing the safety of banks. “When you have a traditional bank deposit the standard deposit insurance amount is up to $250,000 in the US and up to €100,000 in the EU, and from there on you are on your own,” Trenchev wrote in an e-mail to Bloomberg.

“That feeling of security that deposits are safe and insured above these amounts at traditional banks is largely rooted in the perception that banks are solid, trustworthy institutions.” Trenchev said that Nexo can be trusted because its loans are overcollateralised.

Yet many dedicated bitcoiners remain sceptical of crypto yield accounts in general. Dan Held, a longtime bitcoin investor, writes a monthly report on the state of the bitcoin yield market. Held says he deposits a small percentage of his bitcoin holdings into interest-bearing accounts, but that he advises his readers to be cautious. “Never risk your whole stack, and don’t risk what you can’t lose,” he says. “These are private companies with no federal backing.”

Some apps offer even higher yields if you accept payment in the company’s own custom token. Held says he avoids these. “There is no reason why you need a token as it introduces regulatory and structural risk,” he wrote in his March yield report.

For a sense of what can go wrong, consider the case of cryptocurrency lender Cred. It filed for bankruptcy in November after an executive was alleged to have misappropriated at least 225 bitcoins. Because of stories such as that, Brandon Quittem, head of user acquisition at Swan Bitcoin, an application that automates regular purchases of bitcoin, urges hodlers to forgo seeking interest.

“The historical precedent is custodians blow up,” said Quittem. A custodian is anyone who holds your crypto instead of you. “Bitcoiners have a bit of PTSD [post-traumatic stress disorder] around custodians, but to be fair we’ve come a long way on the exchange and custodial front.”

To Quittem the idea of risking bitcoin, an asset that has had annualised growth of about 200% over a decade, for single-digit interest payments is one not worth taking. “Why would I take on additional risk to seek a yield?” he says. “I find the excitement around these products to be slightly misguided. I don’t think retail understands the risk here.”

Parker Lewis, head of business development at bitcoin financial-services company Unchained Capital, cautions against lending out more than a small percentage of one’s holdings and says half of Unchained’s clients indicate that they would never lend their bitcoin. (The company is working on its own lending product that is meant to address concerns about custody and the transparency of risk.)

To fintech companies and institutional traders, bitcoin might be just another asset to borrow, lend, and bet with. For many bitcoiners, it is a precious asset that they firmly believe could take over the world. “If you do decide to lend bitcoin,” says Lewis, “you better be able to quantify the costs because you’re trading the greatest asymmetry that has ever existed for counterparty and credit risk.”

Bloomberg Businessweek. For more articles like this, please visit us at bloomberg.com



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