How Centralized Crypto Lenders Obtain High Yields for Customers
Centralized crypto lenders tend to mimic traditional banks with their lending approach but with a lot more generosity towards clients.
Key Takeaways
- Crypto lenders are applying known strategies from TradFi (Traditional Finance) to obtain attractive yields and low fees for their customers.
- High yields come with the potential cost of increased regulatory scrutiny, smart contract vulnerabilities, and systemic financial risk.
- Phemex applies a high level of due diligence, risk management and fintech experience to ensure high returns for their clients.
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How is it possible that centralized crypto lenders offer double-digit APYs for depositing stablecoins, while (inflation eroded) dollars are yielding pennies sitting in a traditional bank savings account?
Crypto Products are Helping Provide Value that Banks are no Longer Offering
Sounds too good to be true or even scammy. Users of crypto lending platforms should ask themselves, where does their crypto go? How can these companies offer such high returns? And where does the risk stand?
We first have to understand how banks operate to pay interest on savers’ balances.
Simply put, banks lend out the money sitting in depositor’s accounts and charge more interest than they pay to clients. Banks use the funds deposited to lend to borrowers, who pay interest on their loans. After paying for various costs, the banks pay interest to depositors.
The difference between the low rate that banks pay and the high rate earned is “the spread” (or the bank’s “margin.”).With this business model, banks have conditioned their clients to earn low returns on their money and play a zero-sum game.
On the other hand, although centralized crypto lenders mimic bank accounts with their business methodology, they follow a more generous approach.
Crypto lenders use clients’ coins transferred to the platform to engage in yield generating activities and pay generous rewards. The main difference between banks and centralized exchanges is the amount of value that goes back to the community.
Generally, crypto lenders can lend out 100% of clients’ collateral money while clients can only borrow 25% of its value. This overcollateralization lets them charge low rates on large loans to pay high rates on small deposits.
In traditional finance, they call this practice rehypothecation. It means that banks or brokers use clients’ collateral to generate additional yields. In exchange, users can enjoy lower borrowing costs or fee rebates.
It is important to note that users mainly take loans from crypto lenders to delay capital gains tax or cover a short-term cash need. As previously mentioned, loans are only offered at 25% LTV (loan-to-value). This means that to borrow $2000, you must put up $8000 in collateral. This way, the exchange ensures that the loan is 100% safe on their end, and there is no risk of the borrower defaulting.
However, if a customer takes out a loan using crypto as collateral, they will no longer earn yield (the lender no longer has to pay interest on the $8000 collateral, and can lend it out further to generate yield, at an industry average of 10-20% APY).
While the exact investments that crypto lending platforms use to offer high yields on deposits are not clear. Some lenders disclose investing clients’ holdings in equities and futures to generate yield.
To the present date, we haven’t seen a notorious example of an institutional crypto lending failure. If we ever experienced such a scenario of loan default, that could bring cascading failures throughout the crypto industry. That’s why regulators often talk about the systemic financial risk that crypto poses.
This partial lack of transparency has caught the attention of regulators. In the U.S. some agencies like the SEC have even tagged these products as securities by applying the Howey Test.
Alternatively, crypto lenders can also tap into DeFi systems to earn the money they pay out to their customers. Through smart contracts, they can set up liquidity pools to facilitate loan origination, engage in yield farming or take advantage of arbitrage opportunities which all help them earn fees.
Due to smart contract risk, firms that engage with DeFi protocols have to thoroughly scrutinize their activity. This is the exact approach that Phemex follows.
Phemex’s Earn Crypto assets are held in special crypto savings accounts that are continuously monitored. Transactions require a meticulous approval process and regular audits by a third party to ensure crypto interest payouts, even if Phemex has to sometimes cover a loss due to underperformance.
Phemex’s trading systems employ a sophisticated combination of risk management, algorithmic calculation, and quantitative analysis techniques.
To learn more about how you can get up to 11% with Phemex’s Earn Crypto accounts, visit: https://phemex.com/earn-crypto
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