Crypto lending as an alternative to a savings account

One common advice for personal finance is to alway keep 3 to 6 months of salary in a savings account for an emergency. This money has to be liquid and not tied to any investment like stocks, crypto or even a GIC. Just a good old fashioned savings account with enough money in it. The problem is that in the age of money printing interest rates for savings accounts in Canada and the US (and I suspect many advanced economies) are near zero while inflation is picking up. Keeping money in a savings account is a losers game.

To put numbers into the problem, here in Canada the biggest private bank in the country, the Royal Bank of Canada or RBC, is offering an interest rate of 0.05% on their savings account while the Consumer Price Index (CPI) is right now 2.2% and expected to increase. Even if you shop around you won’t be able to find a savings account that gets you an interest rate anywhere near the CPI.

A solution to this problem is to exchange your Canadian or American dollars into a particular type of cryptocurrency called a “stablecoin” and instead of lending your money to a bank in the form of a savings account, you can lend your money to a DeFi (Decentralized Finance) service that in turns lend the collected pool of money to individuals at a higher rate. With this approach you will be able to create a highly liquid rainy day fund that will grow ~6% per year while avoiding the market fluctuations typical of the crypto world.

What is a stablecoin?

A stablecoin is a crypto currency whose value is pegged to the value of a FIAT currency (like the US dollar) at a 1 to 1 ratio. This means that, even though it is a cryptocurrency much like Bitcoin, it doesn’t suffer from volatility, its price is stable across time. Contrary to other cryptocurrencies, you don’t buy a stablecoin in the hope that it will increase in price over time, its main use lies in DeFi. Although in theory you can have a stablecoin for any FIAT currency, I’ll focus only on stablecoins pegged to the US dollar as they are by far the most popular and mature.

Stablecoins come in two flavours, centralized and decentralized.

A centralized stablecoin is a cryptocurrency that’s backed by cash (US dollars) somewhere (a bank, a vault, a bunker, under the mattress, etc.) and that money is managed by the institution that develops and maintains the stablecoin. If the supply of a stablecoin increases by 100,000 coins (in the form of crypto), the company that maintains the stablecoin should increase the amount held in cash by $100,000 USD. The key here is that you have to trust that this is in fact happening and that the stablecoin is backed by the same amount of cash. In the world of crypto having to “trust” something is considered a red flag (and for a good reason!).

The two most well known centralized stablecoins are USDC and USDT (also known as Tether). Even though USDT has a much bigger market capitalization ($55 billions) than USDC ($14 billions), USDT has been surrounded by rumours and legal problems related to their backing of the asset in hard cash. USDC seems to be faring better with regulators and thus considered a safer asset at least in my opinion. Both stablecoins are available as ERC20 tokens on the Ethereum blockchain.

The most well known decentralized stablecoin and the only one worth mentioning at this point is DAI. DAI relies on an Ethereum smart contract, over collateralization and economics to maintain its peg to the US dollar without the need of being backed by hard cash. To explain how this is possible would require its own article but the solution is elegant and secure as it removes the need for trust as in the case of USDC and USDT. Unfortunately its market capitalization is still “low” ($4.5 billions) and it’s not yet integrated into many exchanges or wallets. Its time will come I’m sure but it’s not today.

Based on this analysis, USDC is right now our best bet to create our rainy day fund with a higher return than putting cash in a regular savings account.

Crypto lending

In a nutshell the idea is to lend your crypto to a platform that in turns lend money to individuals. This platform pays you an interest rate for providing liquidity while charging lenders a higher interest rate to make a profit. This lending can be done in a centralized or a decentralized way.

Centralized systems often offer higher returns but at a higher risk as you have to trust that the company who will take control of your crypto will not lose it to hackers (or just steal it). Remember, these institutions are not yet regulated so if you lose your money you don’t have any government agency to go to for support. For this reason I’ll be focusing only on decentralized alternatives that although offer lower returns, they are much more secure as the whole process is automated and transparent to all parties thanks to smart contracts.

If you have ever lent your money to a friend or a family member you know the risks associated with giving your money away. People might be late paying you back or simply unable to pay you what’s owed. Fortunately this type of lending is more similar to a bank providing you a second mortgage than to lending money to a friend. Lending in DeFi is over collateralized with crypto.

Overcollateralization

If you own property you can go to the bank and ask for a loan using your property as a guarantee. This means that, in case that you are unable to pay back, the bank will simply take ownership of the property, sell it and get back the money they lent you. From the bank’s perspective is a safe business. DeFi lending works in a similar way but instead of using a property as a guarantee it uses crypto. An example might help illustrate the point better.

Suppose that you own a certain amount of crypto that at today’s market value is worth around $40,000. There’s a business opportunity that you want to take advantage of but it might require $20,000 of investment. Sadly you don’t have that money in your bank but you do have valuable crypto. You could sell half of your crypto holdings and get the money for the investment. The problem is that if the crypto market keeps getting hotter and prices continue to rise, by the time you are able to recover the initial investment from the business those $20,000 might only get you a fraction of the amount you sold in the first place.

What you can do instead, is to go to a DeFi lending platform like Compound and get a loan for $20,000 in USDC. Once having the stablecoin you can go to any crypto exchange and get the needed $20,000 USD in your bank account (we are not counting fees yet as to not over complicate the example). To qualify for the loan you will have to cede control of part of your crypto holdings to the platform as a collateral. This is similar to the example of getting a loan from the bank by putting one of your properties on the line. If you are unable to pay the loan back, the platform will sell your crypto used as collateral in the open market and get the money that’s owed.

Because the value of crypto is much more volatile than the value of a property, the amount of crypto you have to put on the line has to be bigger than the amount of USDC you want to loan. That’s called overcollateralization. Let’s say that your lending platform requires a 150% overcollateralization for a loan. This means that, if you want to get $20,000 worth of USDC, you might need to put as a collateral $30,000 worth of Ether for example. Once you pay back the $20,000 USDC loan plus interest, you will be able to get back the same amount of Ether you put down as a collateral. If the value of Ether drops and is now equivalent to let’s say, 120% of the loan, the DeFi protocol will either ask you to add more Ether as collateral or outright sell your Ether to recover the value of the loan while charging you a penalty fee. This way the house never loses and neither do you as a provider of liquidity.

The mechanics

The figure shown below outlines the steps to create a rainy day fund, with a higher yield than a savings account, by lending crypto using a hardware wallet (for extra security) and the DeFi protocol Compound.

In this example we want to create a rainy day fund of $10,000 USD. Because we want to use a stablecoin to reduce volatility the first step is to fund your Crypto Exchange account with that amount of money. Once the funds are in the exchange we can proceed to buy the equivalent amount of USDC that are nothing more than ERC20 tokens in the Ethereum blockchain. This means that the crypto now lives in an Ethereum wallet inside the Exchange (this is known as a hot wallet).

Step 3 is all about increasing security and for that purpose we will move the USDC tokens out of the hot wallet and into a hardware wallet (also known as cold wallet). Hardware wallets like Ledger are much more secure and offer a native integration with some lending protocols to simplify the process.

In step 4 we will send our stablecoins to Compound in exchange for cTokens (step 5). cTokens act like a receipt of how much money we provided to the lending platform that we can use in the future to withdraw the funds. Finally, with this new injection of liquidity someone else can borrow the USDC by providing their crypto as collateral. As of today, USDC in Compound will earn you an annual return on investment close to 7%. You can check the latest exchange rate as well as a comparison with other crypto lending platforms here.

It’s important to note that we can withdraw the money at any time and that interests are paid daily. Withdrawing the money requires executing the steps in reverse order until we have the money (plus the earned interest) back to our bank account.

Conclusion

DeFi offers new alternatives to money management that are able to beat the rates of traditional markets in a secure way while avoiding the volatility typical of crypto currencies. By using this method you can have the equivalent of a savings account that will yield around 6% per year, a much better prospect than a regular savings account. 

Before you dive in, a word of advice. The fees on Ethereum are getting very expensive and to do the process outlined above will require 3 Ethereum transactions. As of today, each transaction in Ethereum has a cost of $30 USD, so the whole process will cost almost $100. Keep an eye on the cost per transaction going here and only do this process with a significant amount of money to dilute the transaction costs at least in percentage to make it worthwhile.