Why DeFi Savings May Offer Higher Returns Than Traditional Banks

Table of Links

Abstract and 1. Introduction

2. Stablecoins and Lending Markets
3. Fixed-Rate Lending Protocols and Derivatives
4. Staking Derivatives
5. Staking Fees as Stable Interest
6. Stabilization Mechanisms
7. Some Caveats
8. Diversification, Interest Rates Swaps, and Tranching
9. Towards Universal Basic Income
10. Closing Remarks
11. Acknowledgements and References

Abstract

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.

1 Background

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, 5, 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, 13, 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.