What Happens When Cryptocurrencies Earn Interest?

By  //  September 24, 2021

Share on Facebook Share on Twitter Share on LinkedIn Share on Delicious Digg This Stumble This

Bank deposits and stock trading are not suitable for everyone, and there are many more ways to make money on money. Even cryptocurrencies are now used to earn interest. The DeFi (decentralized finance) systems allow holders to accumulate returns without intermediaries. This works like a Treasury bill. 

The idea was caught on incredibly quickly. Deposits in DeFi applications increased fourfold in six months, reaching $40 billion by late January 2021! This evolution of blockchain technology is poised to enter the mainstream. 

How It Works

The premise of a crypto interest account is simple. A few years ago, most holders profited from the surging value of their coins, so they did not care about small fluctuations. Then, with the advent of stablecoins like Terra, that calculation changed. These cryptocurrencies are designed to have a constant value. In 2020, their market grew by over 400%, which has created opportunities with lower risk. 

Today, investors may get compensation for owning cryptocurrencies even if they do not rise in value. This changes the entire narrative of this asset class, as its initial purpose was to be sold at a profit. DeFi protocols may soon be able to challenge their centralized counterparts while staying true to their nature. 

Yield Farming 

Passive returns in the digital realm are referred to as “yield farming”, and they are available on a number of landing platforms. One of them has been launched by Compound Labs. It lets users borrow and lend any cryptocurrencies on a short-term basis and with rates calculated by algorithms. This allows the equivalent of the carry trade in conventional finance when a trader borrows an asset with low interest to lend an asset bringing a higher return.

The second way to make a profit is by depositing stable coins to gain rewards. The benefits are twofold:

 members get the annual percentage yield, and 

 they may qualify for a subsidy in the form of a new token on top of the yield for the lender. 

On Compound, this is the COMP token, which confers governance rights. The more people use the protocol, the more valuable its native token is, and the more users are attracted to farming. This creates a positive growth loop.

Automated Market Makers 

DeFi systems are built on automated market makers (AMMs) that use algorithms to set prices depending on real-time supply and demand for every asset in circulation. This is very different from the market maker model offered by NYSE or NASDAQ. 

 The pricing is more simple, as only orders for immediate trades are accepted. 

 The system is more transparent, so its members have confidence in its pricing. 

 As the algorithms work continuously, this eliminates gaps — orders that cannot be fulfilled. 

While volatility is a concern for liquidity to providers, it is offset by collection fees. Such systems are yet another confirmation of DeFi’s potential to engage a wider audience. Decentralized systems can make crypto a financing option for every household.