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Where do Decentralised Finance (DeFi) yields come from?

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Published on 19.11.2021
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"5% What's the catch?"

The most common skepticism newcomers have when being introduced to decentralised finance (DeFi) is how can the rates be so high. Especially so when compared to what everyone is used to getting from their banks. A common response runs along the lines of “My bank rate is less than 1%, but here I get more than 5%? What's the catch?”

The good news is that skepticism is healthy.  We should know what we’re getting ourselves into before investing our money. This article will help shed light on how a 5% annual yield is sustainable with evolving systems of finance.

Before we carry on let’s go back to the basics of where interest rates come from in the first place. And let's begin with the question “Are 1% interest rates the acceptable to begin with?".

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Let's get back to banking basics

When you deposit money into a bank, your interest rate is what the bank's “payment” for allowing them to keep your money for you. Sounds great, right? However, what is happening is that banks business model is to make money by giving loans to individual for high value purchases – Cars, houses, starting a business, and other such initiatives. 

When a Bank loans you money, they charge an interest rate on that loan to make a profit for taking the risk of loaning out the money. Interest rates are usually set by a central bank in each country which determines what the rate should be given the current economic climate. A bank then will assess your risk and add an additional interest rate on top of that as an “insurance” premium, to protect their risk.

The capital used to loan out the money comes from everyone’s deposits. As you can imagine, with 100,000s of people’s deposits in a bank, there is a huge pool of capital to loan the money out to borrowers. Because Banks use your capital for loans, they pay you an interest rate of X% and charge the borrower X% + Y%, where Y% is kept by the Bank.

In the end everyone wins, right? Not exactly, mostly the bank wins. 

What about the Y%?

In traditional banking, banks take your money and loan it to others. That itself is not what’s wrong with the picture. The problem that we have here is that banks serve as a very expensive middleman.

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Due to the nature of how traditional banking is set up, there are a lot of checks and balances along the way. This begins from setting up an account, through to taking out a loan. Because of this bureaucratic system, the banks must take a large spread (difference between the rates, this is basically the Y% we mentioned earlier.), in order to cover their costs and make a profit.  

In a previous article we explained what Smart Contracts are and how they have revolutionized Decentralised Finance (DeFi).

Smart Contracts, in Summary:

Smart contracts make possible features like automatic interest payments on assets like bonds, loans, deposits, or allow for the transfer of financial assets without costly legal fees. This significantly lowers the barriers of entry to more users and increases participation in the financial markets.

It’s with this whole concept we have far more capital efficiency and matching depositors and loaners has never been easier.

In decentralised finance the middle man is a piece of code (a smart contract), so almost the entire interest rate charged to the borrower goes back to the lender. 

Related: What is DeFi, and how is it different from Bitcoin and Ethereum.

See this in action - real world examples

Let’s look at some rates with local banks.

DBS offers 0.05% interest on their deposits for a basic account.

For a car loan, DBS is starting at 2.78 %

We can see here the spread that DBS is making is 2.73%! 

Decentralised finance allows the user to make nearly the full, fair market interest rate on the loan, in a programmable and most importantly safe way.

Back to 5%?

Like any other financial market, price is driven by supply and demand. Because decentralised finance is governed by robust and thoroughly audited smart contracts, the interest rates are set by the market.

There is no central authority which determines the rates in decentralised finance. 

With the Cambrian explosion in the past 18 months of adoption of crypto and specifically stablecoins, the amount of borrowing has increased to where regular crypto users are very comfortable to pay 5% or more for borrowing stable coins.

Without middlemen, when your funds are deposited into a decentralised finance protocol, almost 100% of the interest charged to the borrow comes back to you, and in real time.

This is sounds more like a win-win situation.

Related: What are stable coins? Bitcoin vs stable coins and more.

Who is doing all this borrowing?

As highlighted before, it’s more intuitive why people borrow money in traditional markets.

In fact, most of us at some point have either taken a loan or is planning on taking a loan to buy a high value item.

In crypto markets, there is always demand for borrowing from traders for short term bets, market makers to cover their trades and even institutional investors. This does not mean your money is being gambled with.

Remember, with the innovation and enforceability of smart contracts, rules are set so borrowers are limited in how much they can borrow and have to put up collateral to borrow against (similar to how you get a loan against a house).

Because of these robust rules, the depositors funds are safe despite what the end user does with them, without a middleman enforcer.

Short term traders

Traders often borrow money known as flash loans, where they will borrow money for a quick trade which executes in seconds and the funds are returned for a high premium. They do this because they have spotted an inefficiency in the market somewhere (known as arbitrage) and want to take advantage of it but borrow capital and return it in the same trade, something unique to smart contract infrastructure. 

Market Makers

Traders often borrow money known as flash loans, where they will borrow money for a quick trade which executes in seconds and Market makers are essentially like brokers who need to help make trades on behalf of their clients and would sometimes need to borrow to ensure their trades even out and they are not taking any risk. 

Institutional Investors

Lastly, sometimes people don’t want to sell a certain asset because they believe it will go up over the long term, so they will deposit the asset and take a loan against them to keep their portfolio liquid to make other trades or get further exposure to the asset.

Usually borrowing is for very advanced financial traders and users, and again, because of smart contracts and how they can create robust rule sets to maintain safety of the system, anyone is able lend their money to these protocols to take advantage of the higher interest rates.  

It’s important to emphasize that DeZy only works with stablecoins, so there is no direct exposure to other volatile crypto assets such as Bitcoin and Ethereum. What are stablecoins? And how are they different from Bitcoin and other cryptocurrencies?

Parting thoughts

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Let’s go back to the initial question, “Are 1% interest rates the acceptable rate to begin with?” 

What are your thoughts now of a 5% yield vs 1%? Tell us on facebook, or discord.

It’s important to remember that decentralised finance (DeFi) is a cutting-edge innovation, and sometimes we get caught in our biases of the past and it stops us from accepting what could be in the future. This phenomena happens to all of us when new technology comes out, remember, the internet was once thought to be a fad only. Don't get left behind.


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Disclaimer:

Decentralised finance is an emerging field with fluid regulations. Learn more about the risks involved.


About the Author

Dhruv Sahgal is a crypto investor, advisor and NFT collector. Sahgal is passionate to see the wider adoption of blockchain. technology. Connect with him on Twitter, or LinkedIn.

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    Disclaimers:
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