Sound Money

Traditional investors are confounded by the yields available in crypto. We earn next to nothing on traditional dollars but earn 5%+ on crypto dollars. I can imagine traditional investors look in from the outside and think “this is too good to be true!”, “Those bright shiny lights in the distance are going to blow up in their faces!” In reality those bright shiny lights are slowly sucking traditional finance (or trad-fi as I like to call it) into crypto. You need to pause and take notice! There is a different structure between yield determination in traditional financial markets vs. crypto and there are various strong explanations for crypto yields. TLDR: Bitcoin’s incredible investment opportunity trickles out into numerous sources of yield, enticing new pools of capital into the space.

Conclusions

• Unprecedented opportunity in digitally scarce assets drives yield differential
• Crypto investors pay higher yields for scarce capital - How much would you pay for 100% returns annually?
• Traditional capital charges premium to crypto - of course a premium exists!
• Stablecoins are more useful than trad-fi USDs, warranting higher returns
• Volatility is a major risks but is mitigated through collateralisation
• Counterparty and protocol risks are a more important risk vector than trad-fi
• Yields will narrow when the opportunity is exhausted - in my opinion - 5 years+

This month’s note is a follow-up on last month’s note “Stablecoins - bitcoin’s pandora’s box”.

If you would like to read the August review of market conditions, follow this link.

Before we get into the reasons for crypto yields, let us contrast centralized vs decentralized money.

Central banking creates an interest rate focal point

Fiat currencies are centrally controlled by central banks and their commercial banking network. Central banks use a myriad of interest rates to manage money supply and achieve their monetary policy goals. Each central bank tends to have a benchmark policy rate from which all other interest rates are determined.

For example, the spread between 10-year US Treasury yield and the Fed Fund Rate (FFR) fluctuates but participants certainly use the FFR as the foundation. A clear relationship exists historically.

Bitcoin interest rates are free market determined

In contrast to centralized finance, Bitcoin is a decentralized monetary network with no central control. Decentralization does not imply chaos, however. Quite the opposite. Supply is capped at 21 million and supply growth diminishes in a pre-determined fashion every 4 years. There is no centralized entity managing supply through various interest rate mechanisms and there is no benchmark policy rate from which other participants determine their respective interest rates.

The lack of a centralized interest rate does not imply there are no interest rates though. Interest rates are merely determined in a free market setting. Borrowers and lenders determine funding rates in each transaction or class of transactions. Yields can therefore be more variable and circumstantial, but they certainly do exist.

So, where do these yields come from?

1) Unprecedented opportunity drives return potential

There are numerous sources of yield within the crypto markets, but the most important driver is the opportunity set itself. Bitcoin is a technological revolution comparable to the steam engine, the printing press or the spinning wheel. Stateless, decentralized, sound money has profound potential to change the world in ways that we cannot yet imagine. So, it should come as no surprise that bitcoin offers incredible returns.

With >100% annualized returns over the past 12 years, bitcoin is already the fastest asset class to $1tn in history. I expect bitcoin and the digital asset ecosystem to advance from this foundation. Returns primarily accrue to the holders of the protocol (like bitcoin and ether) but not to protocol holders alone. There are spillover opportunities, which create numerous investment categories.

2) Crypto investors are willing to pay for scarce capital

Crypto investors want access to capital to benefit from on the opportunity set and are willing to pay elevated rates to access it. Think about it like this, if you have a reasonably high probability of 100% annualized returns, how much would you be willing to pay to fund that opportunity?

Higher than zero – that is for sure.

For as long as the return potential remains as high as it is, I expect yields to remain elevated.

As a specific example, the annualised yield between the 3-month bitcoin future and spot averaged 8.7% between September 2019 and March 2021. There have been times when people have paid 25% for funds. Obviously, this is a little crazy and suggests that bitcoin was frothy at that stage, but that just makes my earlier point that yields are variable and circumstantial. The average rate of 8.7% is real and cannot be scoffed at!

3) Traditional capital charges crypto premium

Despite the opportunity in crypto, traditional capital is unwilling to fund crypto at the rates they would offer to traditional investors. Traditional investors’ reticence to invest in crypto is proof of this. So, there is scarcity of funding within crypto markets relative to demand and relative to traditional financial markets, which is another driver of the yield differential.

4) Stablecoins are more useful than traditional USDs

With crypto, demand for native crypto funding (like stablecoins) is stronger than traditional financial market funding because clearance and transfer are quicker than crypto assets. For example, it takes 1-3 days for ZAR/USD to transfer from a bank account into an exchanges bank account and for the capital to be available on the order book. These are not a constraint with crypto native USD tokens (stablecoins), which settle and clear instantly.

Read more about stablecoins in last months note.

Volatility mitigated through collateralization

Volatility obviously poses a risk to lenders because it could raise borrower default rates. But these are mitigated against through fully collateralized loans. I.E. if an investor is borrowing USD to invest into bitcoin, then bitcoin sits as collateral in the transaction. If the value of the collateral falls below a certain level, the position is liquidated. Since bitcoin is highly liquid in all currencies, the lender can instantly receive the underlying, ensuring exceptionally low probability of loan default. So, while volatility is large and borrowers do get margins calls, default is mitigated in lender-borrower arrangements because of fully collateralized loans.

Counterparty and protocol risks become bigger factors

Do not let my confidence mislead you - there are still big risks in the crypto lending markets!

Most borrowing and lending is facilitated by centralized institutions which function as intermediaries between borrowers and lenders. Borrowers and lenders need confidence that counterparty risk is minimized through choosing high quality intermediaries. Crypto intermediaries are not back-stopped in the same way as banks who have FDIC insurance and central bank support during any market stress so we should not discount the counterparty risk.

Lending also takes place through protocols rather than intermediaries. I.E. Developers create software to facilitate the matching of borrowers and lenders, the liquidation levels, and transfers of capital. In these examples, borrowers and lenders are exposed to protocol risk rather than counterparty risk. Investors obviously need to assess the relative risks/benefits of the protocol vs. counterparty to assess their desired execution platform.

When considering crypto yields, the counterparty/protocol is probably the biggest risk to digest. Investors need to dwell on questions like, “Does a counterparty enforce full collateralization to all borrowers or are some institutional clients given special treatment and what risk does this imply for lenders?” and “Who wrote the code for the protocol and how long as it been running without any hiccups?”

Crypto yields are not without their risks, but they are higher than traditional yields for a reason. Bitcoin and the digital asset ecosystem presents one of the biggest investment opportunities in history. The returns are bleeding out into various corners of the market in the form of yield. Counterparty and protocol risks are a much bigger consideration than traditional markets because there’s no central bank back-stop in crypto. So you need to keep your wits about you! I expect the yields between traditional markets and crypto will narrow over time. But I think they will remain elevated for at least 5 years as they suck large swathes of capital into crypto markets - the only true free markets in town.