Earning passive interest
What you'll learn
- The basic principle of fractional banking & passive interest
- The crypto version of passive interest & use of native tokens
- How interest rates reflect risk;
- The difference between Cefi & Defi
Cryptocurrency has come a long way in just over a decade. As Bitcoin continues to fulfil its promise as an effective store of value, its brand recognition broadens.
Whether they understand its value proposition, most people are aware of Bitcoin as something you can buy and trade, speculating that it will increase in value. Less well-known is the fact that Bitcoin and other cryptocurrencies now offer passive interest-bearing opportunities - similar to regular banking - for those users who simply want to hold the crypto-assets but derive additional benefit.
Passive Crypto Interest vs Fractional Banking
Anyone who has ever opened a traditional savings account, obtained a mortgage or acquired a loan should be familiar with the basic concept of interest.
If you deposit savings a bank will pay you interest; the interest rate offered increases the longer you are prepared to leave your savings untouched.
If you want to borrow money, a bank will lend it to you, but you’ll have to pay it back plus interest; the level of interest will depend on whether you secure the loan against an asset (like a house) and your credit history.
In both cases interest rates are relative to a base rate, set by a central bank, which manipulates the rate in order to either promote or reduce economic activity. For this reason, interest rates are often described as the price of money.
Where things get really interesting is realising that the central bank allows private banks to lend out far more money than they hold on deposit. This is what is known as fractional banking.
Not satisfied with making a profit from charging more interest on loans than deposits banks engage in far more complex investments, with a huge amount of risk with money they don’t actually hold on deposit.
The 2008 financial crisis saw that whole system come tumbling down, at which point banks were bailed out, and because of the impact on the wider economy, interest rates plunged to try to stimulate activity.
In that context it is no surprise that banks are distrusted. They crushed the economy, were bailed out and in return, savers get terrible returns on their money. Opening an account or applying for a loan are still complex procedures, requiring a lot of personal information and approval.
The emergence of the crypto-equivalent of traditional banking products shouldn’t come as a surprise, after all, crypto is rebuilding the financial system in a fairer, more transparent way.
How to earn passive income in crypto
The crypto industry features many products - also referred to as protocols - that, like banks, are both interest-bearing (loans) and interest-paying (savings).
There is an increasing choice of passive crypto earning opportunity, but it would be incorrect to suggest that crypto earning protocols are identical to their counterparts in traditional finance.
Crypto is an attempt to fix the inherent problems of fractional banking, and it is important to understand the practical implications.
Cefi vs Defi
As mentioned above, traditional banking is centralised, with the central bank determining interest rates, and private banks following all kinds of rules that related central authorities create around things like money laundering and fraud.
Crypto banking offers two approaches which differ in the degree to which they are centralised.
CEFI or Centralised Finance - Offers savings and loans for cryptocurrencies, but within a traditional centralised framework, offering customer service within a recognised business structure. Cefi is passive, in that you don’t have to make decisions on a day-to-day basis.
DEFI or Decentralised Finance - Offers a broader and more flexible range of financial products for cryptocurrencies, in a totally decentralised way via protocols not people. The protocols are managed by smart contract, so all interaction is essentially dictated by code and they crucially require active user management.
Clearly Defi is much riskier than Cefi, but to compensate the potential rewards can be greater. As this article is focused on passive opportunities to earn interest, that is where the focus will be. A later article explains how to earn via Defi.
The big difference in earning interest on crypto is that there is no central bank setting rates which instead reflect the demand for borrowing coins as well as the desire for CEFI providers to attract new customers.
This is really important to consider when thinking about earning passive crypto income because CEFI rates might change with too many depositors chasing interest and not enough demand for borrowing or simply because a provider decides to be more conservative in its acquisition of customers.
CEFI rates might change with too many depositors chasing interest and not enough demand for borrowing or simply because a provider decides to be more conservative in its acquisition of customers.
CEFI & the Concept of Staking
All crypto-earning CEFI products require users to “stake” their digital assets in order to earn interest.
This shouldn't be confused with "staking" as the method used to run some cryptocurrency networks using the Proof-of-Stake mechanism, rather, this refers to a financial concept.
Staking is the equivalent of depositing, it comes in two forms, Soft Staking and Hard Staking, each with different strings attached weighed up against associated benefits.
Soft Staking - Funds can be withdrawn at any time, with compounding interest paid daily in the asset staked or a token specific to the provider. You can generally switch between the two options at any time.
Hard Staking - Funds are locked for a set period, with the interest rate proportionate to the timeframe. The longer you stake, the more interest you’ll earn on your initial investment. Interest is compounded and paid daily in the asset or a token specific to the provider, which can be withdrawn.
Hard Staking often gives preferential access to other services, such as discounted purchase of crypto, reduced trading fees or access to a pre-paid card with cash-back on purchases in crypto.
Hard Staking providers are essentially exploiting an arbitrage between the returns available from staking directly with a Proof of Stake cryptocurrency that needs validators, and the rate they offer their customers.
Choosing between Hard vs Soft Staking
The choice between Hard or Soft Staking comes down to the trade-off between the flexibility of access of Soft Staking vs much the higher rates but constraints of a lock-up period.
If you opt for Hard Staking and the asset you have staked appreciates over the lock-up period, you win twice - higher interest plus the increase in value.
If you choose to be paid interest in the token specific to the provider (refer to the next section on native tokens), and that also appreciates in value, you’re winning on three fronts, but trebling your overall risk.
If the markets start to tumble during the lock-in period, you have no choice but to watch your deposit fall in value, not just because of the depreciating value of your deposit, but the depreciating value of the specific provider token you're earning interest in. You can withdraw the interest accrued and exchange that, albeit for a declining return but are otherwise powerless.
In general, all cryptocurrencies will fall in value in a market slump, and will all rise during a rally, closely conforming to the performance of major cryptocurrencies like Bitcoin and Ether. The less mature the asset, the more vulnerable it is to volatility -- younger cryptocurrencies tend to rise much faster than Bitcoin in a rally, for example. On the other hand, if Bitcoin falls, they are likely to lose value quicker.
Soft Staking allows you to pull out your funds and convert them into cryptocurrencies that will retain value during a bear market, for instance, stablecoins.
Getting Paid In A Native Token
Getting paid in a token specific to the provider has its own set of trade-offs. Interest rates are higher if you get paid in a native crypto token because the providers are trying to incentivise its use.
Native tokens are however volatile. Indeed, the relative illiquidity of such tokens - difficulty of selling them - make them more unpredictable than the likes of Bitcoin and Ethereum. By choosing to be paid interest in a native token you are speculating that their price will increase, which is no different to speculating on any cryptocurrency:
- What is its value proposition?
- Will the user base grow?
- Will the provider change its model? Is it competitive?
- Is the provider secure from attack?
Top crypto earning rates & providers
One of the biggest attractions of crypto’s yield-bearing products is that they offer higher interest rates than banks. On the face of it, this sounds like great news but remember interest rates are the price of money, or put another way, the rates reflect risk.
There is price volatility; even the most liquid cryptocurrencies (Bitcoin, Ethereum) can fall by 10 or 15% in a matter of hours. So the interest rates reflect this, which is why it is higher for Hard Staking
In part compensating for the risk of it falling in value before your fixed-term staking period ends.
You can mitigate the volatility by simply staking Stablecoins (we explain what a Stablecoin is here). The interest rates of synthetic versions of USD or EUR are much higher than official fiat versions but again this reflects risk.
Cefi providers can charge high interest rates on Stablecoin deposits in part because there is strong demand to borrow, which is in turn influenced by opportunities in the wider crypto economy.
The rates also reflect a risk that the Stablecoin may fail, remember though they sound like their fiat equivalents - USDT, USDC, TGBP - they are not backed by the Federal Reserve or Bank of England, so you’ll need to trust the protocol behind them to retain a stable value.
The risks include regulatory concerns which have been underlined by active lawsuits in 2021 against Blockfi and Celsius - on a state by state basis - who argue that crypto lending products are securities, and the SEC warning Coinbase that they would sue if they launched a new Lend product.
Having explained how passive interest works, we can look at a snapshot of some of the most popular platforms currently available and the rates available.
Centralised earning platforms
Crypto.com is a user-friendly platform that offers some of the best rates in the industry. An assortment of crypto tokens are supported, with interest paid weekly in the staked asset. Annualized rates of 1.5%, 3% and 4.5% are offered on cryptos locked on a flexible, one-month, or three-month basis, while supported stablecoins offer respective rates of 6%, 8% and 10%. Earning crypto interest is even more profitable when users stake the platform’s native CRO token.
One of the world’s leading digital asset exchanges, Binance offers a suite of yield-bearing financial products with attractive interest rates. APY varies depending on the risk profile of the product, with Flexible Savings accounts ranging from 1.2% (BTC) to 6.5% (1INCH) and Locked Savings on stablecoins offering 7% over a 90-day staking period.
With a BlockFi Interest Account, users can earn up to 9.3% APY (on USDT), with interest accruing daily and paid on a monthly basis. The platform also offers 8.6% on GUSD, PAX, and USDC, 5.25% on ETH, and 6% on BTC. Interestingly, users get to decide which cryptocurrency they want to receive their interest payments in: bitcoin, ether or stablecoin.
Fronted by an outspoken CEO in Alex Mashinsky, Celsius offer crypto loans and interest but differentiate themselves by ploughing returns back to their community. They recently raised more investment capital which valued the platform at over $3bn, having distributed $250million in interest to users. You can earn interest on a wide range of coins including up to 13.3% on Tether, 6.2% on Bitcoin and 6.35% on Ethereum.
- Follow this link for instructions on how to open a CEFI account for earning passive crypto interest
- Follow this link for instructions on how to get started with DEFI
Decentralized earning platforms
Compound is an algorithmic, autonomous protocol backed by Coinbase. The difference is that interest rates are “floating,” meaning they fluctuate constantly according to supply and demand. A range of tokens are supported including ETH, DAI, UNI, BAT and WBTC, with the best APY at present 9.8% for USDC.
dYdX supports many of the same assets as Compound and offers interest rates as high as 11.31% (USDC). Because there is no lock-up period, interest is paid continuously, with users able to close their position and withdraw funds whenever they like. Interest also continuously compounds, meaning if the value of your stake increases, you’ll earn interest on that sum rather than the value of the principal.
Aave is a defi lending protocol that provides passive crypto earning opportunities galore. Both stable and variable interest rates are available, and users can also stake the native token (AAVE) to earn protocol fees and rewards on top. Depositors also earn a share of the fees from flash loans offered on the platform.
How to choose the most reliable earning platform
With so much choice, it can be difficult to make up your mind about which protocol to use. Like anything, it is a matter of weighing up the risk and having a clear goal in mind.
Naturally, the least risky options are the more established platforms that insure customer funds. Generally speaking, this means centralized entities like Coinbase and Binance. Emerging platforms offering super-high APYs – particularly decentralized platforms that entail smart contract risk – should be approached with caution.
You may be wondering about the difference between centralized and decentralized options. Centralized platforms are operated by custodians who govern their own systems and set interest rates. Decentralized platforms, on the other hand, are operationalized by smart contracts that automate the distribution of loans and interest rate payments according to market forces. There is no executive board to speak of.
While defi lending protocols offer more attractive rates, they entail greater risk due to the potential for there to be an underlying bug in the smart contract. If something goes wrong and you lose your funds, there’s no recourse or means of protest.
Nonetheless, many people looking to earn interest on their crypto appreciate the transparent, non-custodial nature of defi, as compared to the invasive KYC processes mandated by centralized alternatives. Moreover, decentralized platforms allow users to maintain control of their own private keys.
To learn more about the best crypto staking sites, you can read this Learn Crypto article that lists out and compares six popular places to stake your crypto to earn passive interest.
To summarise, then, passive crypto earning opportunities allow users to benefit from locking up their digital assets. Due to the volatility of cryptocurrencies, fixed staking periods, and floating interest rates (in defi), there is an element risk – but also reward. As such, it’s imperative to do your research and compare and contrast the rates and risks entailed by each platform. It also pays to stay abreast of the regulatory rules around crypto lending practices, which are ever-evolving.