How Can Cryptocurrency Accounts Pay Such High Interest?

As noted last week, I am happily receiving 9% interest in my new crypto account at BlockFi. How can they do that? The short answer is that BlockFi lends out my holdings to other parties, who pay somewhat more than 9% interest to BlockFi. This model is common to essentially all of the crypto brokers who pay out interest, but I will focus on BlockFi because (a) I have skin in the game there, and (b) they have been fairly transparent about their operations.

On the simplest level, this operates like a plain bank savings account does. A bank takes in funds from depositors, and (to oversimplify) lends those funds out to borrowers. The bank then pays to its depositors a portion of the interest it receives from its borrowers. Up until the last few years, this bank savings account model worked pretty well;  a depositor might receive something like 2-3% interest on a savings account or certificate of deposit. More recently, short term rates have been near zero, so depositors get almost nothing in a bank savings account.

As noted earlier, BlockFi pays up to 4.5% interest on Bitcoin and 5% on Ethereum. These are leading, high volume coins that are widely used in decentralized finance (defi). Here is how BlockFi describes the parties to which it lends (mainly) Bitcoin:

Who Borrows Crypto?

BlockFi works with institutional counterparties for trading and lending cryptocurrency. These counterparties look to us to help them provide liquidity for their businesses. But who are some of these borrowers?

( 1 ) Traders and investment funds who see a fragmented marketplace and discover arbitrage trading opportunities. Arbitrageurs need to borrow crypto in order to close mispricing between exchanges or dispersed markets. Similarly, margin traders need to borrow in order to execute their trading strategies. This is a simple example, but it demonstrates how arbitrage and margin trading activities facilitate price discovery, which is an essential component of developed markets.

( 2 ) Over the counter (OTC) market makers make money by connecting buyers and sellers who do not want to transact over public exchanges. OTC desks need to keep inventory on-hand to meet their client demand. Owning crypto outright is capital intensive and comes with the attendant risks of price fluctuations. Instead, they may prefer to borrow inventory in order to facilitate transactions. Liquidity is another essential component to healthy markets.

( 3 ) Businesses that require an inventory of crypto to provide liquidity to clients. This bucket includes companies like crypto ATMs. These businesses also need to be able to support withdrawals while keeping the vast majority of their crypto assets in cold storage. The liquidity we provide them helps with these basic and important functions.

A key piece of this lending is to require that the counterparty post adequate collateral for the loans. This is somewhat similar to a bank lending you money to buy a house, with the house as collateral for your loan. If you lose your job and cannot pay back the loan, the bank has the right to sell your house to recovery its money. Similarly, BlockFi wants to ensure that if something goes sour with their loan of your Bitcoin, they can get their funds back and make your account whole. Obviously, BlockFi customers like me are relying on BlockFi to manage this properly and to minimize lending losses. BlockFi goes on to reassure us:

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Earning Steady 9% Interest in My New Crypto Account

One reason for opening an account where you can purchase cryptocurrencies is to speculate on their price movements. There have been many cases where some coin has quadrupled in a few weeks, or gone up ten-fold in a few months, or even a hundred-fold within a year.

Another facet of crypto accounts is that in some cases you are paid interest on the coin you have purchased and hold in your account. That was the main draw for me. I already have a little Bitcoin and Ethereum exposure in my brokerage account through the funds GBTC and ETHE, enough to feel the thrill of victory and the agony of defeat when they go up, up, up and down, down, down, but I am not a big speculator at heart. So, I am drawn to the so-called “stablecoins”, whose value is tied to some major regular currency such as the U.S. dollar. It turns out that you can get high, steady interest payments on those stablecoins.

There are several crypto brokers which pay interest on coins. Some names include BlockFi, Celsius, Nexo, and Voyager Digital. Several such firms are reviewed here.  Initially I leaned towards Voyager, since it gives access to lots of the new, little alt-coins where you can 10X your money if you pick the right ones and jump in early. However, I still do my own taxes, and the tax reporting from Voyager looked daunting. Last I looked, they just provide a dump of all your transactions in a giant table, and it’s up to you to figure out capital gains/losses. The word on the street is that this is not as straightforward as it seems. Also, Voyager offered only mobile apps, not a desktop interface. All in all, Voyager seems more geared towards intense younger Robin Hood/Reddit crowd, punching daring trades into their phones at all hours.

BlockFi is quite staid by comparison. It only offers a few, mainstream coins. However, it is one of the best-established firms, and it provides a nice clear 1099 tax reporting form at the end of the year. BlockFi is backed by major institutional partners, and manages over $9 billion in assets.

Unlike some of its competitors, it is U.S.-based, and as such it is structured to function well in this jurisdiction. Also, its interest payouts are straightforward. In contrast, many of its competitors incentivize  you to receive your interest in special tokens issued by those companies, which adds another element of risk. Finally, BlockFi allows you to immediately transfer money in and out of your account by using a bank ACH link. I wanted that flexibility since I plan to keep a portion of my cash holdings in BlockFi instead of in the bank, but I want to be able to access those cash holdings on short notice and without penalty. (Last week I described some of my struggles over using the Plaid financial app which manages the bank-BlockFi interface, but I was able to get past that).

All in all, BlockFi is boring in a good way. All I want to do is make steady money, with minimal distraction. Here is a listing of the interest rates paid for holdings of Bitcoin and Ethereum:

BlockFi only pays significant interest for smaller holdings of these coins. (We will discuss the reason for this seemingly odd policy in a future blog post; it is basically an outcome of BlockFi’s conservative financial practices).

For Bitcoin, the interest rate is 4.5% for up to 0.10 BTC, which at today’s prices is about $4,700. After that, the interest plummets to 1%, and to a mere 0.10% for more than 0.35 BTC (about $16,000). There is a similar pattern for Ethereum. If your goal is to hold large amounts of these coins and earn substantial interest on them, there are probably better platforms than BlockFi.

However, the interest picture is brighter for the stablecoins. The biggest U.S.-based stablecoin is USD Coin (USDC), which is backed by significant institutions. Gemini Dollar (GUSD) is smaller, but also takes great pains to garner trust. Its issuer, Gemini, operates under the regulatory oversight of the New York State Department of Financial Services (NYDFS). It boasts, “The Gemini Dollar is fully backed at a one-to-one ratio with the U.S. dollar. The number of Gemini dollar tokens in circulation is equal to the number of U.S. dollars held at a bank in the United States, and the system is insured with pass-through FDIC deposit insurance as a preventative measure against money laundering, theft, and other illicit activities.” GUSD is the “native” currency within BlockFi, though users can easily exchange it for other coins. At this point I am holding just GUSD, though if I put in more funds, I would plan to partially diversify into USDC. Besides being much bigger, USDC now runs on multiple platforms, whereas GUSD is limited to Ethereum; if Ethereum finally does switch from proof-of-work to proof-of-stake, it may be more subject to outages or hacking, so it would be nice to not be totally dependent on Ethereum.

For these two stablecoins, BlockFi currently pays 9% interest on holdings up to $40,000, and a respectable 8% on larger holdings:

A complete list of BlockFi interest rates (which change from time to time) is here.

The alert reader may at this point object, “Hey, you are losing most of the purported benefits of blockchain cryptocurrencies – – without holding the coins in your own wallet, you don’t actually own them, so you are back dependent on The System. Moreover, those stablecoins are centrally managed, not deliberately decentralized like Bitcoin and Ethereum. You are treating this like a plain bank account!”

My reply is, “Yes, I am treating it like a plain bank account – – but an account that pays me 9% interest, with no drama.” That is exactly what I wanted.

Opening My New Crypto Account: Plaid App Wants My Full Bank Login Information

I finally got around to opening an account at BlockFi where I can buy cryptocurrencies directly. Later I will discuss why I chose BlockFi and what I plan to do there. For now I’d like to mention one roadblock I hit in starting it up.

Signing up for the BlockFi account itself was pretty straightforward. But when it came to actually funding it, I was required to use Plaid to handle transfers of funds to and from my bank accounts – – and Plaid wanted me to tell them my full username and password that I use to log into my bank account. “No,” I said to myself, “they can’t really mean that.” But yes, they do mean that.

Armed with these credentials Plaid is able to not only pull money out of my account (like, for instance, PayPal does), but they can also login as me and have access to every financial transaction I have ever done, every check I have ever written. It’s not that I have anything interesting to hide, but this level of privacy invasion creeps me out. Also, the sad truth is that any company, including Plaid and its partners, are vulnerable to hacking, so I am not thrilled at having my bank login information floating out there in cyberspace.

On their website, Plaid is nice enough to disclose the scope of its snooping:

We collect the following types of identifiers, commercial information, and other personal information from your financial product and service providers:

  • Account information, including financial institution name, account name, account type, account ownership, branch number, IBAN, BIC, account number, routing number, and sort code;
  • Information about an account balance, including current and available balance;
  • Information about credit accounts, including due dates, balances owed, payment amounts and dates, transaction history, credit limit, repayment status, and interest rate;
  • Information about loan accounts, including due dates, repayment status, balances, payment amounts and dates, interest rate, guarantor, loan type, payment plan, and terms;
  • Information about investment accounts, including transaction information, type of asset, identifying details about the asset, quantity, price, fees, and cost basis;
  • Identifiers and information about the account owner(s), including name, email address, phone number, date of birth, and address information;
  • Information about account transactions, including amount, date, payee, type, quantity, price, location, involved securities, and a description of the transaction; and
  • Professional information, including information about your employer, in limited cases where you’ve connected your payroll accounts or provided us with your pay stub information.

The data collected from your financial accounts includes information from all accounts (e.g., checking, savings, and credit card) accessible through a single set of account credentials.

Plaid promises not to sell or rent this personal data. Fine. But even if they don’t formally sell it, they may simply give it away widely. In their words:

We share your End User Information for a number of business purposes:

  • With the developer of the application you are using and as directed by that developer (such as with another third party if directed by you);
  • To enforce any contract with you;
  • With our data processors and other service providers, partners, or contractors in connection with the services they perform for us or developers;
  • With your connected financial institution(s) to help establish or maintain a connection you’ve chosen to make;
  • If we believe in good faith that disclosure is appropriate to comply with applicable law, regulation, or legal process (such as a court order or subpoena);
  • In connection with a change in ownership or control of all or a part of our business (such as a merger, acquisition, reorganization, or bankruptcy);
  • Between and among Plaid and our current and future parents, affiliates, subsidiaries and other companies under common control or ownership;
  • [etc., etc.]

Yeesh.

I’m sure Plaid means well, but I just didn’t like the sound of all that. So, I came up with a plan: I would start up a second account at my bank, with a slightly different name and a different account number, and just give Plaid access to that one account. The only thing I would do with that account is to fund my BlockFi account, so it would not have years and years of my other financial transactions embedded in it.

In the end, that worked, but it took a more time and phone calls than I expected. Opening the new account was a surprising pain, for reasons I won’t go into here. Then, it turns out that the bank doesn’t have a category for one person having two accounts with two different logins. There was nothing I could do about it online, so I had to talk to someone at the bank who had the power to limit my login authority to my new account. This meant that I now have to use my wife’s login to access my/our old account, which is OK. But it probably would have been cleaner simply to start my new account at some different (online) bank.

Anyway, just in time for the current crypto meltdown (Bitcoin is down more than 20% from its high a month ago), my account is active and funded. More on that in future installments.

China Cracks Down on Cryptocurrencies

The Chinese Communist Party (CCP) is all about control. In the well-known words of Chairman Mao:

Every Communist must grasp the truth, “Political power grows out of the barrel of a gun.” Our principle is that the Party commands the gun, and the gun must never be allowed to command the Party.

These days political power is linked to economic power and control of information, as well as raw military firepower. Cryptocurrencies have assumed financial importance and they entail information processing and tracking.

On the other hand, a key driver for cryptocurrencies is precisely to escape from the domination of big central authorities, such as the CCP. Proponents of crypto revel in the fact that anyone with a PC can get in on “mining” and that the crypto universe does indeed operate on the web as a largely democratized enterprise. Anybody can transact large sums with anybody, with a moderate degree of anonymity.

These two different visions of life collided on Sept. 28 when the Chinese government banned nearly all crypto-related transactions:

China’s central bank said on Friday that all cryptocurrency-related transactions are illegal in the country and they must be banned, citing concerns around national security and “safety of people’s assets.” The world’s most populated nation also said that foreign exchanges are banned from providing services to users in the country.

In a joint statement, 10 Chinese government agencies vowed to work closely to maintain a “high pressure” crackdown on trading of cryptocurrencies in the nation. The People’s Bank of China separately ordered internet, financial and payment companies from facilitating cryptocurrency trading on their platforms.

The central bank said cryptocurrencies, including Bitcoin and Tether, cannot be circulated in the market as they are not fiat currency. The surge in usage of cryptocurrencies has disrupted “economic and financial order,” and prompted a proliferation of “money laundering, illegal fund-raising, fraud, pyramid schemes and other illegal and criminal activities,” it said.

Offenders, the central bank warned, will be “investigated for criminal liability in accordance with the law.”

The Chinese government will “resolutely clamp down on virtual currency speculation, and related financial activities and misbehaviour in order to safeguard people’s properties and maintain economic, financial and social order,” the People’s Bank of China said in a statement.

Well, those are the bare facts. It’s good to know the CCP is so diligently safeguarding people’s assets and public order. And as noted, Mao’s successors would not naturally favor systems that allow people to just do what they want to do, free from guidance from the Party. But inquiring minds want to know or at least speculate further regarding the reasons for this move and its consequences.

Brian Liu and Raquel Leslie highlighted two other motivations for this crackdown. One motivation  concerns China’s desire to launch its own state-controlled digital currency. This will give the government heightened ability to track every single transaction by every single user. It would also provide China with a new means of exerting influence over other nations and corporations:

The ban comes as the People’s Bank of China (PBOC), China’s central bank, is piloting its own digital currency, the eCNY or “digital yuan.” Unlike private cryptocurrencies, the eCNY is issued directly by the central government and is being designed to provide the PBOC with near-real-time financial data on user transactions. Some observers fear that the eCNY will be used as a tool to strengthen the Chinese Communist Party’s domestic surveillance. Others worry that the eCNY will be used to retaliate against international companies that speak out on human rights issues. Fan Yifei, a deputy governor of the PBOC, announced last week that the eCNY has entered a “sprint stage” ahead of the February 2022 Winter Olympics in Beijing.

Another motivation may be to help prevent wealthy Chinese from taking their money abroad:

The crypto ban may also be intended to deter capital flight. Despite past crypto crackdowns and strict capital controls, wealthy Chinese have used cryptocurrencies to funnel more than $50 billion overseas in 2020. As China is in the middle of an economic slowdown that has been exacerbated by other regulatory crackdowns on the tech and education sectors, China may be redoubling its efforts to ward off skittish entrepreneurs from exporting their money overseas.

Will this crackdown fully succeed? Many observers doubt it. They think that people will find ways to do what they want to do, using platforms that are hosted outside China.

As for the digital yuan, well, it kind of goes against most of the reasons people have gravitated to crypto. It represents a move back to government control and surveillance. It is not really a “crypto” currency at all, but simply another form of regular money.  It could get traction, however, in international trade among countries who have reasons to try to escape from the current U.S. dollar dominance. Also, China could hand out its digital currency like candy to impoverished nations, to get them on board. Millions, maybe billions of people live without regular banking access, and so a medium of exchange and store of value that requires only a cell phone to move funds around town or around the world could be attractive. At any rate, count on China to make the digital yuan a big “thing” for international visitors due at the February 2022 Olympics.

The price of Bitcoin took this news in stride. It continues to bounce around in the same $40,000-$50,000 range that it has been in for the past three months. And being banned by China is not a death-knell for a financial entity.  Indeed, it could be a contrarian indicator. Consider that China has also banned Youtube, Facebook, Google, Instagram, Pinterest, and even (because of his uncanny resemblance to President Xi) Winnie the Pooh.

Cryptocurrencies 2. How Hashing Puts the Crypto in “Cryptocurrency”

There are several conceptual pieces that are put together to make the working Bitcoin digital currency. The data which defines Bitcoin transactions is stored in a data structure called a blockchain.  A key feature of blockchains involves cryptographic “hashing”. That is the focus of today’s post.

A hash function is any function that can be used to map initial data of arbitrary size to fixed-size values. The initial data may be called the key or the message.  The values returned by a hash function are called hash values, hash codes, digests, or simply “hashes”. A common use for hashing in the past has been to do large-scale data storage and retrieval more efficiently, as described in Wikipedia. That link also discusses how some actual hashing calculations are done.

Here we will focus on cryptographic applications of hashing. For this purpose, hash functions are chosen which are for all practical purposes one-way. It is straightforward to start with the “message” and compute the hash. But it is not feasible to start with the hash and back-calculate the initial message, even if you know the algorithm used for the hash function. Typically the only way to find the message is to run a brute-force search of all possible inputs until you find a match to the output hash.

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Cryptocurrencies, 1: What Exactly Is Bitcoin?

Everybody knows that Bitcoin is a “digital currency”. But what does that really mean, and what is Bitcoin really good for? Who developed it? Turns out, oddly, that we don’t actually know. Can you buy a pizza with it? Turns out that perhaps the most famous pizza purchase of all time was made with Bitcoin.

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