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.

UPDATE MARCH 2022 – – BLOCKFI INTEREST ACCOUNT NO LONGER AVAILABLE. For some time now, state and federal government authorities have been hassling crypto exchanges that offer interest on crypto holdings. In February, the SEC fined BlockFi $100 million for allegedly violating securities laws, and shut them down from taking in any new funds for interest-bearing accounts. BlockFi hopes someday to provide a regulation-compliant interest product, but don’t hold your breath.

Zealous state and federal regulators have been attacking other crypto firms offering interest, such as Celsius and Voyager. The main player still standing that I am aware of is Gemini. Gemini is very conscientious about audits and has always tried to work closely with regulators. It is offering about 6.5% interest on stablecoins (which is still way better than money markets or CDs), and a measly 1-1.25% on Bitcoin and Ethereum.