Cryptocurrency holders can earn interest on their holdings of the digital currencies they own, often greater than they could earn on cash deposits in a bank, or borrow using crypto as collateral
Over the last decade, the development of Bitcoin and thousands of other cryptocurrencies has changed the definition of money and spawned a parallel universe of alternative financial services, allowing crypto businesses to reach into traditional banking.
Here are some of the developments in the fast-growing crypto finance industry, a sector that is alarming officials in Washington.
What alternative banking services do crypto businesses offer?
Most notably, lending and borrowing. It is possible for investors to earn interest on digital currencies – often much more than they could earn on deposits in a bank – or borrow with crypto as collateral. Crypto loans generally do not require credit checks since digital assets back them.
Who’s in this sector?
Businesses from the vaguely familiar to science fiction-like entities are flooding the market. From BlockFi, which offers interest-bearing accounts and has state lender licenses, to Kraken Bank, which received a Wyoming bank charter and plans to soon accept retail deposits, to markets controlled by computer code and designed to be governed by users through token distribution structures. In 2018, Compound began offering decentralized, automated lending and borrowing services and now has over $18 billion in assets earning interest.
How do crypto offerings differ from bank services?
Superficially, some look similar. Consider the BlockFi interest account, where consumers deposit cash or crypto and earn interest as if they were at a bank. However, one big difference is the interest rate – depositors can earn a yield more than 100 times higher on BlockFi than on average bank accounts.
Rigorous rewards come with risks. Federal Deposit Insurance Corp. does not guarantee deposits. “Cyberattacks, extreme market conditions, or other operational or technical difficulties” could halt withdrawals or transfers, the company warns in fine print. Several regulators and lawmakers believe that the warnings are not prominent enough and that consumers need stronger protections.
Why such high yields?
Traditional banks lend out their customers’ deposits and pay clients a slice of the earnings as interest. Crypto outfits take a similar approach: They pool deposits to offer loans and give interest to depositors. But by law, banks are required to have reserves to ensure that even if some loans go bad, customers can still withdraw funds, whereas crypto banks do not have the same reserve requirements and the institutions they lend to can take risky bets.
BlockFi, for example, lends to hedge funds and other institutional investors who exploit flaws in crypto markets to make fast money without actually holding risky assets, betting on discrepancies between actual crypto values and crypto futures. When successful, their speculation generates returns that help fuel the higher, more difficult consumer yields.
What is a stablecoin?
Cryptocurrency is very volatile, making it less practical for transactions like payments and loans. That’s where stablecoins come in. These cryptocurrencies are pegged to stable assets, such as the dollar. Originally intended for blockchain transactions, they provide the stable value of government-issued money, but they are issued by private entities.
Tether and USD Coin are two popular dollar-tied tokens. According to The Block, the number of stablecoins in circulation globally has increased from $29 billion in January to $117 billion as of early September, a publication dedicated to cryptocurrency.
In order to maintain the value of government-issued money, central bankers manage supply and demand and maintain ample reserves. In a similar way, stablecoin issuers are required to hold and monitor reserves. However, there is no guarantee that they actually have the one-to-one dollar backing they claim. There have been fears that a sudden surge in withdrawals could lead to a collapse in one of these assets, putting consumers, financial companies, and possibly the entire economy at risk. Others argue that a central bank digital currency would make stablecoins irrelevant.
What is a central bank’s digital currency?
Central bankers are studying the possibility of issuing a government-issued cryptocurrency. In theory, this would combine the convenience of cryptography with the security of money controlled by a central bank. A number of countries, including the United States, are considering developing a central bank digital currency. As stablecoins aim to replicate in digital form what government money does – provide a stable value – a US digital dollar could undermine the private money minters of the cryptosphere.
IN JULY, Jerome H Powell, chairman of the Federal Reserve, said that a digital US currency would eliminate the need for stablecoins and cryptocurrencies.
The government will not catch up to the innovations on the market for years – if ever. Furthermore, the system will become more dependent on stablecoins, and it is not clear whether markets awash in these assets will abandon them altogether in favor of a possible FedCoin.
What is DeFi?
Decentralized finance, or DeFi, is an alternative financing ecosystem where consumers trade, borrow, and lend cryptocurrency, theoretically independent of traditional financial institutions and the regulatory structures built around Wall Street and banking. By using computer code to eliminate middlemen and trust from transactions, DeFi aims to “disintermediate” finance.
Generally, users are not engaging with a financial services company – at least not one that collects identifying information or claims ownership of their assets. The market is computer-controlled and executes transactions automatically, such as issuing loans backed by crypto or paying interest on holdings.
DeFi platforms are designed to become independent over time from their developers and backers, ultimately becoming governed by a community of users whose power derives from holding the protocol’s tokens.
CeFi compares more closely to traditional finance, such as TradFi, where consumers enter into an agreement with a company like BlockFi that collects information about them, asks them for crypto, and also serves as a central point for regulators.
What is Ethereum?
Developers use Ethereum to build decentralised platforms for crypto borrowing, lending, and trading. The Ethereum cryptocurrency, or token, is used to pay for network usage. Because Ethereum is so popular and has made it possible to create new token offerings, Ether is widely used and crypto fans are enthusiastic about its value. As of early September, it had a market capitalization of over $460 billion, making it the second most valuable cryptocurrency.
What are some risks associated with DeFi?
DeFi cuts out the third parties that US financial regulators rely on to ensure market integrity. In traditional finance, licensed operators like brokers and banks play a quasi-governmental role, collecting and reporting information to the government, such as capital gains on investments made by their clients, to ensure taxes are paid. To participate in the market, they must follow a lot of rules.
DeFi programs, on the other hand, are unregulated apps developed by coders interested in capital markets. Users’ assets can be hacked, and not all operations are built in good faith. Developers abandoning programs after investing significant assets are notorious in DeFi as “rug pulls.”
What’s good about crypto finance?
Cryptocurrency is viewed as a means to foster financial inclusion by innovators. Unlike banks, consumers can earn unusually high returns on their holdings. An estimated one in ten American adults lacks a checking account, and about a quarter are “underbanked” and unable to qualify for a loan. Crypto businesses say they offer financial stability to customers in countries with volatile government-issued currencies outside the United States.
According to industry advocates, cryptocurrency gives people long excluded by traditional institutions the opportunity to engage in transactions quickly, cheaply, and without judgment. As the loans are backed by crypto, the services generally do not require credit checks, although some use customer identity information for tax reporting and fraud prevention. Since users are judged solely on their crypto value in a DeFi protocol, their identities are generally not shared.
What are regulators doing about the emerging alternative banking sector?
Officials from banks are rushing to keep pace with the many developments in crypto and are attempting to slow down the industry’s growth. In the wake of an industry executive leaving the agency as acting comptroller, the Office of the Comptroller of the Currency is reviewing conditional banking charters granted to crypto businesses.
Securities and Exchange Commission chair Gary Gensler has called on Congress to grant regulators more authority over new entities. The Federal Reserve will issue a report in early September on the potential benefits and drawbacks of minting a digital dollar.
What is Congress doing?
Crypto transactions unexpectedly grabbed the attention of the Senate during negotiations over the $1 trillion bipartisan infrastructure bill, which included a tax-reporting clause that defined the word “broker” in crypto transactions. By arguing that the language was too vague, the industry brought attention to the many players in the sector who elude traditional definitions.
Congress may take years to address the many issues raised by blockchain’s alternative banking services. Congressman Don Beyer introduced comprehensive legislation this summer to address the range of issues raised by digital assets, and the legislation has so far received little scrutiny.
What is a possible way forward?
Regulators and innovators argue that new technology requires a new approach, since novel risks can be addressed without necessarily stifling innovation.
Instead of mandating DeFi protocols keep bank reserves and collect customer information, officials may decide to create new requirements for the technology and products, such as code audits and risk parameters.
Flipping the script could be a way to address identity questions, which are crucial to fighting financial fraud. According to J Christopher Giancarlo, a former chair of the Commodity Futures Trading Commission, instead of going after specifics – identifying individuals – law enforcement could monitor suspicious activity using artificial intelligence and data analysis, and then identify who they are.