Market based interest rates on DeFi during the days of negative interest rates – a fun topic for Thanksgiving 

Market based interest rates on DeFi during the days of negative interest rate  .001

Bernard Lunn is a Fintech deal-maker, investor, entrepreneur and advisor. He is CEO of Daily Fintech and author of The Blockchain Economy.

The path to mainstream adoption of Bitcoin is through people living with failing currencies & hyperfinflation They see Bitcoin as a way to put food on the table. That does not help you at the Thanksgiving dinner table, when a relative asks you to explain your fascination with Bitcoin. Hyperinflation is something that thankfully seems remote to our lives in the West. As you explain and watch the expression that says “you are as weird as Bitcoin” you can start a real conversation by asking how they are dealing with negative interest rates. Your prudent relative talks about how hard it is to live off savings when the bank takes your money.

The value of a Store of Value if you are not Scrooge McDuck

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Imagine Scrooge McDuck playing with a hardware wallet full of Bitcoin. It does not seem so much fun. Using a store of value to make somebody’s life better (including your’s) sounds a lot more fun. But if you think Bitcoin can increase 10x or 100x from here and you don’t want to be like the person who paid 3 Bitcoin for a pizza, hoarding seems like the smart thing to do.

If you want to get some value from your store of value without selling it, the option of using it as collateral for  loan looks sensible. In short you need a crypto Lombard Loan.

This is not your parent’s Lombard Loan

As you explain how lending/borrowing works in Decentralized Finance (aka DeFi), one of your wealthy relative chips in by saying “this sounds like a Lombard Loan”.

Your wealthy relative is correct, lending/borrowing borrowing on DeFi) works on a similar principle to a Lombard Loan; you borrow based on collateral held by the Lender. 

Now others are paying attention and somebody else chips in with “I never knew about Lombard Loans, but I thought that was how banks work in normal mode ie they can only lend what people deposit with them”. Your family is then actually listening while you explain how Fractional Reserve Banking works!

The wealthy relative who sparked the Lombard Loan conversation says he will call you tomorrow to learn more.

Now everybody is paying attention. Another relative who is always short on cash tells people about their experience borrowing through Lending Club. The older relative who looks for interest on their cash says “oh honey I wish I had known, I could have lent you some cash and we would both have done a lot better than doing this through a bank”.  That is how Peer To Peer (P2) Lending was supposed to work.

Could DeFi enable a decentralized P2P version of Lending Club?

Lending Club was conceived of as P2P lending/borrowing, but in an effort to scale to meet IPO valuations, it became a front end to institutional/bank lending.

The idea of P2P decentralization is obviously core to DeFi. If DeFi credit markets really do work, they will usher in a decentralized P2P version of Lending Club. Both lenders and borrowers are sitting around the same Thanksgiving table.

After a big meal and a snooze you wake up from your dream

The conversation has moved to sports and celebrities as everybody avoids talking about Trump. Bitcoin and DeFi is well and truly off the agenda.

However it was not only a dream. The wealthy relative does call you the next day and asks you about DeFi credit markets. Before explaining how they work you ask him a question “Why would a sane person lend at negative interest rates?”

Why would a sane person lend at negative interest rates?

The question has been bugging you. Clearly lots of people are lending at negative interest rates. They cannot all be crazy. Your wealthy relative explains it quite simply as being better than worse alternatives, telling you “I would prefer to lose 0.5% a year than lose 50% from a risky asset such as equities at the top of a bull cycle”. When you suggest being in cash, he asks you which currency and points out that the more stable the currency, the more negative the interest rates are. For example, if you want the famously stable Swiss Franc, be prepared to pay a high interest rate for the privilege of lending to bank that promises to repay you in Swiss Franc.

Now that he has answered your question he wants to know if DeFi credit markets are a real option for an investor/lender.

The realities of DeFi credit markets

You point him to a site called DeFi rate that shows what interest rates a lender can get in the DeFi credit markets. He rightly asked “but what is my risk adjusted return on capital?”

To show him you understand the issues you tell him that he will need to evaluate the risk against these criteria:

    • Insurance: you obviously won’t get government insurance like FDIC in these markets but are there any private insurance options?
    • Collateral Risk %: Legacy Lombard Loans work on the % the bank will lend against the collateral. The more volatile the asset the smaller % they will lend against. In Crypto Lombard Loans, the volatility is obviously high. In fact the DeFi credit markets do NOT assume that risk. Let’s say they ask for 150% collateral (eg to borrow 100 in USD, deposit equivalent of 150 USD in  ETH) and ETH falls more than 50%, the Lender loses all collateral and has to put up more.
    • Counterparty Risk: there is no centralised equivalent to a bank, so you do not have Counterparty risk. You do not worry about the bank holding your deposit going bankrupt (watcb the Lehman story if you don’t think this is as risk). Although you do not have  Counterparty risk, you do have Storage risk.
    • Storage risk: this is not an issue in legacy finance as the bank takes that risk. As Bitcoin and other crypto assets are bearer instruments you have storage risk, meaning you have to figure in the cost of storage (either doing it yourself or paying some firm to do it for you but in such a way that you control the private keys like ye olde lockbox in a bank vault). 
    • Repayment risk:you do NOT have traditional repayment risk because the borrower has deposited collateral, but the details matter around recourse in the event that their collateral is wiped out by a sudden market move.
    • Weirdness risk: very high!

You suggest he ask his/her financial adviser and leave in a hook “if they don’t get it yet, come back to me and I may be able to help you.”

Something to be thankful about

To those at the Thanksgiving table who want to be as well informed as you are, suggest they get an annual subscription to Daily Fintech.   Membership costs just US$143 a year (which equates to $2.75 per week or $0.39 per day).

In case you don’t already have your own Membership, if you subscribe by 30 November 2019 you get a 50% discount off your first year. Simply use the coupon code: Thanksgiving in the payment field of the Subscription page, and you’re on your way to being that well informed person at the Thanksgiving table.

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