Juicy Yields in Crypto Are Attracting a New Type of Credit Fund

As interest rates approach 5,000 year lows and investors increasingly speculate that the 40 year bond bull market is coming to an end, yield is popping up in a surprising corner of the world: digital assets.

The primary source of income for lenders in crypto is the same as it ever was, it’s just the market and the asset that is new.

The main instrument that is used to generate income is a new type of financial construct called stablecoins, a central primitive to the emerging area of decentralized finance.

DeFi often makes headlines for the wrong reasons, but its core components should look familiar to fixed income investors.  

Ben Forman, Founder and Managing Partner of ParaFi Capital, explains:

“There are a whole host of different types of financial tools and architecture that you would see in traditional fixed income markets.  You have interest rate swaps, you have stablecoins that trade at discounts to premiums that can be arbitraged, you have zero coupon bonds.”

Some of the largest protocols in DeFi effectively act as high interest savings accounts.  These networks pool the assets of lenders and match them with borrowers, in a way that effectively negates counterparty risk and allows lenders to earn juicy yields.

Yield Generation

Just how attractive are these yields? Ignoring some of the riskier opportunities in DeFi, which have generated triple digit returns for some investors, yields on popular stablecoins can range anywhere from 7% to 10.2%, according to data provided by Vision Hill.  

These rates vary depending on the type of venue they’re sourced from and on the asset.  The opportunities funds like ParaFi pursue tend to be what’s known as “on-chain,” and separate from more traditional OTC lending operations.

Although, as Forman notes, these lines are increasingly blurring.

“Crypto banks [like Genesis, BlockFi, and Galaxy Digital] that are off-chain and doing more borrowing and lending in OTC markets, that business is exploding.  It’s one of the fastest growing areas within crypto… although the lines between what those guys are doing and DeFi is increasingly blurred.

If you can borrow at, call it, 5% on DeFi, and lend it out at 8% to someone in an OTC market and make a 3% spread in a capital efficient way, the worlds inevitably blur.”

Lending out stablecoins is the primary source of returns for most crypto funds. The borrowers post collateral in other types of digital assets like Bitcoin, and generally borrow to fund trades or to access liquidity without triggering a taxable event.

These lenders and borrowers take advantage of networks that pool the assets of lenders and borrowers and match them up with each other. These networks have a built-in “margin call” mechanism which looks very similar to a margin facility in a brokerage account like Fidelity or TD Ameritrade.

In the same way that TD Ameritrade allows you to borrow against a share of Amazon, these networks allow you to borrow against assets like Bitcoin.  However, if the value of your collateral goes down, just like a brokerage, the network will automatically begin liquidating your position.

Funds that are willing to brave this new technology and lend assets into a decentralized pool are rewarded handsomely, often earning double digit yields over short periods of time.

Arbitrage

Another source of returns comes from arbitrage.  Unsurprisingly, DeFi markets are almost completely devoid of institutional participants.  That means the majority of players are non-professional traders, leaving unprecedented opportunity for sophisticated arbitrageurs to swoop in.

There are a number of platforms and sites that all do the same thing.  On one of these platforms you may be able to borrow an asset at 2%, while another allows you to lend it at 4%.

Or, as Forman puts it, “Someone needs to pick up the pennies, dimes and nickels that are lying around.”

For a fixed income veteran used to investing in ultra efficient public markets, this should be a dream come true.  So why aren’t more of them pouring into this space?

The Future of Fixed Income?

For one thing, decentralized finance is fraught with risks and complications.  The knowledge and cost of just setting up the infrastructure to take advantage of these opportunities is immense. The tax treatment of income generated by these strategies is still uncertain, prohibiting many funds with certain types of LP’s from engaging.

Scott Army, Founder & CEO of Vision Hill, confirms that it is still early days for these funds.

“There are not many of these dedicated credit strategies in the market yet other than a few early movers. It is more common to see funds deploy a portion of their capital towards these types of activities in a multi-strat fashion, but we expect to see more develop this year.”

The benefits are there for investors though.  Credit strategies allow investors to allocate to crypto in a less volatile, more risk averse way while capturing some of the early stage inefficiencies of the market.

Finally, although Forman comes from a credit background himself, he cautions that the skill set required to generate alpha in these markets may not align with those of traditional credit investors.

“You almost want people building this stuff that don’t have traditional finance backgrounds, because they’ll be building it without any baggage.  They’ll be building it from scratch, like a blank sheet of paper.”

Investors who can stomach the risk and ignore the negative stigma of an early stage market like DeFi may be giving themselves opportunities that their analogs in traditional finance can only dream of today.