The report notes that interest rates on “risky opportunities” are a function of a “risk-free” rate and the default risk (counterparty risk) in traditional financial markets. When we apply this concept to crypto-assets, we know that assets like Bitcoin (BTC) have no central entity controlling the “printing” of the digital token due to its decentralized nature. The total BTC supply has been algorithmically capped at 21 million coins – which effectively reduces “inflationary uncertainties,” the report stated.
According to the Kraken Intelligence team, in this particular case, we can “argue that the risk-free rate is zero.” But there are also some virtual currencies with “no capped supply which may have a natural inflation that accrues to the holders of the currency,” the report confirms. In these cases, the inflation would “imply a risk-free rate.”
The report added:
“Cryptocurrencies have varying degrees of risk-free rate or none depending on the cryptocurrency, and for those with no risk-free rate, interest rates will be made up of risks unique to each currency and thereafter any product offering a reward or yield.”
The report further noted:
“Decentralized finance (DeFi) is an open system where traditional financial products and services are offered peer-to-peer, operationalized through smart contracts. … DeFi lending is conceptually akin to traditional lending where you receive interest on each currency deposited, and (automated market makers) AMMs are liquidity aggregator platforms that automatically match orders through code, from a pool of cryptocurrency tokens.”
The report explained that each lending platform or AMM set their own rules, which means “available assets, yields, and rules to participation will differ by platform.” At present, the majority of DeFi platforms are on the Ethereum (ETH) network, meaning that the lending/borrowing is mostly conducted in ERC-20 tokens or wrapped tokens such as Wrapped BTC (WBTC).
The report also mentions that WBTC is an ERC-20 compliant token that’s backed 1:1 by BTC. It adds that “interest rates are more volatile on DeFi applications than on Centralized Finance (CeFi) applications as there are no centralized entities setting the rates, but rather market forces that determine return rates.” It further noted that AMMs are “slightly different in that they are decentralized exchanges that operate liquidity pools through smart contracts.”
The report further explains that “each liquidity pool has a mix of different cryptocurrency pairs from which participants can deposit and swap assets.” It also notes that “the proportion of assets in a pool are customizable in that individuals have the option of creating their own pool with a preferable ratio of assets if they do not wish to participate in an existing liquidity pool.” In exchange for offering liquidity, the liquidity providers (LPs) are usually paid the fee charged to those who carry out trades in the pool, the report noted.
The research team at Kraken pointed out that CeFi, or centralized finance involves the lending/borrowing across various digital assets and interest rates on these platforms are determined by the centralized entity themselves (in contrast to DeFi platforms). In many cases, interest rates tend to be significantly higher on CeFi lending platforms and they also “bear custody of customer funds,” the report noted. It added that loan applications “must be approved by the centralized platform and may geographically restrict users access to its services.”
The report went on to explain that staking involves “the act of locking up a cryptocurrency for the chance to validate new blocks on the network, for which stakers (validators) receive a reward.”
The report further noted:
“Stakable cryptocurrencies reward validators for participating in the validation, maintenance, and security of their blockchain. Some networks will calculate reward based on a number of different factors such as duration of staking and amount being staked, whereas others have a fixed reward schedule, often expressed as a percentage. Stakers receive payments from newly minted coins and transaction fees. The percentage of reward given out to a staker is denominated in the currency being staked.”
Payment channels such as the Lightning Network (LN) node operators help carry out “decentralized” and “near-instant” payments between senders and recipients by offering different routing channels off-chain, the report explained. In return for these services, the node operators are able to earn a transaction (TX) fee that may be set by the operators, and users select the channels they want to use to conduct their payment, the report added.
It also noted that there are two different types of fees that make up the TX fee rate for LN node operators: a “base fee” and a “fee rate.” The report explained that the base fee is “a flat fee charged per transaction routed through the node and the fee rate is a percentage fee charged per satoshi sent through the node’s Lightning channel.”
The report pointed out that derivatives have “implied interest rates for traders.” It explained:
“This price premium (for derivatives trading) is generally a reflection of the net cost incurred by the seller in the financing, buying, storing, and insuring of an asset or commodity until its delivery date. This is also known as the ‘cost of carry.’ There can be situations where futures prices are at a premium to spot prices (contango), … [and] where futures prices are lower than spot prices (backwardation). This difference in price is what we would consider the interest rate curve. By the expiration date of the futures contract, since the futures and spot price must equal one another, prices will converge.”
The report concludes that there are several different ways to earn interest or rewards on digital assets with each product offering more sophistication and “a different portfolio of risk.”
(Note: you may access the full report here.)