Confused about cryptocurrency? Here’s how investors are making money.
Warren Buffett famously said, “If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.” A close relative of this maxim was coined regarding social media: “If you’re not paying to use the product, you’re the product.”
And applying this to cryptocurrency, “If you’re earning yield and you don’t know where the yield comes from, you’re the yield.”
Here are three ways interest-bearing crypto works, and the risks associated with each.
Centralized Exchanges (CEX)
Buy crypto, hold it on an exchange, and you receive more of that token effortlessly. Pretty great, right? It’s great until the CEX handling your money makes bad loans. CEXs make money by:
1. holding your crypto;
2. paying you a yield;
3. lending your crypto out to others; and
4. keeping the spread for their profit.
The third item has been especially problematic lately. Risk management policies, or lack thereof, resulted in many bad loans supporting leveraged positions.
Voyager, Celsius, BlockFi, Genesis and many other CEX platforms have failed recently due to poor lending decisions, and their depositors have lost some, if not all, of their money.
Using a CEX for yield, as easy and appealing as the process may be, has proven to be extremely risky. Where does the yield come from on a CEX? You placing your assets into the hands of risk managers.
If you hold your crypto on a CEX, and that CEX is lending out your assets, understand where the yield is coming from. The next two interest-bearing strategies will cover Decentralized Finance (DeFi), and how those yields work.
DeFi Through Token Emissions
What does Decentralized Finance (DeFi) actually mean?
DeFi is a series of permissionless systems. Unlike other financial tools (banks, brokerages, qualified retirement plans, credit cards, etc.) which require you to create an account, DeFi allows anyone with a digital wallet to interact with the platforms.
DeFi platforms, then, are in a race to gather as many users as possible. Think about startup companies that have grown to become huge, like Amazon, Facebook and Uber.
They’ve all succeeded where their competition failed by acquiring more users/customers.
DeFi is closer to Uber than the other two examples. Uber (and their main competitor, Lyft) attracted customers by offering subsidized rides—new users got to both try the new “push a button, get a ride” technology while paying less than the cost of a cab.
With DeFi, platforms earmark tokens as a reward for those using the platform. This is a component of what’s called “tokenomics.” Tokenomics—a mash-up of the words ‘token’ and ‘economics’—is the calculation used in crypto protocols to determine value.
Read more commentary by Spencer X Smith here.
Much like stocks, where the market capitalization is the price of a stock multiplied by the outstanding number of shares, crypto follows a similar formula: price of the crypto multiplied by the outstanding number of coins.
DeFi platforms—as a component of their tokenomics strategy—will earmark a portion of their tokens for emissions, which creates inflation. As the outstanding number of coins grows, it creates downward price pressure on the token.
Fully diluted value, similar to market capitalization, is a dollar representation of the price of the crypto multiplied by the total supply that will ever exist. If there’s a difference between the fully diluted value and the market cap, this indicates there are still tokens that are yet to hit the public market. These could be locked tokens (for venture capitalists or other early investors), team allocations for those who work there, or tokens set aside for future projects, such as pre-engaged emissions.
Users on a DeFi platform could benefit from these prearranged emissions by participating in myriad ways, and each platform is different. Some users may choose to “stake” their cryptocurrency, which can act as both a liquidity mechanism or even support the security of the token’s underlying blockchain. Other DeFi platforms will “reward” users if they contribute to the community, produce educational content or serve in roles requiring their time or expertise.
Some platforms have chosen to emit tokens to users who are simply conducting transactions such as buying and selling. Since all crypto transactions—and the underlying blockchains that support them—are fully transparent and auditable, buying and selling will drive volume (and by extension, attention) to the platform.
Where does the yield come from in this token emissions example? Tokenomics is designed to reward users, giving them more of the tokens from the platform. Poor tokenomics design could put you or your clients’ crypto returns at risk, however, as runaway token inflation may drive down the price.
DeFi Through ‘Real Yield’
Unlike emission-based yield, some interest-bearing options come from fee generation… called “real yield.” Platforms make money by providing a service, and those holding that platform’s tokens can benefit as user adoption grows and value transacted increases.
Crypto platforms with real yield offer us the opportunity to conduct fundamental research, such as a discounted cash flow analysis. If the token has claims on the profit, we can value the token by analyzing the sequencing of the future cash flows of the protocol. More mature platforms—with many users and demand for transactions—have generated revenue via these users utilizing the platforms.
Where does the yield come from in a ‘real yield’ scenario, then? A platform earning money through fee generation. The main risk? People stop using the platform, and the fee generation disappears. Earning yield on your crypto investments has great appeal, especially if the alternative is zero interest. Understanding where yield comes from, however, is critical to participating in these platforms confidently.
When analyzing or considering a yield-bearing crypto project for yourself or your clients, assess which of three scenarios is producing the cash flows. Is it the risk of a centralized exchange? A token driving up its supply through emissions? Or a protocol generating revenue via its use? All three can play a factor when building a crypto portfolio.
Spencer X Smith is the founder of AmpliPhi Social Media Strategies. He’s a former 401(k) wholesaler, and now teaches financial services professionals how to use social media for business development. This column first appeared in the Spring issue of NAPA Net the Magazine.