The advent of permissionless lending protocols is likely one of the most valuable DeFi applications we’ve seen to date. Over the course of 2019, lending saw substantial growth as DeFi users capitalized on the high-yielding passive income opportunities available within their respective markets.
Protocols like Maker, Compound and dYdX among others enable an entirely new paradigm for permissionless lending, allowing anyone in the world to lend capital and earn interest for doing so.
Compared to traditional savings accounts where the US National average offers only 0.09% APR on US dollars, stablecoin returns on permissionless lending markets offer higher returns than anything seen in traditional finance. The average APR on major lending protocols range from 6.88% for Dai to 5.47% for USDC – translating to over a 7,500% higher return on Dai-based loans and a near 6,000% increase on USDC.
While these stablecoins are fundamentally different (Dai being permissionless and USDC being permissioned) they both have relatively liquid markets across a range of applications.
DAI
With its circulating supply nearly reaching 120M, Dai is the leading permissionless stablecoin within the DeFi ecosystem. In essence, the ability for anyone to collateralize Ether and receive Dai effectively makes MakerDAO the world’s first open, permissionless digital central bank.
It issues a stable currency (Dai) while being governed by a decentralized ecosystem of participants (MKR holders). MKR holders receive cash flows for governing the protocol based on the interest from the debt accrued from its global users minting Dai. Moreover, with the introduction of Multi-Collateral Dai (MCD), Maker offers a native high-yielding savings account for its users.
The Dai Savings Rate (DSR) allocates a portion of the interest accrued from the system’s outstanding debt into an open savings account, allowing Dai holders to earn a passive income by depositing Dai into the contract.
While the DSR is one of the newer earning mechanisms within DeFi, we’ve also seen the emergence of a handful of other protocols establishing permissionless lending markets for its users to supply loans to earn a significant interest rate.
As of February 2020, dYdX offers the highest lending rate of 8.70% on Dai loans followed by Compound at 8.07% and the DSR at 8.00% APR. Other prominent lending platforms include Nuo (4.50%), CoinList (2.60%) and Fulcrum which offered 9.57% APR before executing an emergency pause due to the exploit with the bZx protocol earlier this month.
From the 90-day average, Dai lending rates across the above platforms. Maker and the DSR have offered the highest yielding savings opportunity over the past three months – right when MCD was first introduced back in November 2019. Compound – the permissionless lending protocol – offered the second-highest returns on Dai holdings with a 90D average of 5.23%.
The combination of a permissionless stablecoin largely backed by a trustless asset with open, liquid lending markets offering high-yielding opportunities creates a powerful dynamic for our nascent industry. Having open stable value accessible by anyone empowered with the ability to earn equity-like returns on an annual basis with little counterparty risk is one of the driving factors behind the proliferation of open finance.
However, while the entire market may not have the same core characteristics (permissionless and trustless), we’re beginning to see how permissioned assets can leverage permissionless DeFi protocols to imbue the asset with similar properties.
USDC
Coinbase’s USDC is a permissioned stablecoin backed 1:1 by a reserve of US dollars held in a custodial account. While it doesn’t offer the same permissionless, trustless characteristics of Maker’s Dai, it does act as a bridge between traditional finance and decentralized finance at large.
The permissioned stablecoin has been adopted by the DeFi community within a range of lending protocols as well as supported by “crypto bank” interest rates (think Coinbase and CoinList). Users can supply USDC across a multitude of both permissionless and permissioned lending markets, including 1.25% to simply hold USDC in a Coinbase account.
Since the issuing crypto bank (Coinbase) offers the lowest interest rates for USDC on the market, other lending platforms have grown to provide significantly higher interest rates on the asset.
Lending protocol dYdX yields 6.42% APR on USDC loans, followed by Compound with 4.23%. The other major crypto bank, CoinList, offers 2.40% APR on USDC deposits after raising their rates from 1.60% earlier this February. Lastly, Nuo has seen a consistent rise in lending rates, now boasting the highest APR of 13.52%.
In terms of the 30 day average on USDC, Nuo offers the highest APR of 7.42%, followed by dYdX yielding 5.46%. Compound and Fulcrum both offered similar rates of 4.51% and 4.45% respectively. Lastly, the two major crypto banks – Coinbase and CoinList – averaged 1.25% and 1.79% – significantly lower than their decentralized counterparts. This difference shows how open protocols are vastly more capital efficient than centralized crypto banks, allowing them to pass on that value to its users.
In the future, we can imagine that rather than trying to compete with open protocols, crypto banks will elect to leverage them to provide their userbase with much higher rates at a lower cost – and likely taking a cut.
Risk Premiums
In traditional finance, there’s two interest rates that dictate the rates offered within lending markets: the risk-free rate and the risk premium.
The risk-free rate is the rate of return an investor would expect from an absolutely risk-free investment. The risk premium rate is the excess return compensating investors for incurring the additional risk compared to that of the risk-free investment.
In practice, the risk-free rate is largely represented by the returns offered on US treasuries. While the assumption that the US government has a 0% chance of default may not go over lightly in the eyes of cypherpunks and the ethos of DeFi at large, this is widely accepted as common practice in legacy financial markets.
Calculating the risk premium on investment can be seen as follows:
Decentralized finance and its encompassing lending markets could begin to adopt a similar idea. While calling it the “risk-free rate” may not be the best description given the nascency of the market and the technical or financial risks associated with the underlying protocols, there is an approach for calculating the risk premium on these lending markets.
In the lens of DeFi, the risk premium can effectively be calculated as:
Risk Premium = Platform Interest Rate – Issuing Bank Interest Rate
Risk Premiums on Dai
In essence, the Dai Savings Rate (DSR) could be considered the “risk-free rate” for Dai lending markets as it’s the base rate offered by the issuing protocol. Lending protocols looking to offer rates outside of the DSR will ultimately have to factor in a premium for the additional smart contract risk associated with using that respective protocol (or platform).
While this may not necessarily be true in its entirety today, the trend is definitely beginning to take form.
The Dai Savings Rate only launched a few months ago in November 2019 and most lending platforms today are now offering the DSR plus a risk premium.
| DAI | Interest Rate | Risk Premium |
|---|---|---|
| MakerDAO | 8.00% | – |
| dYdX | 8.70% | 0.70% |
| Compound | 8.07% | 0.07% |
| Nuo | 4.50% | -3.50% |
| Fulcrum | 9.58% | 1.58% |
| CoinList | 2.40% | -5.60% |
As the DSR and Multi-Collateral Dai at large continues to evolve into a robust, antifragile protocol, we can expect these rates to follow the DSR as the risk-free rate.
The interesting thing to note with the risk premium on Dai markets is that a centralized, permissioned lending platform (CoinList) offers a significantly lower interest rate on Dai loans, making the risk premium on the platform negative.
All other platforms factor in the risk premium associated with leveraging their respective smart contracts. Compound currently offers the lowest risk premium on Dai – only 0.07%. Given the fact that Compound has undergone multiple security audits as well as being around significantly longer than the DSR (making it more battle-hardened), it should come as little surprise that the risk premium on the lending protocol is this low.
With Fulcrum and Nuo having the two highest risk premiums, it will be interesting to see how long these protocols continue on offering these rates. As seen with Fulcrum, the risk premium was definitely needed as the platform experienced a $1M exploit due to the bZx arbitrage loophole earlier this month. Given that Nuo’s risk premium is significantly higher than Fulcrum, prospective depositors should be cautious as the higher interest rates offered obviously come with a risk.
Risk Premiums for USDC
For USDC, or any permissioned stablecoin, the “risk-free rate” or the base rate can be considered as the rate offered by the issuing company. In other words, the rate offered by Coinbase on its stablecoin can be seen as the base rate for the encompassing lending markets and the difference between those two rates is the risk premium for leveraging a different platform.
| USDC | Interest Rate | Risk Premium |
|---|---|---|
| Coinbase | 1.25% | – |
| Compound | 4.23% | 2.98% |
| dYdX | 6.42% | 5.17% |
| CoinList | 2.40% | 1.15% |
| Fulcrum | 5.23% | 1.15% |
| Nuo | 13.26% | 12.01% |
As we can see, Nuo currently offers the highest risk premium out of any other lending platform on the market. This is followed by dYdX and Fulcrum with a risk premium of 5.17% and 3.98% respectively. Unlike Dai, Coinlist actually offers a higher rate compared to the risk free rate offered on USDC.
Key Takeaways
With dozens of lending protocols emerging in recent years, we can begin to see these markets mimic traditional finance when looking at the risk free rate and the risk premium.
Users interested in depositing Dai or USDC into platforms where the interest offered is significantly higher than the risk free rate should be cautious.
As seen with Fulcrum – a platform with the second highest risk premium of 1.58% behind Nuo’s 3.50% – there are risks associated with DeFi protocol that the broader community is beginning to realize. The potential for these platforms to default (centralized lending solutions) or face a malicious attack (decentralized lending protocols) must be factored in when making a decision on where to store your crypto assets.
By looking at historical interest rates and the current risk premiums, we hope that DeFi users can have a basic quantifiable measure of the underlying risks.
To stay up to date with lending rates, visit our lending page with interest rates updated hourly!
Analyst at Bankless – one of the leading resources for open finance. Lucas is an active contributor to the DeFi ecosystem with appearances in other notable DeFi outlets including The Defiant and Our Network. He has years of experience working with dozens blockchain and token startups where he focused on token economics, marketing, and growth.