Credit and interest rate – Next frontier for crypto

Key takeaways

• Interest rate and credit markets could be the last piece of the puzzle to complete the whole cryptocurrency ecosystem.
• Interest rate derivatives could be the next frontier for the crypto industry, especially for exchanges.
• Staking yields could be one of the metrics to measure the risk and volatility of a specific token.

 

Overview

Crypto lending and staking have been getting more market attention these days. Thanks to the rapid growth of DeFi and the product innovation from crypto exchanges and wallets, more crypto market participants are now able to diversify their portfolio with such products or earn passive income by staking, saving, and lending.

This segment of the crypto space may still be green and in its early stage of wider adoption. Yet, ultimately, this sector could evolve into one of the most critical parts of the broader crypto space and provide some vital information to the markets, and that is interest rates.

Market participants may able to give a more precise valuation and assessment for coins and tokens based on their interest rates, similar to what we have been doing in the traditional markets. Interest rates of a company or a country is a vital indicator of its financial health.

Product developers may also be able to build new derivative products based on interest rates, such as options of EOS’s staking rate, or interest rate swap like what has been commonly trading in the fixed income markets.

This article will explore the initial stage of the crypto interest rate space, and what this sub-sector of the broader cryptocurrency space could tell us. Also, we will envision how a matured interest rate markets in crypto could shape the future of trading.

 

The yield of crypto staking

The concept of earning interest with cryptocurrency did not take off until recent years, and staking is one of the ways to make interest and could generate extra income for investors. 2019 was a robust year for staking, and that trend has continued before the market crash in March. Now, we see that the staking market has been gradually recovering.

Source: Staking Rewards

Although investors may able to find attractive returns by contributing to the PoS network of an asset, increasing the efficiency of the blockchain, however, the yield here could be various.

Source: Staking Rewards; Messari

Interestingly, we can see that higher yield assets, usually with relatively weak Sharpe ratios, which means the asset itself has a lower risk-adjusted return. For example, the staking yield of IOST has reached 10.41%, which could be attractive for many investors. However, both the 30-day and 1-year Sharpe ratios of IOST were in negative. In the textbook, a Sharpe ratio is negative when the investment return is lower than the risk-free rate. Comparatively, XTZ offers a much lower reward rate (5.72%) than IOST, but both XTZ’s Sharpe ratios were at least positive.

Of course, other factors could affect the yield and returns, such as the inflation rate, the price volatility of that token. Investors may also want to put market conditions under consideration.

 

The credit markets

Crypto loan is another area that has drawn quite an attention. Again, investors may find the yields could be vastly different across service providers, and below is just one of the many examples.

Source: Loanscan

On top of that, these interest rates were floating. It means they change from time to time according to market conditions. These changes sometime could be fluctuating, even volatile.

Source: Loanscan

We believe that the market may continue to see these rate fluctuations in the future, given that cryptocurrency remained a relatively volatile asset class compared to conventional assets (although oil has reached USD 0 before BTC). However, from a longer-term perspective, the market could expect these fluctuations to slow down gradually, as the lending market continues to mature and increasing participants in crypto investing.

 

Looking ahead

The crypto credit market has been one of the fastest-growing areas within the cryptocurrency space. Reports from Credmark shows that the entire crypto lending industry expanded 52% in 4Q19, and the active debt grew 474% in 2019.

At the same time, analysts believe that the strong performance of the staking market could carry forward to 2020, as a wide range of PoS blockchain projects is expected to hit the market and the thriving expansion of the related infrastructure.

We foresee that the interest rate and credit markets could become a gamechanger for the broader cryptocurrency space; its impact could be in multiple layers.

Better price discovery – In the traditional finance world, debt and credit markets are some of the key micro factors which impact on price discovery on securities. A company with a lower credit rating usually can only issue high-yield bonds, because of its higher risk of default. Investors could put this factor in their consideration when it comes to giving a valuation of the company. In other words, this extra piece of information could further improve the price discovery of the company. The same idea could also be bought into the crypto space. If we have matured credit and interest rate markets in crypto, interest rates may able to provide investors a complete picture when it comes to pricing a coin/token.

Interest rate derivatives – Exchange houses may able to develop new kinds of derivative products based on crypto's interest rates. Such products allow traders to hedge or gain exposure to risk within the PoS protocol and may able to help savers to hedge against interest rate changes.

Complete the crypto space – The credit market has been one of the most critical elements of the modern financial system, and still, it is today. A sophisticated credit market in crypto may be the last piece of the puzzle to complete the crypto picture, which could warrant the future growth of cryptocurrency, no matter as an asset class or the whole ecosystem.