By Dr. James M. Dahle, WCI Founder
Crypto savings accounts allow investors to earn interest on their cryptoassets, most commonly stablecoins like USDC. Even white coat investors who do not invest in cryptoassets wonder if they should use these accounts for their savings. Check out this recent email:
“I had a question regarding the BlockFi Interest Accounts (BIA). They advertise that they offer 9.5% APY in Stable Coins invested in their BIA. This seems too good to be true, and I was wondering if this is somewhere where I can store my emergency fund and receive a good return.”
How Does a Crypto Savings Account Work?
While every account is slightly different, the general idea is that you deposit your cryptoassets into the account and then you are paid interest in that same cryptoasset. Not every cryptoasset can be deposited, but many (usually large, popular ones and stablecoins) can be deposited including Bitcoin (BTC), Litecoin (LTC), Ethereum (ETH), PAX Dollar (USDP), PAX Gold (PAXG), Tether (USDT), USD Coin (USDC), and Gemini Dollar (GUSD). Cryptoassets are treated by the IRS as investments, so if you hold them for longer than a year, you pay taxes at the long-term capital gains rates. However, interest, whether paid in crypto or not, is taxed at ordinary income tax rates.
It's just like a bank. While your crypto is on deposit, the holder of that deposit (a “bank” is far too generous of a term) can do whatever it wants with it. For the most part, that means lending it out in hopes of earning a higher return than they are paying the depositor.
Crypto savings accounts do not have FDIC or NCUA insurance. They also often use simple interest calculations rather than compound interest, and they place restrictions on how quickly you can withdraw your assets (and sometimes, in times of turmoil, they don't let customers withdraw at all). In exchange for these limitations (and the significant additional risk), these savings accounts pay a much higher rate of interest than a typical bank account.
Stablecoin Savings Account
A stablecoin is a cryptoasset that is pegged to a fiat currency, typically the US Dollar. There are a number of these including USDC, GUSD, USDP, and USDT. Using a stablecoin savings account eliminates most of the exchange rate risk of a crypto savings account and causes even non-crypto investors to think about using these accounts.
Exchange rate risk is the reason why people don't simply send their money to Australia or India to deposit in a bank and earn the higher interest rates typically available in those countries. Sure, it would be nice to earn 5% instead of 1%, but if the US Dollar strengthens against the Australian Dollar or the Indian Rupee over the year by more than 4%, you come out behind. Exchange rates are affected by all kinds of things but particularly by the respective rates of inflation and taxation in the two countries.
When you are saving in a BTC savings account, you might be paid 4% and that feels good, because in a traditional savings account, you might be paid less than 1%. However, if the value of BTC drops by 35%, you're not exactly coming out ahead. That's exchange rate risk.
More information here:
What Are the Risks of Crypto Savings Accounts?
Why does a crypto savings account pay 9.5% when your high-yield savings account at Ally Bank is only paying you 0.5%? Because it is riskier. When you are comparing fixed-income investments, you can pretty much always assume that if one has a higher yield than another, it's because it's riskier, even when you cannot figure out what the risk is. There are precious few free lunches out there.
Exchange Rate Risk
The primary risk of a crypto savings account is the risk of the underlying cryptoasset. What's a 4% yield when the value of the underlying asset goes up and down by 30%-200% a year? Who cares if you got a 5% yield when Bitcoin dropped from $67,000 to less than $28,000? Remember also that interest in these accounts is paid in the underlying cryptoasset and not in dollars. If you put BTC into an account when BTC is worth $65,000 and are expecting a 5% yield over the next year ($65K * 5% = $3,250) but then the BTC drops to $30,000, your yield does not rise like it would when a bond falls in value. You are now only earning $30K * 5% = $1,500. Not much of a reward for HODLing. Not only did the underlying value get cut in half but so did the yield.
Obviously, this risk is much lower with the stablecoins, and that is why people are so much more interested in stablecoin savings accounts. But they are also not free from risk. With yields in the 3%-12% range, you should expect that your total risk is similar to other fixed-income investments yielding 3%-12% such as peer-to-peer loans or private real estate debt funds. It's certainly not like a CD or treasury bond that carries far more guarantees and liquidity.
Peg Breakage Risk
Stablecoins are supposed to be pegged to a fiat currency, usually the US Dollar. But there is no guarantee behind that peg. The long history of foreign exchange has demonstrated time and time again that currencies that are pegged to more stable currencies sometimes become unpegged. When that happens, faith in that currency disappears quickly, sometimes with dramatic collapses in value. That's what happened in May 2022 when the TerraUSD coin (UST) fell from trading at $1 to trading at basically nothing, leading to major questions about whether the stablecoin would survive.
Not all stablecoins are the same either. Some have US dollars locked away in vaults and get regular audits. Those have risks of theft or crooked auditors. Others are decentralized, managed by code and computers. Hacking and code errors are risks there. While I suspect this risk is far lower than most of the risks you see with cryptoassets, it certainly exists and it may explain a great deal of the higher yield available in these accounts.
Custodian Hack Risk
It seems that several times a year, we hear about a cryptoexchange being hacked or going out of business. At best, these events cause you to be more illiquid than expected. At worst, you can lose the assets you had on the exchange in crypto savings accounts. The newer the institution, the higher the risk. The blockchain itself does not have to be hacked for you to lose money. There is no FDIC or NCUA insurance (i.e. the US government with the most capable military and the wealthiest taxpayers in the world) standing behind your deposits.
More information here:
Smart Contract Risk
Lenders in the Decentralized Finance (DeFi) space use smart contracts (computer code) to run their operations, lending money and allocating capital. This code is transparent and there is great incentive to make sure it is well done. But if there is an error there, it may enable a hacker to steal your funds.
In times of crisis, many assets can become very illiquid. Aside from not being able to sell the underlying asset for dollars, you may not even be able to get the asset out of the account. The accounts have withdrawal restrictions in normal times, but those are likely to tighten further in a crisis.
The cryptoassets, the institutions, and the whole ecosystem are all very new. Governments and their institutions are still trying to figure out how to deal with, tax, and regulate the whole thing. This can result in sudden regulatory changes that can cause the value of the assets and the institutions to drop precipitously with unknown effects on your investments. For instance, in 2021, the largest US-based crypto exchange, Coinbase, dropped its interest-paying products because it couldn't get the SEC to answer its questions.
Portability/Lost Secrecy Risk
While most people buy cryptocurrency to speculate on its value, one use of it is to easily flee an untenable political situation. It is far easier to transport code from one country to another than stacks of Benjamins or gold coins sewed into your clothing. However, if you have deposited your cryptoassets onto an exchange (along with the keys), you now have illiquidity risk AND there is now a record of you owning those cryptoassets. There is another step or two required before you can take your wealth with you while fleeing an apocalyptic situation. In the words of Nassim Nicholas Taleb, you are now less antifragile.
When you deposit your cryptoasset into the account, you no longer control it. The account provider does. This account provider, whether a lender or an exchange or whatever, has not been in business very long. Like other businesses, it can go out of business. What will happen to your assets when that happens? Well, you'll get in line along with all of its other creditors and, hopefully in a few years, you'll get back at least some of your money. You are counting on it staying in business to earn your return.
Loan Default Risk
These accounts are not just leaving your cryptoassets sitting there. The companies are using them; that's why they want them. They are generally lending them out to others in exchange for collateral. However, just like mortgage borrowers default all the time, so do crypto borrowers. If the value of the collateral drops, you and the account provider could be out of luck to get your principal back. This is a well-known risk, so most loans tend to be “overcollateralized,” but given the volatility of cryptoassets in normal time periods, you can only imagine what it could be in a real crisis. If the collateral drops in value by 90% in minutes, you can probably expect the borrowers to “mail in the keys” rather than meet their (and your) previously expected obligations.
What Does It Look Like When Risk Shows Up?
This article was published on the WCI website for months after I wrote it before it was actually run on the blog in July 2022. In between those two times, the world experienced a severe meltdown of a stablecoin. Terra is a blockchain protocol and payment platform. The stablecoin is TerraUSD (UST) and Luna is its reserve asset cryptocurrency. Over the course of a week in May 2022, this algorithmic stablecoin basically collapsed and the Terra blockchain was halted. This wiped out about $45 billion worth of market capitalization. It didn't just break its peg to the dollar, both UST and Luna went to essentially zero. Crypto fans will argue that UST was dramatically different from the non-algorithmic stablecoins, but remember that nothing that is risk free pays you 10%. Just because you can't see the risk doesn't mean it isn't there. Terra isn't the only StableCoin to break the peg either. Tether did too, although not nearly as dramatically.
High Yield Crypto Savings Account
How Can These Accounts Pay Such a High APY? For these accounts to be paying you 3%-12%, they must be doing something with the money that earns them even more than that. Just like regular banks do “fractional reserve” banking, so do crypto banks. They are lending out more than they have. The difference is that there is no FDIC/NCUA insurance behind them. Remember all those bank runs in the 1800s and in the beginning years of the Great Depression? Yeah, it's totally possible. Now, these institutions may carry some kind of insurance, but read the fine print carefully.
Who is borrowing these assets from the crypto account providers at such high rates? For the most part, it is institutions. They may be crypto dealers and market makers who are generating even greater profits than the interest they are paying. It takes capital to make a market. Arbitrage traders trying to take advantage of rate differences between exchanges are also frequent borrowers of short-term loans. Finally, there are margin traders. They feel so confident they know that ETH (or whatever) is going up that they want to borrow it to have more exposure to it. They are confident that they can get out of the market before the next downturn.
While you would think that stablecoins would be far less useful for these purposes, these coins provide liquidity within the crypto ecosystem. They provide blockchain technology without the usual massive volatility of other coins. This makes them particularly useful as collateral. There must be enough demand for them in the system because many of the crypto accounts actually pay a higher rate of interest on stablecoins than other cryptoassets. For instance, at the time I originally wrote this piece several months ago, BlockFI was paying up to 9.5% on USDT but only 4.5% on BTC.
Now, USDT isn't even being offered, and you can only get 3% for BTC (you can still get 7% on a few others like USDC and BUSD).
It is also interesting to note that these accounts function a little bit like a high-interest checking account. With some high-interest checking accounts, you can only earn the high rate on a certain amount of money, like $10,000 or $25,000. They're not going to let you put in $3 million and pay out that same rate. It seems to be the same with many of these crypto savings accounts. They don't necessarily just want a lot of capital. They want lots of “little guys” to open accounts. Probably because that means all those little guys will make other transactions at their institution, generating more in fees than they are paying in interest. You can see what I mean when you notice that BlockFI is paying 3% on 0-0.10 of a Bitcoin but only 1% on 0.10-0.35 of Bitcoin and 0.1% on >.35 of Bitcoin :
Even with the stablecoins, the rates drop rather than rise when you have more money in the account.
Where Can I Get a Crypto Savings Account?
There are a fair number of institutions out there providing these accounts. One of the most popular is BlockFI, mentioned by the reader who emailed in. This is a crypto custodian around since 2017. Coinbase, founded in 2012, is the largest US-based crypto exchange, and it was also a popular choice until it dropped its interest-paying products in 2021 in response to an unclear regulatory environment. Crypto.com (2016), Linus (2019), Celsius Network (2017), Hodlnaut (2019), CoinLoan (2017), Gemini (2014), YouHodler (2019), and Nexo (2017) are other options to explore for those interested. Getting the picture? Most of these companies are so new they make WCI (2011) look like a stodgy old blue-chip stock. There are vast differences between these institutions; choosing one is not simply a matter of comparing interest rates paid. Tread carefully and caveat emptor.
Should I Use a Crypto Savings Account?
Well, here's where the rubber hits the road. Anybody can spew back information easily found on the internet to their blog readers. But I bet you don't come here just for information. You also want my take on this new investment. Well, here you go.
Regular readers know that I find crypto to be fascinating, but given its newness and incredibly speculative nature, I have chosen to watch the whole thing from the sidelines. I've explained my reasoning multiple times over the years, but perhaps the primary reason is that I simply don't need to take on these risks to meet my financial goals. There are no called strikes in investing.
It's also worth noting that in June 2022, BlockFI announced it was laying off 20% of its staff (close to 200 people) because of a “dramatic shift in macroeconomic conditions.” Meanwhile, Crypto.com laid off about 260 workers (5% of its work force). Those decisions came just as Celsius paused all withdrawals and transfers between accounts because of “extreme market conditions.” None of this gives me much confidence.
I have cautioned the WCI community that if they do “choose to partake in this forbidden fruit,” they limit their investment to something like 5% of their portfolio. Within that general outlook on cryptoasset “investing,” here are my thoughts on crypto savings accounts.
#1 If You're Just Speculating, Get Some Income
If you've bought some BTC or ETH because you think it's cool or you think it “has to go up” and you're mostly just speculating on it, then you might as well deposit it into a crypto savings account of some type and earn some interest on it. The risk of loss due to the additional risk from the savings account pales in comparison to the overall risk of the speculation. Think of it as a stock that pays a 0.1% dividend. You didn't buy it for the dividend, but you should still cash the dividend check when they send it to you.
If, however, you bought your BTC to hide money from the deep state and you are prepared to flee to Switzerland at a moment's notice, then I would probably just keep your keys hidden at home and skip the idea of earning interest with a crypto savings account.
#2 This Is an Investment, Not a Savings Account
If you're considering buying stablecoins JUST to earn these high-interest rates, then I think the key is to treat it intelligently like you would any other investment. This is not the place for your emergency fund. Leave that in your checking account, a high-yield savings account, or a money market fund (or if you really want to go nuts, put some of it into a CD or I bonds). But don't send it to BlockFI.
When you're dealing with something new and unproven, treat it like you would an investment that is sold only to accredited investors. Even though these accounts do not require you to be an accredited investor, you should be a de facto accredited investor in my opinion. My definition of that is two-fold:
- You should be able to lose your entire investment without it affecting your financial life.
- You should be sophisticated enough to be able to assess whether it is a good investment on your own.
If either of those isn't true, this isn't for you. Still, you cannot know everything and the way you protect yourself from what you do not know is by diversifying. So split your investment up between perhaps three of these different crypto savings accounts and between three different stablecoins.
Finally, with a new-fangled investment, you should keep a closer eye on it than you do your boring index funds, and you should limit the entire investment to something like 5% of your portfolio.
The bottom line is that a stablecoin savings account seems like the least bonkers method of investing in crypto that I have seen yet. But as we've seen recently, there is still plenty of risk there. I'm still watching from the sidelines. I don't need an investment that can go to zero while I'm on a rafting trip.
What do you think? Do you have a crypto savings account? Why or why not? If so, which account and which asset and why? Comment below!