DeFi vs. Banks | Are Stablecoin Yields The New Savings Accounts?
We all have heard phrases or felt sentiments such as these, “Things aren’t like they used to be,” “The rich get richer, and the poor get poorer,” “Our financial system is broken,” and “Banks are ripe for disruption.” Even your everyday Joe, who doesn’t actively participate in investing or follow financial news, can sense that things are changing and something isn’t quite right.
You might notice in your budget that food costs have increased much more than what you’re being told the inflation rate is or that bank’s savings account rates seem only to go lower.
I’m going to explain why your bank savings account offers such a low yield and why you shouldn’t give up on the idea of earning more from your cash savings. How the traditional financial system is failing, and specifically how Decentralized Finance (DeFi) is benefiting early adopters around the world.
Savings accounts and inflation
The average savings account rate at large US banks is 0.06% today. In 2009 it was 0.2%, and it has only gone down since then. People have gotten used to earning next to nothing from bank accounts. However, we’ve heard our parents’ stories about how much they used to be able to get from a savings account. Back in 1990, it was common to see regular savings accounts at 4.5% to 5.5%, and in the ’80s, they were even higher. But we always have to consider inflation in the equation.
The official inflation numbers from the Federal Reserve are now at 8.3%. That is slightly down from the previous months, 8.5%, the highest we have seen in 40 years.
We find that bank savings rates often rise and fall with inflation, but this is less consistent than expected. There are other factors at play. So let’s look at why savings account rates have not gone up with inflation this time around.
What determines savings account rates, and why are they so low?
Although financial institutions set their interest rates, they have many limitations and variables to consider. Those variables include profitability, the fed funds rate, the demand from the market for loans, and competitors offering higher yields.
The federal funds rate is set by depository banks charging other banks on overnight/short-term loans. By law, banks must maintain a reserve equal to a certain percentage of their deposits in an account at the Federal Reserve bank.
Most banks and financial institutions don’t have an account with the Fed, mainly the biggest ones do. Since 2008, the fed funds rate and variables that influence it have changed. The main addition is the Fed paying interest on excess reserves to the banks (IOR). IOR is the rate banks get paid on their deposit account with the Fed.
Because the Federal Reserve can print money, they choose whatever rate to pay the banks on their reserves based on their target for the fed funds rate. This addition allows them to implement quantitative easing (QE, easy monetary policy.) Without IOR, the fed funds rate would drastically decrease due to the supply of new money flooding the bank’s reserves.
The Fed is basically creating a floor to the actual fed funds rate. It works because the banks would not decide to lend their reserves to other banks unless they produce a higher return than what the Fed is paying them. The savings account with the Fed is considered the risk-free rate, whereas the loan to another bank has counterparty risk.
The fed funds rate trickles down to affect other interest rates, including your savings accounts and the rates you pay on auto loans, credit cards, and mortgages. Another way to think about the federal funds rate is the cost of money or the cost of borrowing cash overnight. So far, the Fed has successfully raised rates from 0% to between 0.72% and 0.83%.
Banks don’t need to attract new deposits depending on the market environment, so they’re not as motivated to pay higher rates. In a contracting or stagnant credit environment, the banks don’t see enough opportunities for new loans to make the returns they need for the risk they would be taking on.
That return to risk ratio from loans is relevant to what they can get from their investment side of the banking services, which goes into assets like stocks, bonds, etc. They will always have both types of investments. A comparative way to look at it is like a diversified capital allocation portfolio. They will be rebalancing based on where the opportunity lies between personal/business loans, mortgages, etc., vs. stocks, bonds, and cash.
However, these banks can’t force market participants to take on loans from them. Banks are on the sell side of loans, so they are subject to the demand side from individuals and companies wanting to get loans.
Our personal savings rates in the US jumped during the pandemic mainly from the Cares act/stimulus checks, recession fears, and a pause on rent and student loan payments.
(This consistently goes up over time from new money creation and spiked during Covid)
Banks don’t need to incentivize more depositors without a corresponding increase in demand. Another source for demanding higher rates would come from the customers voting with their money by going to competitors offering better rates like newly started online banks. These competitors are still only in the 0.5% to 0.75% range in most cases. So even though it could be a 10x increase, it still doesn’t look very enticing or worth the effort, especially when inflation is high.
Smaller banks require customer growth/bank depositor growth more than big banks. That is why they offer higher yields, choosing to value growth over higher margins. At the end of the day, banks won’t raise savings account rates, even if the Fed funds rate continues to increase until they need more deposits (supply for loans) to keep up with an increase in demand for loans or they are losing too many depositors due to customers going to alternatives.
These things happen in reaction to knock-on effects. Many other factors are at play as interest rates are a beast of a topic. Still, the key takeaway is that the Federal Reserve influences the most critical rate, the fed funds rate, which trickles down to all other interest rates in the economy.
How does regulation affect the efficiency of financial companies/banks?
The regulator’s goal, especially since the 2008 financial crisis, is to avoid a systemic collapse at all costs. Established banks and financial institutions also have this risk-averse approach because they have been at the top of the food chain for a long time. Many institutions and government actors have a vested interest in and benefit from maintaining the status quo. As you can imagine, there isn’t much desire for innovation or experimentation within the system, which is why we see it coming from outside through Bitcoin and crypto.
This is straight from the Federal Reserve.
“Regulation entails establishing the rules within which financial institutions must operate. This includes issuing specific regulations and guidelines governing the formation, operations, activities, and acquisitions of financial institutions.” “Several federal and state authorities regulate banks along with the Federal Reserve. The Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), the Office of Thrift Supervision (OTS), and the banking departments of various states also regulate financial institutions.”
That’s quite a lot of human capital and resources. It’s challenging to calculate the cost of regulations, but that hasn’t stopped people from trying.
Competitive Enterprise Institute’s annual report
There are specific limitations for almost every kind of financial product offered. A simple example is a cap on the interest rates that banks can provide for things like money market accounts/funds.
The ever-changing and enormous amount of banking regulations creates a significant barrier to entry for newer players and requires access to massive amounts of capital. This discourages financial innovation because it would usually come from new companies and entrepreneurs rather than the big players. Not to mention the power that large banks have, and any large companies have, to stomp out their competition through various methods.
Another example of inefficiency is how slow and cumbersome the process of getting a loan can be. Especially if the economic conditions are tight. These rules are meant to provide safety but they do not come without downsides.
Long story short, regulator’s requirements bring added costs and bureaucracy to all financial institutions. Regulations will always have pros and cons that must be weighed against each other to try and find a healthy balance.
The regulators are trying to weed out bad actors, maintain stable financial infrastructure, and establish fraud protection. Achieving these results is expensive for everyone and doing it without going too far isn’t easy. Immutable, transparent, and globally dispersed ledgers sure sound like a better solution, doesn’t it?
Let’s dig into decentralized finance and its value proposition.
What DeFi does better when it’s done right.
The backbone of the financial system hasn’t evolved much since the 1940s. Most people don’t realize this because additional layers cover it up. Those layers are what we interact with.
By adding intermediaries and financial technology companies (fintech), it seems as though the financial industry has kept up with the speed that the internet brings, but when you pull back the curtain, this is not the case.
DeFi
DeFi leverages the innovative combination of cryptography, decentralization, and blockchain technology to build a modern financial system from the ground up.
Believe it or not, especially for those of you new to crypto, DeFi is a much simpler ecosystem than the traditional financial world. That is one of the advantages of being designed from the bottom up in recent times. Rather than the conventional financial system, whose foundation was designed in the early 1900s with additions and fixes stacked on top. You can’t keep patching a sinking ship forever; you have to abandon the boat at some point. As Raoul Pal called it in 2020, “The Bitcoin life raft.”
I want to be clear upfront, DeFi is not yet a robust, fully decentralized ecosystem. It’s not offering as comprehensive a set of services as tradfi. We’re not at the stage where we could run the whole world on DeFi.
That shouldn’t stop us from taking advantage of specific areas within DeFi that are more mature and proven than others. One such area that provides a similar service offered by banks but with significant benefits is earning yield on stablecoins through decentralized protocols.
Banks require thousands of employees to function, whereas decentralized protocols require far less human labour. Smart contracts can automate services like storing, lending and transferring your coins. A smart contract is a self-executing contract with the terms of the agreement between buyer and seller directly written into lines of code.
DeFi’s design is much closer to, or entirely, peer-to-peer (P2P) instead of peer to business one, to business two, and so on until peer two is involved. The fewer hands involved in the process means, the fewer parties taking their cut.
I mentioned this briefly, but transparency is a core tenant in making a blockchain a blockchain. Blockchains, protocols, and smart contracts must be transparent/publicly auditable to bridge the gap in trust for the users. Instead of trusting a centralized party to carry out a transaction, we are verifying the code of the transaction itself. This is where the phrase “don’t trust, verify” came from in the crypto space.
Some of the transparent and visible things on a blockchain are the trading volume (across all exchanges), the number of outstanding loans, total value locked in a protocol (TVL), total debt, and, of course, transactions. These cannot be easily tampered with because it is verifiable and public. Another advantage blockchain’s public nature brings is that it makes accounting much more accessible. The accountant’s job can often be completely automated.
One of the critical components of this new financial system is stablecoins. Stablecoins, just like Bitcoin and Ethereum, are bearer assets, meaning you own them without needing permission from someone. Other examples would be physical gold, physical cash, or coins. Your bank deposits would not be bearer assets as they are simply numbers on a screen representing the bank’s internal ledger.
A huge advantage of digital bearer assets is that they can achieve final settlement when transferred from one wallet to another. This is one of the reasons that intermediaries for transactions are unnecessary in DeFi. The speed and cost of final settlement depend on the properties of each blockchain.
Still, it is the same speed and cost no matter where the transaction is sent globally. (location-agnostic, i.e., it doesn’t matter if the wallet owner resides in the US or China; however, other factors can change the efficiency of a blockchain transaction.)
Some people mistakenly compare the TPS (transactions per second) of blockchains to payment networks like Visa or PayPal. Financial intermediaries are using their liquidity to cover the costs of the transactions until the final settlement occurs much later.
Seeing the digits on your PayPal app change from a bank transfer when you realize that’s all it is, just digits on a centralized ledger. Put another way, the banks and fintech companies simply send and receive messages about transactions/transfers.
Bitcoin and Ethereum or the faster chains like Solana and Avalanche, etc., achieve final settlement transactions in seconds and minutes compared to the tradfi final settlement of 1 to 3 business days. Depending on the circumstances and if national borders are being crossed, it can be much longer.
Bitcoin and stablecoins are already being used for international transactions and remittances. The obvious example is El Salvador, which made Bitcoin legal tender in late 2021. Many small countries like El Salvador rely on remittances for 10–21% of their GDP. They benefit the most from saving on costs and foreign exchange fees, so it makes sense why they have been the first sovereign adopters.
Market structure
Most of DeFi is over-collateralized. Specifically, with the peer-to-peer borrowing and lending markets, many prominent protocols require more collateral than the loan value, unlike fractional reserve/leveraged bank loans.
In tradfi, the collateralized credit markets are way smaller than under-collateralized credit markets. DeFi will likely eventually mirror that of tradfi in the size of collateralized credit markets relative to under-collateralized.
Crypto is a fantastic medium for real-time economic/monetary experiments, which cannot be understated. The system the US and, therefore, the world have been running on since we went off the gold standard in 1971 is one big experiment.
Economic theories have been tested on the largest scale throughout all of history. Although there are ways to test these theories in small, controlled environments, crypto takes this to the next level.
Anytime you can increase the frequency of experiments, you will discover exponential growth in understanding and advancement. Interestingly there is a branch of monetary economic theory called algorithmic central banking. So that is not something that Satoshi invented.
In 2020, Hasu wrote about DeFi and central banks learning from and taking ideas from each other and how the new financial system could be a mix of the two. He also explores the idea of removing governments’ ability to influence central bank policy through popularizing ‘commitment structures.’ An interesting concept to think about for sure.
What determines the yield of stablecoins in DeFi?
If bank savings accounts are around 0.06% and at the same time they will offer us loans at much higher rates, then wouldn’t it make sense that the user should be getting a more significant portion of the returns?
This spread between depositors’ returns and the rate charged to borrowers is an example of the inefficiency that DeFi removes. Even though lending protocols charge fees, a large portion of the interest paid by the borrower finds its way back to the lenders.
Both sides of the transaction get a better deal than in tradfi because the user/depositor is also the lender. Even centralized crypto companies take advantage of various DeFi yielding protocols on the backend. The difference is that in DeFi, you truly own your assets, while with CeFi, it’s still the middleman who controls your assets.
Getting more for less is the natural result whenever innovation and technology are allowed to thrive.
For perspective, decentralized stablecoin yield products offer at least 0.2% for the safest methods. The riskiest and most complicated yield farming strategies range between 50 and 100%+. There are plenty of low-risk yield strategies that give around 5–10% returns.
The disparity in return is caused mainly by different levels of risk, whether there’s leverage involved and timing considerations. Being early can give you a big chunk of the pool rewards as there are fewer participants. Different protocols also have different tokenomics (token economics.) Highly inflationary tokenomics can provide a higher return for a limited time (sell pressure usually pushes down the token price and hence the yield).
You can achieve higher returns with various leveraged strategies, but this requires know-how to manage and accurately evaluate the method.
As a general guideline, anything much over 7–8% is likely not sustainable long-term. (The higher yields are often paid out in the project’s coin via dilution of its supply, AKA inflation). The 7–8% isn’t a hard rule. It is always a good idea to thoroughly analyze the source of yield.
During bull markets, rates will increase due to a higher demand for loans and heightened trading activity. The opposite is often true for bear markets. For example, in the 2018 bear market, we saw stablecoins yielding around 4–5%.
If I went into all the ways DeFi projects generate a return on your stablecoins, we would be here all day. But it’s something we will cover in-depth in a future article.
Difficulties with DeFi compared to bank accounts.
One of the advantages a bank savings account has over DeFi today is being FDIC insured. This covers up to $250,000. It’s worth mentioning that this would not cover something like a bank run for any of the largest banks. The FDIC reserves make up only 1–2% of the amount they insure across US banks. So if a small to medium bank goes bust, that’s manageable. Or if there are isolated hacks, it’s good for that.
In Europe, the FDIC equivalent is the deposit guarantee scheme. In general, the guarantee covers deposits up to 100 000€.
The crypto industry does not (yet) have similar standards. But various insurance products already exist, and new ones are coming to the market. Still, a lot of stress testing needs to be done.
Crypto gives the ownership back to the people. It means that users keep their coins in self-custody wallets. This requires learning best practices to protect your funds from bad actors.
One way to limit your risk of getting funds stolen from a hack is to be sceptical of newer/untested projects and use proper security measures. Ensure they have open-source code that reputable firms have audited. When interacting with new DeFi protocols, It’s safer to use a separate wallet address than the one (or more) that holds all your assets. It is wise to diversify your protocol exposure and not invest in or commit more than you’re willing to lose. The same is true for CeFi.
Conclusion
There are billions of unbanked and underbanked people in the world. DeFi provides banking services to those who need it most. Those who worry about their money being confiscated or frozen by their government. Those who need a way to save in a world of currency debasement. All you need is an internet connection and a free digital wallet. Blockchain has the potential to be a more transparent and secure system that does not rely on complex regulation-driven relationships.
DeFi is a new form of finance built for the modern age. A more inclusive and more efficient system. One where you can beat inflation by earning a lot higher yield than the banks can offer. However, it’s still complex to use and has quite a steep learning curve. That’s why we built Clip Finance. To simplify the DeFi experience and make higher yields accessible for all. Stay tuned for more educational DeFi content!
How Clip Finance delivers the DeFi benefits globally
Clip Protocol is a single-click yield optimization protocol. We find the best opportunities in DeFi, auto-compound your rewards, and diversify your risks by routing your funds to multiple yield-earning strategies. Smart contracts execute the process from choosing the method, routing the user funds, auto compounding, and exiting underlying yield farms without active human intervention.
