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What Is Stablecoin Interest and How Does It Work?

By Brian Nibley · October 10, 2022 · 5 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

What Is Stablecoin Interest and How Does It Work?

Stablecoin interest refers to the interest rate that investors can earn by lending out their stablecoins.

Stablecoin holders can put their tokens on a number of platforms that lend those stablecoins to other investors in exchange for a fee. Because the rate for borrowers is higher than what depositors receive, some companies are happy to provide this service, as they pocket the difference.

Some platforms that let investors earn interest are centralized, while others are decentralized. Because there are different types of stablecoins on the market, and this sector has come under the scrutiny of regulators in 2022, it’s important to understand how stablecoins work.

Understanding How Stablecoins Work

Stablecoins are unique among the many types of crypto. A stablecoin is a cryptocurrency whose value is pegged to a particular asset at a 1-to-1 ratio. Most often, the asset is a fiat currency, like the U.S. dollar (USD), though it can also be a commodity like gold.

U.S. Dollar Coin (USDC), for example, is a U.S. dollar-backed stablecoin that allegedly holds 1 dollar in reserve for every 1 USDC in circulation. To understand what USDC is: One USDC generally has the same value as one dollar.

That said, despite the name, stablecoins have a less-than stable track record. The stablecoin sector has come under scrutiny, owing to questions about their actual fiat currency reserves and how stable these coins actually are.

Different Types of Stablecoins

When discussing stablecoins, it’s important to consider which category the coin falls into.

There are three main types of stablecoins:

•   Fiat-collateralized stablecoins

•   Crypto-collateralized stablecoins

•   Algorithmic stablecoins

Fiat-collateralized stablecoins like USDC or Tether (USDT) are widely thought to have the least possibility of losing their peg.

Crypto-collateralized stablecoins (like DAI) might be considered somewhat safer, but still carry the risk that their collateral could lose value.

Algorithmic stablecoins, like Iron Finance (IRON), might be the riskiest, as most have seen their values drop to zero. One notable stablecoin failure occurred in May 2022, when the Terra stablecoin fell below its $1 peg and collapsed.

💡 Recommended: Understanding the Different Types of Cryptocurrency

What Are Stablecoin Interest Rates?

Stablecoin interest rates refer to the amount of money investors can earn by depositing their stablecoins into a centralized lending platform or a decentralized smart contract.

Interest rates are often referred to as yields — i.e. the amount an investment can yield over time. An interest rate of 5% annual percentage yield (or APY), for example, could earn an investor $50 on an investment of $1,000 over 12 months. One of the benefits of cryptocurrency is that anyone from anywhere in the world can earn interest on stablecoins. Many exchanges offer 8% to 12% interest or more on stablecoins.

Why Are Stablecoin Interest Rates So High?

Interest rates on Stablecoins are high for a few reasons:

•   Stablecoins involve greater risks than a traditional savings account

•   The market is still new and immature

•   Traditional savings rates are at or near historic lows

We may view stablecoin interest rates being “high” as a relative comparison. In the 1970s, savings accounts and U.S. Treasury Notes yielded rates of around 17%, which is comparable to some of today’s stablecoin rates.

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Tips for Earning Stablecoin Interest

If you are earning high interest on stablecoins, you are wise to consider two risks: 1) that the coin could lose its 1-1 peg, and 2) that the lending platform might become insolvent.

1.    First, make sure the stablecoin you’re using is actually stable. The coins need to have audited reserves showing that their tokens are backed by a fiat currency at a 1-to-1 ratio. A coin with proven backing could carry less risk.

2.    Second, it’s critical to conduct due diligence on whatever platform you’re using to earn stablecoin interest. While all of these platforms are younger and less proven than traditional banks or credit unions, some still could be more trustworthy than others. Before you invest, consider looking at user reviews, reading the terms of service, and finding out as much as you can about how the company works and who is behind it.

Investors have lost a lot of money because they assumed that their stablecoins would always maintain their pegs, and the platforms they used would always stay solvent. Neither is necessarily true.

Keep in mind that there is no Federal Deposit Insurance Corporation (FDIC) insurance for stablecoin lending platforms. So, if the company goes bankrupt, investors could possibly lose everything. There may be no legal means by which to recover funds or protect yourself until new regulations are put in place.

Stablecoin Interest on CeFi vs DeFi

There are two different types of platforms that can be used to earn stablecoin interest: centralized finance (CeFi) platforms and decentralized finance (DeFi) platforms.

•   CeFi platforms require customers to comply with anti-money laundering (AML) and know-your-customer (KYC) rules. They usually manage users’ funds and hold the private keys to their customers’ crypto. Some CeFi lenders offer insurance to protect against losses, while others do not.

•   DeFi platforms work a little differently. Instead of the borrowing and lending being handled by one central entity, financial activities in DeFi are managed by smart contracts. These programs provide automatic lending pools to participants. The system operates outside the control of any centralized authority and users’ assets are held in a non-custodial way, meaning they are controlled by the users, themselves, not a third party.

Types of Stablecoin Interest Platforms

CeFi

DeFi

Governed by a central entity Governed by smart contracts
AML and KYC compliance enforced No verification required
Custodial Non-custodial

Pros and Cons of Stablecoin Interest

Here are some of the pros and cons of earning interest on stablecoins.

Advantages:

•   High interest rate. The interest rates that you can earn on stablecoins typically exceeds that of traditional savings accounts and even long-term savings bonds.

•   Less verification required than traditional banks. In many cases, anyone can access the stablecoin interest market.

•   Allows users to remain within the cryptocurrency ecosystem. Exchanging fiat currency and crypto often involves long wait times and additional fees. With stablecoins, users can switch between traditional cryptocurrencies like Bitcoin or dollar-denominated stable crypto like USDC without having to make bank transfers.

Disadvantages:

•   Rates can vary without notice. Especially in DeFi, interest rates can fluctuate wildly.

•   Risk of losing 100% of principal. While some CeFi platforms might offer insurance, many do not. In the past, platforms have gone bankrupt, leaving investors empty-handed because there was no insurance.

•   Lack of transparency among many coins. Currently, stablecoin issuers are not required to disclose which assets back their coins, though this could change soon, based on proposed legislation. Borrowing and lending institutions also may not need to provide full disclosures regarding their operations at this time.

Pros and Cons of Stablecoin Interest

Pros

Cons

High interest rates Rates can vary
Minimal verification needed Risk of 100% loss of principal
Funds can remain in crypto Lack of transparency around reserves

Interest on Stablecoins vs on Savings Accounts

Interest on stablecoins can be much higher than the average interest rate on a bank savings account. Most savings accounts today yield very little, although some high-yield savings accounts might offer close to 1%.

Compare this to interest on stablecoins, which in 2022 can range from about 4% to 12%. Note that over time, these yields likely could fall.

The Takeaway

Anyone who holds stablecoins can earn interest on them easily. While the potential returns are attractive, the risks are also high. Investors should be aware that it’s possible to lose 100% of their investments.

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FAQ

How do stablecoins generate interest?

Stablecoins generate interest in much the same way as a bank. A business entity accepts stablecoin deposits from investors and loans those coins out to borrowers at a particular interest rate. Depositors then receive a portion of the interest paid by borrowers.

Can you really earn interest on stablecoins?

Yes, you can earn interest by lending your stablecoins. Be careful to select a borrowing/lending platform with a good reputation, as some have gone bankrupt in the past and some could be scams posing as legitimate companies.


Photo credit: iStock/filadendron

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