Reckless – Chapter 11: The Earn Model

Chapter 11 of the book Reckless: The Story Of Cryptocurrency Interest Rates is published below. The full book is available on Amazon. The book was written before the bankruptcy of FTX and therefore does not include coverage of this event. However, the book does provide useful commentary in the run up to the failure of FTX, which provides context for the eventual calamity.

BlockFi’s Earn Pivot

In March 2019 BlockFi rolled out a new feature: interest bearing cryptocurrency deposits. This is often referred to as the “earn” model, a way to attract retail deposits. As the project launched, a client could deposit Bitcoin and earn a yield of 6.2%. This was a variable interest rate and BlockFi reserved the right to change the interest rate at any point in time. When questioned about the interest rate in 2019, the BlockFi CEO, Zac Prince, described the rate as a “loss leader”. Prince went on to say:

We believe that we will be able to continue raising venture capital supporting the growth and at a certain point down the road [when] we’re a much bigger company, maybe we’re a public company, then we can say: ‘Ok, we turn to profit now.’ We anticipate being able to raise larger and larger amounts of venture capital for a while, at least for the next couple of years.

Mr Prince was considered a darling of the VC firms. He thought like them and said what they wanted to hear. Growth was the priority, not generating cash flow, profitability or sustainability. BlockFi generated significant losses due to this strategy. In 2020 the company made a gross loss of US$5 million on US$64 million of revenue. This loss was due to negative interest spreads, designed to attract customers, grow and build market share. When including administrative and other costs, the company generated US$63 million in operating losses in 2020. In 2021, a year of massive cryptocurrency price appreciation and flows into the space, the company did generate a gross profit, however the operating loss was even larger. The operating loss in 2021was US$222 million, on the back of US$101 million in staff costs, US$45 million in marketing costs and amazingly US$37 million in Ethereum gas fees (transaction fees). This growing cost base was to facilitate the huge growth, which was expected to continue. In 2021, client assets generating a yield increased by 125% to US$9.9 billion and BlockFi’s headcount soared 121% to 818 people. This was clearly following the playbook BlockFi’s investors wanted. In a period of such low interest rates and cheap money, they were happy to keep financing the losses as long as the company was growing and future fundings rounds at higher valuations were on the cards.

The theory that BlockFi did not need profits early on as investors could finance the growth was proved correct. Venture funding appeared incredibly easy to obtain. According to Crunchbase, BlockFi was able to raise:

• US$50m in a debt round in July 2018,
• US$4m in a convertible note in December 2018,
• A venture round in January 2019,
• An US$18.3m Series A round in August 2019,
• A US$30m Series B round in February 2020,
• A US$50m Series C round in August 2020,
• A US$350m Series D round in February 2021 at a US$3 billion valuation, and,
• A US$500m Series E round in August 2021 at a US$4.5 billion valuation.

This represents total funding of US$1 billion. Investors included Bain Capital, Tiger Global, Susquehanna Government Products, Peter Thiel, Jump Capital, Castle Island Ventures, Three Arrows Capital (3AC), Galaxy Digital, Coinbase Ventures and Paradigm.   A who’s who of some of the most respected VC firms in the world including the biggest cryptocurrency VC firms.

This growth model often works in the technology sector, when backing the clear leader such as AirBNB or Uber, or even Amazon. These companies can operate at a loss for years, building their dominance and only then do they raise prices and generate profits. This is probably what the VC investors had in mind. However, it is not clear if this aggressive growth at all costs plan always works. Particularly in the financial services industry, when lending is involved. At the same time BlockFi was not especially dominant. There were other competitors and it did not seem logical that this lending and banking business model had a winner takes all network effect dynamic, which applies in other areas. If BlockFi won customers by offering unsustainably high returns for a period of time, these customers would not necessarily remain captive to BlockFi, unlike AirBNB or Uber where there is a large pool of service providers.

BlockFi kept the yield on Bitcoin deposits at this 6% level for several years and this did attract a considerable number of customers and a large amount of capital. 6% was far above the base rate one could earn with US Dollars. In theory, Bitcoin should have low interest rates, as there is very little real fundamental demand to borrow Bitcoin. With its robust supply cap, Bitcoin is a strong asset and does not require high yields to attract investors. Especially in an environment where the base US Dollar rate in the economy was almost 0%. The 6% Bitcoin deposit rate may therefore have been too high and unsustainable. Paying a rate like this for so long probably meant BlockFi was operating with negative interest spreads, at least with respect to this product.

BlockFi also started paying interest on US Dollar stablecoin deposits. These interest rates tended to be much higher than the rates with Bitcoin or Ethereum. This is primarily because there was more demand to borrow US Dollar stablecoins and this greater demand drove up the potential returns that BlockFi could earn by lending out the US Dollars. From the point of view of the lender, it is also somewhat logical that an inflationary currency (The US Dollar) should produce higher yields than a currency with a fixed supply like Bitcoin, where most users expect its value to appreciate. To be encouraged to invest in US Dollars, one needs to be enticed with a higher yield. The US Dollar stablecoin yields may also have been too high, as they were far in excess of what traditional banks paid in the period (essentially zero). The rates may therefore have indicated that BlockFi was taking excessive risks in order to obtain these yields. Risks that the customers may not have been aware of.

However, BlockFi did implement caps on the high rates, at least with respect to Bitcoin. In July 2020 the retail interest rates BlockFi offered were as follows:

BlockFi Earn Rates – July 2020

Source: https://web.archive.org/web/20200609062720/https://blockfi.com/rates/
Note: USDC is a custodial US Dollar stablecoin provided by Circle

While BlockFi’s earn business was growing, the interest rates in its collateralised cryptocurrency lending business were also coming down. At launch the rate BlockFi lent out money was 12%, by June 2020 this had fallen to 9.75% with a 50% loan to value ratio, or only 4.5% with a 20% loan to value ratio. This 4.5% rate is a negative spread compared to the unsustainable 6% Bitcoin deposit rate on offer.

There were obviously some synergies between the cryptocurrency lending business and the earn business. Interest payments from the lending business could pay for the interest costs on the earn side of the business. Very much the idea of a simple banking model, with customer loans funding deposit interest payments. However, the earn business grew much faster than the lending business. This therefore meant customer funds were no longer just safely stored, they were now leant out to other counterparties. This applied to both sides of the business, on the earn side and the lending side, customer funds were lent out. The counterparties included proprietary trading firms, market makers and other financial entities. This was necessary in order to try and earn a yield to pay the customers the rates they desired.

While there was some retail demand to borrow US Dollars, retail demand to borrow Bitcoin was extremely low. On the other hand, some traders, proprietary trading shops and market makers did want to borrow Bitcoin. They needed Bitcoin to deploy on trading platforms such as BitMEX and move funds between cryptocurrency exchanges. These firms often did not want exposure to Bitcoin, but just wanted to use it to earn returns, deploying, for example, quantitative trading strategies they had developed in the traditional financial world into the cryptocurrency ecosystem.

BlockFi’s high earn rates persisted all the way until the summer of 2021, when the highest Bitcoin rate was lowered from 6% to 4%. At this point Bitcoin balances over five Bitcoin earned just 0.25%. The US Dollar rates also declined. Tiers were introduced for US Dollars and the highest rate went from 8.6% to 7.5%. For balances over US$50,000 the interest rate was 5%. By October 2021, BlockFi increased the Bitcoin rate slightly, to 4.5%, but lowered the cap to just 0.1 Bitcoin. Balances above 0.35 Bitcoin received just 0.1%. These Bitcoin and US Dollar rates persisted into 2022.

Ledn’s Pivot

As BlockFi lent out customer funds, they were able to offer more competitive interest rates. These superior rates helped BlockFi win market share from competitors such as Ledn. The Ledn founders asked some of their clients what they wanted: more competitive interest rates or to stick with the model of no rehypothecation. Perhaps unsurprisingly, clients chose the more competitive interest rates and Ledn started deploying client capital, although it must be said, in a much more cautious manner than BlockFi. Only Unchained Capital remained stubborn with its ultra conservative no rehypothecation stance. Ledn also adopted the earn model, something Unchained Capital never engaged in.

From 2020 onwards, there were also several other notable changes in the collateralised cryptocurrency lending industry. The lenders stopped using bank wires to send US Dollars to their clients. Instead, customers required US Dollar stablecoins. This may indicate the success, adoption and better user experience of the stablecoins. On the other hand, it could indicate that customers were no longer using the funds in the real world, to purchase things like cars and houses. It could indicate that customers were keeping the funds inside the cryptocurrency ecosystem, perhaps to speculate. Indeed, Ledn noticed that many clients would do what they called a “deposit cycle”. An example of this is as follows: A customer has 1 Bitcoin and uses it to borrow US Dollars at a 50% loan to value ratio. The customer then takes this 0.5 Bitcoin worth of US Dollar stablecoin and purchases more Bitcoin with it. This Bitcoin is then deposited back at Ledn and used again to borrow 0.25 Bitcoin worth of US Dollars. The customers were now using the cryptocurrency lending platforms to increase their exposure to rising cryptocurrency prices in a bull market, not to buy houses and avoid capital gains taxes. After Ledn spotted this customer behaviour, they then automated the whole process, allowing borrowers to obtain a 100% loan to value ratio product.

Maple

There is one more lending company worth mentioning, one marketing itself as a DeFi protocol, a project called Maple. Maple adopted the earn business model of BlockFi, attracting cryptocurrency deposits and lending it to proprietary trading firms. However, Maple was based on DeFi, rather than being a centralised company. What this essentially means is that customers deposit funds, typically in the form of USDC, to an Ethereum smart contract rather than a central entity. This contract was still effectively controlled by the Maple organisation, therefore the argument that Maple is DeFi based is a bit flimsy. It is mostly a centralised company just like BlockFi, with smart contracts used to improve transparency. In addition to the normal yield, users were also rewarded with Maple’s native token, this supplemented the yield and allowed the company to advertise a higher rate of return.

The key differentiator between Maple and the other earn businesses was transparency. With Maple you could see exactly what happened to your money. The USDC you provided was lent out in a pool to a number of proprietary trading firms and on Maple’s website all the details of the loans were provided. These details included the counterparty, the loan value, any collateral they provided (typically Bitcoin or Ethereum), the loan duration and the interest rate. The counterparties included many of the top trading shops and market makers in the space, including Alameda Research, Wintermute, Amber Group, FBG Capital, GSR and BlockTower. These companies typically borrow at 10% to 15%. Lenders typically earned around 9% or 16%, when including the Maple token rewards.

According to maple.finance, at the time of writing in October 2022, around US$1.9 billion of loans have originated on the platform and the current outstanding balance is US$322 million. The peak balance of outstanding loans was around US$1 billion. Although this is a significant decline since the booming market of 2021, the loan book performed reasonably well, with only one major default of around US$10 million.

The key point here is that Maple’s more fully transparent model appears superior to the model adopted by BlockFi and the other centralised earn companies. If you are going to lend US Dollars to a group of cryptocurrency proprietary trading houses, which may be risky in certain economic climates, it’s probably better to make that clear to the lender, rather than trying to frame it a bit like a bank deposit.

New Players Join The Game

In 2021, with the earn model proving itself to be a huge success, in terms of asset growth at least, a whole host of new companies joined the game, providing the same services. With interest rates in the real economy suppressed to dangerously low levels, the recklessly high yields inside the cryptocurrency ecosystem appeared exceptionally attractive. This caused a huge flow of both retail and institutional money into the space. These investors were both keen to earn the attractive yields and also to obtain leveraged upside to increasing cryptocurrency prices in the bull market. Eager to capitalise on the flow and excitement of the space, many other companies entered, adopting the earn model.

In April 2021, leading Bitcoin researcher and engineer, Jameson Lopp evaluated the leading earn model companies. The companies are listed, with their respective Bitcoin interest rates, in the following table.

Bitcoin Interest Rate Offered to Depositors – April 2021

Source: https://blog.lopp.net/custodial-bitcoin-yield-generator-testing/

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